Correct use of entities in a real estate investing business is one of the most common mistakes I see investors making. A Single Member Limited Liability Company or SMLLC, being the most common. In the states we work, we are lucky to be afforded the opportunity to use SMLLCs because not all states allow them. A SMLLC is an LLC with only one member, and there are pros and cons with this structure, as described below.
Before I get too far, I need to say that I am not an attorney and do not practice law. I am simply sharing my experience and what I have learned from attorneys and judges through my career as a real estate investor and hard money lender.
As a hard money lender, I see a lot of business structures.The most common is by far the SMLLC. CPAs love these and push them hard. The reason for that is SMLLCs are extremely easy to set up, the are forgiving if you do not maintain them, and they do not require a separate tax return. All income and expense in a SMLLC will flow directly to the member’s personal tax return without the need to file a return for the company. This is a big tax advantage and prevents the cost and time of filing a separate tax return. The problem with this is, although it is great for CPAs, it may not be the best entity for asset protection. And what other reason would you have an LLC if you were not trying to protect your assets?
The SMLLC has some significant pitfalls. Because they are easy to set up and easy to run, many owners of an LLC will do nothing with the company. This could allow a plaintiff in a lawsuit to penetrate the LLC, leaving no protection for the owner. The two most common examples of this include, the member not having an Operating Agreement and co-mingling of funds. It sounds funny, but yes, you need to set up an agreement in writing with how your LLC will operate. This includes disclosing the owners, managers, and authorized decision makers. Of course, you will be all of these, but you need to put it in writing and sign it. Yes, you need to agree with yourself. The Operating Agreement is the bylaw of the company, and without it, you do not have a legitimate company. Co-mingling 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 into the company books as owner contributions or distributions. Once money is in your personal account, you can spend it how ever you want. If you spend the money directly from the LLC account without first transferring it into a personal account, it could be considered co-mingling personal money with business money. You would be surprised how many of our clients shop at the grocery store or Starbucks or Redbox out of their business account. These are obvious red flags that the owner is not running a separate business from themselves.
Another disadvantage to a SMLLC is the lack of protection from outside lawsuits. Let’s say you own a rental property in a SMLLC and someone slips and falls because the sidewalk was icy. That could create a lawsuit inside the LLC. In this example, assuming you run the LLC correctly, your assets outside the LLC will be safe. The challenge comes if you get sued personally, like if you were to get into a car accident. In that case, all 50 states will allow the creditor to obtain a charging order giving them rights to the LLC distributions. A charging order would award the creditor any distributions the LLC makes to that member. You can protect the LLC from a charging order by not making distributions. In most states, this charging order rule is set aside for SMLLCs, and the creditor can force a distribution to the single member. Charging order rules are there to protect the other partners or members of a group. Most states view the a SMLLC as an asset owned 100% by the member and there is no need to restrict a creditor because there are no other members to protect. The advantage of the charging order for multi member LLCs is it protects all the other members from personal liability by any one member. There are three states that I know of that will prevent a forced distribution with a charging order on a SMLLC, which is why you hear some gurus say you should set up your company in Delaware or Nevada. Although it is true that these states offer some additional protection to SMLLCs, it requires that you file each year in their state. That could include paying for a registered agent in that state AND you will need to file the foreign entity in the state you want to do business in. This costs more money and leaves additional room for error by not operating the company correctly. Setting up a multiple member LLC, even if it is a close friend or spouse with a minority interest, will offer the same or even better protection from charging orders. States govern LLCs, so it is important to check state laws when deciding what entity to use and where to file that entity. It is important for you to speak to competent legal council about your situation and your state LLC rules before you make any decision.
I am not saying that you should never consider a SMLLC. In fact, quit the opposite. If you are just getting started and do not have a lot of assets to protect, it probably makes since to use an entity that is easier and cheaper. A SMLLC is extremely easy, so it is a great starting point. One benefit of a SMLLC is it allows you to get a separate tax ID number, which is important when you need to send tax forms to vendors. You do not want to hand 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 are taxed. No matter how you decide to structure your entity, it is highly recommended you operate it correctly.