Asset Protection – Part 1
Asset Protection – Part 1
Although sometimes considered an approach to risk management, asset protection is actually a subset of risk management. Good risk management includes a number of issues in addition to asset protection. Asset protection becomes important primarily when other risk management measures have not been totally effective.
Some risks can be avoided or eliminated, others can be controlled or minimized, still others can be transferred to someone else, and some can and should be retained. Part 3 of our past Risk Management series of articles discussed the
risk management approach of transferring risks to others, the most common method being that of insurance.
Many real estate investors assume that their assets are protected because they have business insurance on their rental properties and maybe even umbrella policies. Unfortunately, they are wrong. For a long time now, judges and juries have been awarding outrageously large judgments for personal injury lawsuits and there is little chance that this will change in the future. In fact, judgments will likely increase at least as fast as real estate values.
Accordingly, landlords must understand that having liability insurance policies, no matter how high the coverage limits, doesn’t necessarily provide adequate protection in the event of a large judgment. Two or three million dollars of insurance
coverage doesn’t help much when a judgment is many millions of dollars.
All assets held in the name of an individual are at risk in the event of a judgment resulting from an event related to any one rental property owned by the individual or from any other cause for litigation. Assets at risk include rental properties, personal residence, stocks & bonds, bank accounts, and all other personal property of value (jewelry, furnishings, antiques, art, autos, boats, etc.).
Insurance coverage is necessary and provides protection against many claims, but it is usually cost-prohibitive to attempt to fully protect all your assets against every possible risk with insurance at a cost that is practical. Even if you
spent the money in an attempt to cover all assets regarding all possible risks, you could still discover in the end that it provided inadequate protection.
Risk of loss of assets other than the property that is the subject of a lawsuit is greatly reduced by having rental properties vested in a limited liability entity.
A variety of limited liability entities are available in most states. Typically, these are:
- Corporation
- Limited Liability Company (LLC)
- Limited Liability Limited Partnership (LLLP)
- Limited Liability Partnership (LLP)
Although the general partners of a General Partnership or a Limited Partnership have historically been personally liable to creditors, the Limited Liability versions of those entities, where available, provide protection also to the general partners.
Each type of limited liability entity has somewhat different operation requirements and tax issues. Which entity is best depends upon a number of factors. Not all entities are available in all states or defined identically where available.
Although the discussions of this article apply similarly to any limited liability entity, we’ll discuss only corporations and limited liability companies because they are basically quite different from one another, while the non-corporation entities are quite similar to one another. Furthermore, after initial discussion of corporation basics, we’ll use the term LLC in our discussions because (1) it is the form currently most used for ownership of real properties and (2) most discussion is applicable to all types of limited liability entities.
Corporation
A corporation is created under state law and is treated by law as a legal entity. It has a life separate from its owners and has rights and duties of its own. The structure and powers of a corporation are defined in its Articles of Incorporation and its By-Laws. The owners of a corporation are the stockholders. Stockholders elect a Board of Directors, which in turn hires Officers who are responsible for day-to-day operations of the corporation. Board members and Officers may or may not be stockholders. Forming a corporation involves a transfer of money or property, or both, by the prospective shareholders in exchange for capital stock in the corporation. For the purpose of federal income tax, corporations include associations, joint stock companies, trusts, and partnerships that actually operate as associations or corporations.
There are two basic types of corporations, ‘C’ corporations and ‘S’ corporations. They are the same for most purposes except for income tax treatment.
‘S’ corporations are domestic small business corporations that can avoid double taxation by electing to be taxed under Subchapter S of the Internal Revenue Code. A maximum number of shareholders is allowed while qualifying for ‘S’ status and only certain individuals and entities are allowed to be shareholders. These limitations would not be of concern for most real estate investors and tax issues usually dictate use of non-corporate entities.
For ‘S’ corporations, income is taxed in a manner similar to that of a partnership. In general, an ‘S’ corporation does not pay tax on its income. Instead, the income and expenses of the corporation are divided among its shareholders, who then report them on their own income tax returns. Generally, an ‘S’ corporation is exempt from federal income tax other than tax on certain capital gains and passive income.
An ‘S’ Corporation must pay reasonable compensation (subject to employment taxes) to shareholder-employees in return for the services that the employees provide to the corporation, before non-wage distributions may be made to those shareholder-employees. Therefore, shareholder-employees cannot avoid employment taxes by taking all compensation as dividends or other payments that are not as heavily taxed. The IRS has recently identified this issue as an area of non-compliance and will likely be looking at it more closely in the future. In both types of corporations, profits and losses are shared in proportion to the number of shares owned.
Unlike a partnership, flow-through income from an ‘S’ corporation is not subject to self-employment tax (Revenue Ruling 59-221, 1959-1C.B. 22). In direct contrast, a partnership’s flow-through ordinary income is generally subject to
self-employment tax.
A ‘C’ corporation is a regular corporation. Profits and gains are taxed at the corporate level and dividends paid to shareholders are taxed to the shareholders, thus, double taxation. Employees – whether shareholders, directors, officers, or none of those – pay income taxes on compensation the same as if they were employed anywhere else. A ‘C’ corporation is not normally considered a vehicle specifically for real estate investment purposes, although there are sometimes reasons why one would utilize a ‘C’ corporation rather than an ‘S’ corporation, particularly when an operating business is involved rather than passive investment in real property.
Maintaining the liability protection of a corporation requires strict adherence to various procedures including those related to record keeping and meetings.
The governmental costs of forming and maintaining corporations vary significantly among the states.
Limited Liability Company
All states have enacted limited liability company (LLC) statutes. An LLC is a separate legal entity formed by filing Articles of Organization with the Secretary of State. LLCs (and similar entities called Limited Liability Partnerships – LLPs) combine certain features of partnerships with certain features of corporations, most notably, limited liability for its owners and managers. LLCs are more like a partnership, providing management flexibility and the benefit of pass-through taxation.
The individual members are not personally liable for the LLC’s debts, except to the extent of their investment and capital commitment in the company. It is important to note that an LLC is not a federal tax entity and is generally treated as a partnership by IRS. Most states also permit “single member” LLCs, those having only one owner. A single-member LLC can be treated as a “disregarded entity” for tax purposes, even though still respected as separate for legal purposes. Thus, if owned by an individual, an LLC can be reported as a Schedule C sole proprietorship on the owner’s personal tax return. There are certain circumstances when courts have recently allowed piercing of the “corporate veil” specifically for
single-member LLCs and accordingly, there is a benefit to having a spouse or other person being a member.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs, and foreign entities. There is no maximum number of members.
Another advantage of an LLC over a corporation is that LLCs have flexibility of distribution of profits and losses. One may divide up the profits and losses any way agreed upon rather than being limited to dividing them proportionate to the amounts of capital contributions.
LLCs are managed by their members unless they elect to be managed by a management group. The management group can consist of some members and/or non-members. Small LLCs are usually member-managed.
A LLC should always have a detailed written operating agreement that defines the rights and responsibilities of LLC members and managers. If you will have a manager-run LLC rather than a member-run LLC it is especially important to have an adequate management agreement. Although a registered LLC is not legally required to have written agreements and can operate on the basis of oral understandings, it can be a very big mistake to do so.
The LLC is probably the most often recommended entity for holding title to real property because it provides (1) limited liability, (2) favorable tax status, and (3) relative ease of operation.
Requirements for operation of LLCs so as to maintain liability protection are significantly less stringent than for corporations.
As for corporations, the governmental costs of forming and maintaining LLCs vary significantly among the states.
In Summary
A risk management program utilizes a number of devices including (1) practicing a variety of preventative and control measures, (2) vesting each real property in properly formed limited liability entities, and (3) having good insurance coverages. These three approaches utilized together can provide a relatively effective shield against the largest lawsuit at a reasonable cost.