Questions You Should Ask Before Forming an LLC
Limited Liability Companies (LLCs) can be advantageous depending on the strategy a real estate investor chooses to employ. There are some crucial questions you should ask to determine if an LLC is the right choice for your real estate investments.
Starting a business is an exciting experience. As you begin to formalize your plans to start a Limited Liability Company (LLC) , it also comes with lots of questions. Everything from your marketing strategy to determining your entity structure are important things to consider. These decisions can greatly impact how your business operates along with benefits and potential limitations.
In this article, we’ll be focusing on business structure. An LLC is one of the most popular structures for those forming a business. Before you commit, it’s important to evaluate the pros and cons. This article is not intended to be legal advice, for that you should defer to the help of an attorney specializing in real estate and business law. You will also want to consider the tax implications of each business structure by consulting with a certified public accountant (CPA).
Instead, the focus of this article is the thought process behind your final decision. These questions are a way to get you thinking about what you need to know. From here, the expectation is that you conduct further research to determine what’s best for you. Here are some key questions to ask before you form an LLC.
What is your ownership structure?
Your ownership structure plays a crucial role in how you choose to proceed when formalizing your business. As the first question you should ask yourself, this is where you’ll decide if an LLC is a viable option for your business. There are different ownership structures that you can choose from:
Easy to start, and gives you full control. However, a sole proprietorship doesn’t separate your business assets and liabilities from your personal.
An easy to start structure when there is more than one owner. A partnership is formed when at least two people have a written or verbal agreement to engage in business activities together, where at least one person has unlimited liability. Other partners have at least some liability and control.
Provides the strongest protection from liabilities to owners. However, a corporation is expensive and has many layers to get started. A corporation is a separate entity created under state law which provides liability protection for owners.
If you decide to go this route, you’ll also need to determine whether an S Corporation or a C Corporation is a better choice. Much of this has to do with tax considerations, so be sure to discuss this with your CPA.
The LLC is popular and known for being the most flexible business structure. An LLC is formed by at least one person pursuant to state law which provides liability protection for the owners. LLC’s are also taxed in different structures such as personal, corporation, or self-employment.
One reason people consider using an LLC to run a business is to protect their personal assets. While it’s more challenging to form than a sole proprietorship or a partnership, it fits the requirements for many small business owners. Generally speaking, if you conduct a business through an LLC (adhering to corporate formalities, as discussed below), and a customer brings a claim regarding those business activities, that customer would be required to look to the business assets to seek compensation, – they generally can’t go after your personal assets. In real estate, this may also limit your liability to the properties held within it.
Do you plan on investing in a new state?
A common question for newer business owners especially in the real estate industry. Having an LLC in another state has advantages that any business owner should consider. Real estate investors, for example, may wish to invest long distance in other states. However, each state has their own regulations. Some states have laws in place that favor tenants and others lean towards landlords. States also have different tax rates and other considerations.
Growing a real estate business means that you’ll likely consider other states to invest in. By forming an LLC for this reason, it creates an organized sheet for your assets and liabilities for real estate investments in each state where you operate.
The largest challenge here is the fact that every state operates differently. Most states consider an LLC formed in another state to be a “foreign LLC”. A foreign (from another state) LLC typically needs a registered agent for service in each state which incurs more fees and expenses. State laws vary so it takes research to figure out if it makes sense to form an LLC there or not. If you are considering investing in real estate in another state, you should consult an attorney licensed to practice law in that state to determine whether to form an LLC there.
Which real estate strategy are you pursuing?
Real estate investors have several strategies that they target. Two of the most popular strategies are doing fix and flip operations or collecting rental income.
If you flip homes, an LLC might make sense. There’s a lot that can go wrong during rehab that could make you liable. An LLC may create a safety net for a worst case scenario which may help you separate yourself from your business liabilities. Keep in mind that having multiple properties in a single LLC may increase the assets available to creditors. Talk with an attorney and/or a CPA to determine if forming an LLC is the answer – or if using multiple LLCs would make more sense for your situation.
As a rental property owner, this question comes down to size and tax considerations. Larger businesses are capable of owning dozens if not hundreds of properties. You may have property managers, laborers who handle maintenance calls, or partners who help you finance deals. Real estate businesses scaled higher likely benefit more from a corporation structure because of the complexity associated with the operations, e,g. rent checks, payroll, and other assets and liabilities present.
Smaller real estate owners may benefit from using an LLC because of pass-through taxation. A corporation is usually taxed directly on profits and income, and then the owners of the corporation are typically subject to personal taxes as well. If used properly, an LLC can avoid this ‘double taxation’ by passing income directly to the owner. This flexibility may reduce the overall amount of taxes incurred.
Can you shield your assets?
Generally speaking, an LLC may serve to shield your personal assets from business creditors, as long as you are disciplined about corporate formalities, business agreements and operations. That said, agreements involving a personal guarantee can defeat the effectiveness of an LLC and make your personal assets accessible to business creditors. You should act as a representative of your entity rather than acting on your own behalf, and your LLC should always be listed as the party to the agreement instead of your personal name. Be sure to seek advice from a real estate attorney to help you draft documents using appropriate wording.
There’s also a special case and phrase you should keep in mind, “piercing the veil of liability protection”. This is where the court disregards protection and holds the LLC members responsible. Generally speaking, this may be found when the company’s actions were fraudulent, unethical, there was no real separation between the individual and the company, or when certain professional services are rendered. This serves as a reminder to always abide by the law. Again, an attorney should be consulted to understand when the corporate veil may not apply to your actions.
When an LLC is properly structured and its owners use it properly to operate their business, it can help shield the owners’ personal assets.
Are there potential tax benefits?
Like other business structures, LLCs have certain tax advantages that you should consider. Depending on your industry, different write-offs are available. Be sure to consult with a real estate attorney and CPA for specific guidance throughout this process. Here’s a list of more common tax benefits for LLCs across the board.
Rental Expense. Home offices or spaces where an LLC pays rent. A portion of rent expenses are deductible.
Property Expenses. Any kind of property expenses, taxes, insurance, mortgage interest, management fees, and maintenance can all have write-offs available.
Operations. From advertising and marketing, to travel and accounting fees are included as deductibles for LLCs.
A pro tip here is to keep detailed and organized records of your expenses every year. Your CPA will know of more tax benefits available to your LLC and receipts are critical in case you have to deal with an audit from the IRS.
Should you form an LLC?
Starting a business is a milestone, but choosing the right structure is critical. When investors know what each structure entails, they can choose appropriately based on their business needs. An LLC may help a real estate investor protect certain assets and pursue long distance investing opportunities. Whether an LLC is right for your business is a decision for you to make after consulting with your attorney and/or CPA to ensure you know the pros and cons of choosing this structure.