Limited liability companies have become the most popular business entity for small, midsize, and even some large businesses. LLCs have become so popular, because they bring the limitied liability protection of corporations with the pass through taxation treatment of partnerships. But another reason why LLCs are so convenient is because unlike corporations, an LLC is not required to have bylaws, elections, meetings, or keep corporate minutes in order to maintain its limited liability so one cannot pierce the corporate veil. While the organizational documents of an LLC can require the LLC to do these things (and to add holding meetings and keeping minutes is generally good business practice), an LLC is generally not legally required to do so thus maintenance of an LLC is less cumbersome than a corporation. This is particularly beneficial if you own multiple properties and have deeded each property to its own LLC which brings me to my next topic...
Because each LLC will require minimal maintenance, it is prudent practice to put each of your properties into its own LLC to diversify liability. Any incident that would occur on the property or with the LLC owning the property that could give rise to liability will isolate the risk of loss only to the assets owned by the LLC. If all of an investor's properties are owned by one LLC, then all the properties are equally at risk of loss in litigation. If each property is deeded to its own LLC, each LLC is only liable up to the extent of the property owned by the LLC. In sum, deeding each property to its own LLC insulates liability to the property individually rather than collectively.
LLCs are considered "disregarded entities" by the IRS for tax purposes. This means that you can elect any form of taxation in regards to each property. The most popular tax treatments tend to be either as sole proprietors/parternships or as S class corporations. The best tax treatment to select is dependent on a number of factors including whether the property is for flipping or renting, how long you intend to hold onto the property, the long term goals for the property (possible 1031 exchange), and the amount of the taxable income generated by the property. Consult with an accountant well versed in tax issues related to real estate property.
Flexible Distribution of Profits
In a corporation, your right to distributions is reflected by the number of shares you own in the corporation. In a limited liability company, profits distributed by the company can be done in a number of ways regardless what each member's ownership percentage may be in the LLC. A 75% equity owner may only be entitled to 25% of profits and vice versa. A member may only have a profits interest in the LLC rather than a true equity ownership interest in cases where someone may be managing the property but didn't put up any capital in order to help acquire the property. In sum, there are a variety of ways to distribute profits in an LLC that isn't limited to having to buy a certain number of "shares" in the LLC. Keep in mind, the tax treatment you choose to elect will greatly affect an LLC's ability to take advantage of this feature. Coordinate your accountant with your attorney to figure out what is the best structure for your business.
LLCs can also provide asset protection in the event an investor hits hard times and may have to declare bankruptcy. Because the properties have been deeded to the LLCs and are now the property of the LLCs, they cannot become part of the bankruptcy estate. There are a few caveats to this rule. The first being is that the properties must be deeded to the LLCs BEFORE insolvency occurs. For asset protection to work, it must be done proactively - not reactively. If the properties are deeded after bankruptcy is declared or a judgment causing insolving occurrs, a court will typically void the transfer because it will be deemed a "fraulent transfer." While a creditor may not be able to seize the properties themselves to satisfy the debt, it may seek a charging order against the distributions paid out by the LLC. A work around to this problem is for the investor to pay themselves a salary as an employee of the LLC rather than through distributions as an equity owner of the LLC. See * comment.
Beware of the Due on Sale Clause
If the property you plan on transferring to the LLC is financed, be sure to get the lender's blessing. Most mortgages have what is called a "due on sale clause" which states that if you transfer or sell the property to another party the lender has the right but not the obligation to accelerate the unpaid amount of the note. Most lenders will not have a problem with an investor transferring their property to an LLC but be sure to get their permission before hand.
Beware of Title Insurance Issues
Once you deed your property to the new LLC, you could possibly end up nullifying your title insurance policy purchased on the property if you transfer the property via quiclaim deed. There are a couple of ways to handle this problem. The most successful way to ensure the title is protected on the property after the transfer is simply to call up your title insurance carrier and ask them to transfer the existing policy to the new entity. It may cost a small fee, but it is worth the element of certainty. Another possible way to avoid a title insurance coverage problem, would be to convey the property via warranty deed. In the event a title claim were to arise, you (the grantor) would end up suing yourself with your own LLC (the grantee). At that point your title insurance carrier would be required to honor your claim for coverage. However, this can get really messy and of course requires the title insurer to honor the claim. Option 1 is much more preferable than option 2.
*The effectiveness of a charging order can vary greatly from state to state. Additionally, single member LLCs may have the entire interest seized even up to the extent of management and voting in federal bankruptcy. Speak with an attorney in your jursidiction regarding the treatment of LLC charging orders in your jursidiction on the state and federal levels.
DISCLAIMER: This guide is for informational purposes only and does not constitute legal advice. Consult a licensed attorney in your jurisdiction for advice on setting up the right entity for your real estate investment property.