Using entities correctly in a real estate investment business is one of the most common mistakes I see investors make. A Sole Partner Limited Liability Company or SMLLC, being the most common. In the states we work in, we are lucky to have the opportunity to use SMLLC because not all states allow them. A SMLLC is a single member LLC, and this structure has advantages and disadvantages, as described below.
Before I go too far, I must say that I am not a lawyer and I do not practice law. I am simply sharing my experience and what I have learned from lawyers and judges throughout my career as a real estate investor and big money lender.
As a hard money lender, I see a lot of business structures. CPAs love them and push them hard. The reason for this is that SMLLCs are extremely easy to set up, forgive if you don’t maintain them, and do not require a separate tax return. All income and expenses in a SMLLC will flow directly to the member’s personal tax return without the need to file a return for the business. This is a great tax advantage and avoids the cost and time of filing a separate tax return. The problem with this is that while it’s great for CPAs, it might not be the best entity for asset protection. And what other reason would an LLC have if it wasn’t trying to protect its assets?
The SMLLC has some major pitfalls. Because they are easy to set up and manage, many LLC owners will do nothing with the company. This could allow a plaintiff in a lawsuit to break into the LLC, leaving no protection for the owner. The two most common examples of this include the member not having an operating agreement and the pooling of funds. Sounds like fun, but yes, you must have a written agreement on how you will operate your LLC. This includes disclosure to authorized owners, managers, and decision makers. Of course, it will be all of this, but you must put it in writing and sign it. Yes, you have to agree with yourself. The Operating Agreement is the charter of the company, and without it, you do not have a legitimate company. Mixing of funds is very common and would indicate to the court that you are not operating the LLC as a business. If it is not operating as a business, it is not a business and will not offer the protections of a business. The best way to get money in and out of an LLC is to transfer money to and from your personal account and enter these transactions on the company’s books as owner contributions or distributions. Once the money is in your personal account, you can spend it however you like. If you spend the money directly from the LLC’s account without first transferring it to a personal account, you might consider mixing personal money with business money. You’d be surprised how many of our customers shop at the grocery store, Starbucks, or Redbox from their business account. These are obvious red flags that the owner is not running a separate business from them.
Another disadvantage of a SMLLC is the lack of protection against external lawsuits. Let’s say you own a rental property in a SMLLC and someone slips and falls because the sidewalk was here. That could create a lawsuit within the LLC. In this example, assuming you manage the LLC correctly, your assets outside of the LLC will be safe. The challenge comes if you are sued personally, such as if you were in a car accident. In that case, all 50 states will allow the creditor to obtain a collection order giving them rights to the LLC’s distributions. A collection order would award to the creditor any distributions the LLC makes to that member. You can protect the LLC from a collection order by not making distributions. In most states, this collection order rule is reserved for SMLLCs, and the creditor can force a distribution on the sole member. Load order rules are there to protect the other partners or members of a group. Most states view a SMLLC as an asset that is 100% owned by the member and there is no need to restrict a creditor because there are no other members to protect. The advantage of the collection order for multi-member LLCs is that it protects all other members from the personal liability of any one member. There are three states I know of that will prevent a forced distribution with a collection order in a SMLLC, which is why you hear some gurus say you should set up your business in Delaware or Nevada. While it is true that these states offer some additional protection to SMLLCs, it does require that you file a return each year in your state. That could include paying for a registered agent in that state AND you’ll need to file the foreign entity in the state where you want to do business. This costs more money and leaves additional room for error in not operating the business correctly. Creating a multi-member LLC, even for a close friend or spouse with a minority interest, will offer the same or even better protection against collection orders. States govern LLCs, so it’s important to check state laws when deciding which entity to use and where to file that entity. It is important that you speak with competent legal counsel about your situation and the rules of your state LLC before making any decisions.
I’m not saying you should never consider an SMLLC. In fact, it leaves the opposite. If you’re just starting out and don’t have a lot of assets to protect, you’ll probably want to use an entity that’s easier and cheaper. A SMLLC is extremely easy, so it’s a great starting point. One benefit of a SMLLC is that it allows you to obtain a separate tax identification number, which is important when you need to submit tax forms to vendors. You don’t want to give out your personal social security number to everyone you do business with, so I would say using an LLC and not doing business in your personal name is smart. An LLC is extremely flexible, as your LLC gains more assets you can always add a second member or even change the way you pay taxes. No matter how you decide to structure your entity, it is highly recommended that you operate it correctly.
