Rental Property: Should I put it in an LLC?
Investment property is real estate purchased to buy and sell for a profit or to produce rental income. Many investors who purchase rental properties own them personally. A more prudent way to own rental property for investment purposes is to form a Limited Liability Company (LLC) to own each property. This method protects it’s owner-member’s personal assets—cash, equity in real estate, primary residence, investment accounts, retirement accounts, etc. – from litigation. It also allows for more flexible profit distribution and estate planning.
Liability Protection Benefits
If the owner of real estate rental property has a personal creditor, the creditor generally cannot make a claim on real estate owned by an LLC. Should tenants, guests, or anyone else on the property sustain injuries, and if the rental property is owned in the client’s name, the owner’s personal assets are at risk.
Example: An owner has a rental property occupied by a young couple. The couple has a holiday party. One of their guests falls down stairs and is hospitalized. The guest sues the owner for her injuries, claiming the stairs were hazardous. If the guest successfully wins the claim against the owner, any judgment in excess of the liability insurance can be satisfied from the owner’s personal assets.
An LLC formed with two or more members is classified as a “pass-through” company for tax purposes. This means the LLC’s income is passed through to its owners and claimed on those owners’ individual tax returns. Hence, it is subject only to capital gains rates on the ownership shares of the member, and not to corporate capital gains taxes. So there is no double taxation. LLCs with just one owner-member, however, are taxed as a sole proprietorship. No separate tax return is required. So the actual tax dollars saved from holding real estate in an LLC, as opposed to personally holding the properties, is zero. However, if you actively participate in the management of the income property, and your adjusted gross income is less than $150,000, you can write off up to $25,000 in rental losses. Losses may occur, for example, due to depreciation or repair expenses. The amount of rental losses that you can write off is phased out between $100,000 and $150,000.
For example, if your adjusted gross income is $125,000, you can write off $12,500 in rental losses in the year of the loss. If your adjusted gross income is $150,000 or more, you cannot write off any rental losses in the year of the loss. Even if the loss is disallowed for that particular tax year, it is not completely lost. When you sell your income property, you can write-off any unused rental losses that have accumulated while you have owned the property.
Estate Planning Benefits
Holding rental property in an LLC has advantages for estate planning. It allows for transfer of ownership in a more seamless manner than if personally owned.
For example, when property owners owning real estate individually wish to gift certain percentages of their real estate to family members, the process can require many trips to the court house to update deeds every time percentages of ownership change. However, when the real estate is LLC owned, the owner can simply issue membership certificates to the family member. No changes need be made to the deed.
Whether you own twenty properties or one, owning them personally can be a major liability. All your hard work and planning could be wiped out with one misfortune. Understanding the benefits of forming an LLC and the pros and cons of ownership structures are important considerations when purchasing rental property.
If you have any questions about buying or selling investment real estate, please feel free to email your questions to firstname.lastname@example.org
Business Damages: Evaluating & Measuring
VALUATION of a small business to determine business damages in litigation is often difficult. Particularly if the business shows a loss on its income taxes. Our experience is that the majority of clients who run small businesses overestimate the value of their businesses, and–consequently–overestimate their losses.
The courts are crowded with people arguing over valuing everything from the income-stream of a mom-and-pop corner store to a market advantage in the sale of complicated technology. This article is limited to an overview of issues that affect the valuation of small businesses with limited fixed assets and debt financing. Here are some of the basic questions our firm asks when looking at a small business damages claim.
QUESTION 1: Lost profits or increased expenses? When looking at a profitable business, it is easy to quantify how much money the business was making before and after the event giving rise to the lawsuit. Subtract, and you have a defensible business loss as business damages.
However, if the business is not profitable, or not very profitable, looking at profits can undervalue the loss. Just because a business is not profitable does not mean that there was no business loss. There are three ways our firm thinks about capturing increased business expenses as business damages when there are no lost profits.
(1) Increased demise of the business. Sometimes the breach of a major contract, a competitor’s unfair business practice, the misappropriation of trade secrets, a personal injury to a key employee, or other “wrong” giving rise to a lawsuit is the last nail in the coffin of a struggling business. The rapid demise of a business can create its own additional losses. There is a significant difference between the timely dissolution and sale of an ongoing business concern versus a “fire sale” price precipitated by an unexpected unfair business practice, failure to pay on a major contract, or unexpected injury to a business owner. A look at cash flow can uncover the difference. If a business had revenues of $300,000, against expenses of $450,000, it is losing $150,000 a year. But, when the injury or business wrong occurs, the revenues can fall much further, while many fixed expenses stay the same. If the business is a type that is regularly bought and sold (e.g., restaurants, bars, brokerage companies), there are experts who can assist in valuing the difference between the value of an ongoing business and one that has ceased (or nearly ceased) operations and needs to be liquidated at a fire sale.
(2) Unavoidable fixed costs and unrealized expenses. Even if a business can be shuttered easily, that does not mean that the expenses of the business can be avoided. For example, lease obligations and equipment rentals that cannot be avoided become a business loss. It is worth looking at pre-injury business investments into projects that were abandoned because of the incident being sued over. For example, investments in leases, insurance, licenses, remodels and the like are all investments that the business may have anticipated recouping, and which can justify a business damages award.
(3) Key-employee replacement costs. In the case of a business owner whose suffered a personal injury, there are additional staffing costs and increased hours by existing employees while the business owner is unable to work. In addition, sometimes we can look at the average wage for what the business owner did and argue that the benefit to the business of their work was at least what they would have been able to receive on the open market.
QUESTION 2: Is the income in cash? A surprising number of businesses are profitable even though they do not generate significant (or any) cash for their owners. The rental business is one example. Many landlords are in the business as part of a long-term strategy to acquire property, even if there is no income coming out of the business. Other businesses are carefully set up to generate tax losses through–for example–depreciation of fixed assets or amortization of intangibles like patents or goodwill, and thereby offsetting other business income.
QUESTION 3: When does the money come in, and what part is from future repeat business? The easiest business to look at are those–like retail stores–that make money on each transaction at the time of the transaction. However, it is often the case that income is spread over many years and may come in long after the business owner’s work is done. For example, insurance brokers often earn a percentage of the premium paid every year the insured buys the insurance. Because many people do not change their insurance from year to year, a sale by a broker in Year 1 often means income in Years 2, 3, 4 and 5. The same is true for many professionals (doctors, dentists, lawyers, accountants) who expect income from future follow-ups. What this means is that an interruption in the business in Year 1 can cost our clients in Years 2, 3, 4 and 5. One way to inquire into this is to ask, how much of the business income is passive, and how much of it is repeat customers?
QUESTION 4: Do the tax returns reflect reality? Businesses are permitted to keep two sets of books: one for the purpose of taxes (cash accounting) and the other for their investors (accrual accounting under Generally Accepted Accounting Principles – GAAP) Plenty of tax preparers have creatively found ways of making all or nearly all of their client’s income disappear from the tax returns. It can be hard to explain to a judge or jury that, even though the business owner told the IRS that they were not profitable, the business in fact had significant income that justifies an award of business damages. The way we lawyers get around this to look, in detail, at what business expenses (tax deductions) are unavoidable when the business is not operating or operating in a limited manner, and argue that those expenses were a legitimate business expense before the incident or injury and will be a legitimate expense going forward, justifying a business damages award.
CONCLUSION: The lesson is simple: small business people are often too busy running their businesses to understand the value of their businesses. So when representing small business owners in business injury litigation– whether it be unfair competition, breach of contract, theft of trade secrets, or personal injury to the business owner–smart lawyers dig into the business books to understand the dynamics of the business. Otherwise, we may either undervalue the losses or mistakenly overestimate them when calculating the amount of business damages.
If you or your business has suffered a loss or injury for which you deserve compensation, feel free to contact us at Shenfield & Associates.
Christopher Shenfield, at Burlingame, February 15, 2016
Think Your LLC Guarantees Limited Liability? Think Again!
INDIVIDUALS CREATE LIMITED LIABILITY COMPANIES (“LLC’s”), same with corporations, for ownership and investment purposes primarily to enjoy limited liability. The idea is that if you invest $10,000 in an LLC, and someone successfully sues the LLC and obtains a huge judgment, the most you could lose is your investment–$10,000. The judgment creditor would not be able to come after you personally to collect the balance of their judgment.
However, not all LLC’s or corporations have assets from which a judgment may be collected. San Francisco Bay area business and real estate attorneys are occasionally asked by clients with judgments what can be done to go after the members, managers, directors or shareholders of an LLC or corporation.
As one group of LLC members recently discovered, if the LLC’s distributions to them leaves the LLC penniless and essentially dissolved, the creditor may collect from the members.
In CB Richard Ellis, Inc. v. Terra Nostra Consultants (2014) (“Ellis v. Terra Nova”), the real estate broker was seeking commission on the sale of 38 acres in Murrieta for $11.8 million. While the broker had the property listed, the buyer made an offer. Before closing, either the listing ended, or the LLC which owned the property fired the broker, it was not clear which. The sale closed. A few days after the cash went from escrow to the seller LLC’s bank account, it all left the account and was distributed to the members, without the broker having been paid his fee.
The broker arbitrated the fee dispute with the LLC (because there was an arbitration provision in the listing agreement) and obtained a judgment against the LLC. But, of course, the LLC had no money!
The broker then filed suit against all 25 of the LLC members. His argument was based on the California Corporations Code, which provides for liability in the event the LLC entity has been dissolved. Applicable was the old Section 17350, which was since replaced by the equivalent Section 17707.07. They provide that claims against a dissolved LLC, whether arising before or after dissolution, may be enforced against members of the dissolved LLC “to the extent of the limited liability company assets distributed to them upon dissolution of the limited liability company.”
The result in Terra Nova? The broker obtained an enforceable judgment against all 25 individual members of the LLC for the broker’s half of the commission, interest and attorney’s fees of $960,649!