One common question real estate investors of all types have – including flippers – is the question of forming a business entity. For most of you, forming a separate business entity is going to be a good idea – once you actually get involved in buying properties.
Real estate property of any kind is what lawyers call a “liability-generating asset.” Home and property owners are a steady source of income to the membership of the Trial Lawyers Association. People can slip and fall on your property, or someone can get sick from chemicals found on your property, or someone can slip and fall on your sidewalk, or a child can come and play in your unattended pool, without your knowledge, and drown. Any of these things can result in a hefty lawsuit against you – and result in a nasty cash payment, judgment and even force you into bankruptcy.
Forming a separate legal entity, such as a corporation or limited liability company – and in some cases, a limited partnership – can help shield your own personal assets against claims against your investing business. You may have a nice amount of cash in your personal account. If someone gets hurt working on your roof on a house flip, and it’s not covered by workers compensation insurance for whatever reason, everything you have in your bank account, your cars, your personal property and even your home (depending on your jurisdiction) is on the table, and may potentially be stripped from you if you lose a lawsuit and have a judgment against you.
On the other hand, if it’s not you who owns the property, and it’s not you personally who contracts with the workers and contractors fixing and preparing your properties, but a corporation, you have some degree of protection, due to the legal doctrine of corporate personhood and limited liability.
Basically, the doctrine states that a corporation or LLC (depending on state law) can enter into contracts itself, and it is a legally separate entity from the owner, with its own assets and books.
Why You May Not Want to Form an Entity
The only reason you might not want to form a separate business entity to hold your properties, really, is that:
A.) You believe you have nothing to lose (which is false, because even if you have no assets, a creditor can attach your future income).
B.) You might not actually go through with your plan to invest in a property. Once you decide to cross the Rubicon and burn your boats behind you and become an investor, though, I definitely recommend speaking with an attorney licensed in your state, and an accountant, and selecting and forming a business entity.
You’ll have to pay a filing fee and a corporation or entity tax every year. And you’ll have a few other pro forma responsibilities as well, if you form a corporation. But the asset protection you gain from this small investment is well worth it for a serious property investor. If you own a lot of properties, sooner or later chances are you’re going to get sued. You want to have that limited liability protection already in place.
Note: There’s a line in a Rush song called “Free Will” that says, “If you choose not to decide, you still have made a choice.” If you don’t form a separate entity, you will have chosen the form of a sole proprietorship for your investing business. If you have a partner investing with you, then you will have chosen a general partnership by default.
What Kind of Entity do I Need?
Remember I said consult a lawyer and an accountant? I wrote that deliberately. Yes, it’s easy enough to file articles of incorporation directly with your state’s Office of the Secretary of State without an attorney. But when you start a real estate investment practice, forming a close relationship with both an attorney and a tax expert is just one of the basic foundational tasks you will want to do from day one.
The time to have a good relationship with a lawyer is before you have a legal problem – not after. Much of the value you’ll get out of that relationship is preventative, not reactive.
Plus, state laws vary quite a bit. I can’t write a column for every state. Get a lawyer licensed in your state.
Now that I’ve punted the football, though, I can mention a few basic considerations:
C corporations have the fewest limitations on how you can raise capital. If you are thinking big, the C corporation is the way to go, because you can have an unlimited number of investors. If you are a foreign national, or you expect to have investors who are either corporations themselves or foreign nationals, you might want to consider a C corporation. You can even “go public” with these if you get big enough!
The downside of a C corporation is in how it’s taxed. If your corporation makes a profit, Uncle Sam takes a 35 percent chunk of your profits in the corporate income tax, which is among the highest in the world. As of 2013, that tax is slated to increase to 39.6 percent. So the government will take nearly 40 percent of your profits before you even see a dime yourself.
But that’s not all. Once you do take a dividend out of your corporation, you will also have to pay income tax on the corporation. For now, you get a bit of a break, in that the tax is at a favorable qualified dividend income tax rate. But come 2013, that tax goes away, and you wind up paying full boat – ordinary income tax.
This “double taxation” means that you will get to keep a much lower percentage of your total profits by the time tax time comes. For this reason, the C corporation is usually not the first choice of beginning property investors. However, a sharp attorney or tax expert may identify some special considerations that indicate a C corporation is warranted.
S corporations are much more common for smaller property investors. You still get the liability protection you get from a C corporation. But there’s no “double taxation.” S corporations are “pass-through” entities. That means that the IRS disregards the corporate profits. Instead, they “pass through” directly to your individual tax return.
The downside of S corporations? You are more limited in how you can raise equity partners. You can only have 100 owners. They all have to be “U.S. persons,” and they can’t generally be corporations or partnerships. Only U.S. resident individuals and certain kinds of trusts can own shares in S corporations. (In legalese a “U.S. person” isn’t necessarily an individual, but also can be a fictional entity under the doctrine of corporate personhood, such as a corporation or trust. But federal law specifically disallows corporations from being shareholders in S corporations.)
When forming your business plan, take a look at your exit plan, and begin with the end in mind. If it involves selling your investment company to a corporation, or it involves selling a piece of it to your rich uncle who’s a foreign citizen, at some point you may need to switch to another entity.
Begin with the end in mind.
Limited Liability Companies
A limited liability company, or LLC is sort of a cross between an S corporation and a partnership. The IRS does not recognize LLCs as a separate legal entity for income tax purposes. You can choose whether to file taxes as a partnership or corporation, so the LLC provides you with more flexibility. You can also have a wider variety of equity partners (called “members” for LLCs, and “shareholders” for corporations).
Protect Your Limited Liability
That’s some nice limited liability you have there. It would be a shame if something were to happen to it.
Limited liability is not a blank check to do stupid things with your corporation, thinking you can get away with murder because you keep very little equity in your corporation or LLC and your house is protected. The courts can and do occasionally disregard the corporation or LLC and hold the owner personally liable for claims against it. This is called “piercing the corporate veil.”
When does this happen? First, the courts and the IRS will disregard the corporation if you did not pay payroll or income taxes you withheld from any employees – including yourself, for that matter. (This is one of the biggest no-no’s in the tax code. If the IRS thinks you are not paying taxes you withhold from your employees’ paychecks, they will hunt you down like a chicken.)
Next, the courts may pierce the corporate veil if they believe you are abusing the limited liability doctrine. For example, if you are commingling your personal funds with the corporate funds, or using the corporation as a personal piggy bank, or inappropriately using your corporation to deduct personal expenses.
This is pretty technical stuff when you do it right – and things vary from state to state. I definitely reiterate my advice … speak with a good CPA and attorney – and get them on your team from day one.
Jason Van Steenwyk is a veteran financial industry journalist who has been fighting to make the world safe for the retail investor since 1999. He lives at Ground Zero of the real estate bubble in Fort Lauderdale, Florida.