Real Estate Investors: Do Not Feed Your Baby To The Crocodiles!
How To Protect Your Real Estate Investment with a proper Asset Protection Plan including a properly drafted LLC Operating Agreement or Partnership Agreement!
By John Stege, Denver Real Estate Attorney
You did the research, found a great investment opportunity. It's a fix and flip, or a buy and hold, a single family residence, a townhome, a condo, or multi-family. Possibly you bought some commercial real estate. Perhaps you have an equity partner, perhaps it's just you or you and your spouse. You did all the work, and acquired the property, assumed the debt, obtained the equity investment, however you financed the deal. You are happy and proud of your investment.
You've done the work, and now you're going to make a lot of money.
Now don't let your baby get eaten by the Crocodiles!
WHAT ARE THE CROCODILES? Creditors. Lawsuits. Claims. Disputes. Whenever you own real estate for investment purposes, there are at least 15 different sources of potential liability; everything from contractor and sub-contractor claims and contract problems, redevelopment issues, landlord tenant issues, hazardous materials abatement, radon and other environmental contamination, expansive soils, issues with the foundation, the walls, the floors, the roof, the plumbing, boundary disputes, easements and rights of way issues, issues with title and prior existing liens, etc. I could go on and on for hours about different sources of potential problems associated with owning land.
Sometimes you may not even know there was anything the matter. Sometimes you may have disclosed the potential problems. Whatever the nature of the claims, someone involved in the property, whether a contractor or sub-contractor, a buyer, a visitor, a neighbor, or potentially a partner or equity investor, or a spouse -- someone is unhappy. Someone feels that they lost money, didn't get what they bargained for. Somehow there is a problem. And now they blame you! Now, there is a potential lawsuit.
Often the potential claim is many times the value of your equity. If there is not enough money in the property to satisfy them, they are going to want you personally to pay them back or make them whole from whatever injury they imagine you caused them.
That is called “piercing the corporate veil” to hold the business owners personally liable. Veil piercing is bad. How do you protect yourself from this potential problem?
That is where having a properly drafted and maintained Asset Protection Strategy comes in.
Problem: People just don‟t know what they don‟t know about Asset Protection.
Perhaps the biggest problem for startup businesses in recent years has been the significant increase in veil piercing claims by creditors holding the investors and operators of an LLC personally liable for business liabilities. And in many cases it‟s because the ease of filing an Online form at the Colorado Secretary of State website gives people the illusion that they don‟t need to do anything else to protect themselves, that they can form an LLC themselves without the assistance of an attorney.
I run into this all the time! “I've got my LLC. I filed it. I don't need to do anything else!” And many business owners, especially in real estate find out only when it‟s too late that this is just DEAD WRONG! And some businesses are started by investors who want to avoid the “expense of attorney fees” to have a knowledgeable business lawyer help them form the business.
Rule: I‟ve found that it‟s usually around 90-100 times as expensive to fix problems after they occur rather than getting it done right the first time. A corporate lawyer might charge them $1000 or $1500 to form an LLC or partnership. Down the line their litigation attorney is going to charge them maybe $30,000 to $150,000 to solve the problems that arise later in court. That‟s where lawyers make the really big dollars.
So, step 1 is really talking to an experienced small business attorney who will walk you through all the steps needed to properly form and maintain your new business.
This Basic LLC Outline is about what you need to know about piercing the corporate veil and holding the Members liable and what to do to avoid some of these problems.
- Filing the Articles of Organization with the Secretary of State web-site is just the first step. This is not as simple as it appears. Make sure to check your corporate name in this and other states. Just because the Secretary of State accepts it doesn‟t mean it‟s not deceptively similar to an existing business. Make sure your registered agent is reliable.
- Get an EIN number from the IRS.
- Properly set up a business bank account completely separate from your personal bank account. NEVER co-mingle business and personal funds or assets, or pay corporate debts with your personal money, or transfer business property to personal use without documenting a profits distribution, or an asset sale or transfer, etc. There are lots of rules here. You need to know them or have the advice of someone who does.
- Make sure you‟re doing business in the name of the LLC by properly identifying the business entity in all business correspondence.
- If you are signing contracts, make sure you are properly signing the contracts in a corporate capacity in the name of the LLC and not yourself.
- Keep proper business records to properly identify corporate debts versus personal debts.
- Keep proper records to document investments to the business from personal assets or the member(s) directly.
- Most important: Have a professionally drafted Operating Agreement or Partnership Agreement by an attorney who is familiar with your business and what you intend to do with it. Do NOT download an Operating Agreement that is easily found online but typically doesn‟t cover a host of problems. “Free LLC Operating Agreements” – are worth exactly what you paid for it! Nothing at all in most cases.
Operating Agreements: There are two different types of operating agreements – member managed and manager managed.
Manager managed LLCs are just like a corporation: you have a Board of Managers which is just like a board of directors of a corporation. You have Members who are just like share-holders of a corporation. You can have corporate officers who are just like corporate officers of a corporation.
Member Managed LLCs are just like a partnership: You have one or more Managing Members who directly run the business as the only corporate officers, and you have Members who own the Membership Interest of the LLC – just like Shareholders own the stock of a corporation.
There are advantages and disadvantages to both forms of LLC. Partnership and Limited Partnership and Sub-S Corporation structures are similar.
The equity (ownership) structure of the LLC can be as complex or simple as the business purpose. It must reflect the owner‟s investment in the company and not cause tax problems for you. What kind of tax problems? Lots. Depending on how the business is formed and what it is doing there can be a host of potential tax problems, so it‟s useful to present your corporate ownership documents to a CPA or lawyer to make sure you‟re not causing tax problems for yourself. Many people think “my LLC is a „pass-through‟ entity, a tax nothing, so I don‟t have to worry about tax problems.” Many times that is wrong.
Having partners share the work and risk is great, but what happens if your partner:
- Now you‟re dealing with your partner‟s heirs, in a probate.
- Now you‟re dealing with an angry ex-spouse who wants ½ and will sue to divvy up the company assets to get his or her share.
- What happens to your investment if your partner is disabled? Lots of potential problems here.
- Business Divorce. Disputes happen. Business divorce is just as nasty and even more expensive than the marital kind.
These problems are often more prevalent in the context of the single member LLC because there the owners think “it‟s just me, why do I need all this paperwork?” Answer: Because if you don‟t have it done right and if you don‟t keep the proper records after business formation you make it much easier to sue you and hold you personally liable for business debts! That's why!
Just talk to any litigation attorney who understands the business and they will look into your case. Then they will charge you a $5,000 or a $10,000 retainer fee. For the first month. You will be expected to renew that retainer on a monthly basis as the process of litigation proceeds. Before long, you could have debts worth more than your investment.
“BUT I HAVE AN LLC! AM I NOT PROTECTED?” Maybe, if you have set up your legal structure ASSET PROTECTION STRATEGY properly. If not, then no.
And if you don‟t have an asset protection strategy drafted by a knowledgeable attorney?
Overview of Some Potential Threats to Real Assets
Judgment creditors – existing or pending. Some you may not even know exist.
“Fraudulent transfers” do not mean actual “fraud.” “Fraud” can be imputed simply because you did business with a friend or family member – if the transaction is not properly documented and handled.
Industry specific regulations: zoning, building codes, fire, safety considerations, public access, parking, neighborhood codes, yard maintenance, hazardous conditions. There's lots here.
Considerations where there is more than 1 owner of the LLC
Death of a party
Diversion of interests
Management – who does what? What happens when a partner does something not contemplated by your business plan?
Dissolution – What if your partner dies or wants out?
Distribution of Profits and Losses – Is there a profit share agreement including when payouts will occur and under what conditions. This is not as simple as saying “we'll divide the profits 50-50.”
Capital contributions – What happens when there are unexpected expenses? Are the partners expected to contribute more capital to the business? Under what terms? How will such capital contributions be repaid? When?
Just One Example: What if – due to injury, incapacity or change in life circumstances the Managing Member of Manager of the LLC lo longer is devoting their services and time adequately to the LLC? In case where one party is to invest capital and the other is investing time and expertise, then there needs to be some kind of protection for the capital contributing member that the Manager is actually going to do his job in return for his Membership interest and a method for firing him if he does not.
Dissolution circumstances? How will profits and losses divided? Disproportionate division spelled out in operating agreement.
John Stege, attorney at law
There‟s a lot more law to this, but if you have any questions about how you can use a corporate or LLC, Partnership or Limited Partnership structure as an asset protection vehicle you can call me at 720-431-1964 or email me at [email protected]As an attorney with 29 years experience in business and estate planning law I can help with many questions about partnerships, real estate and business planning, wills, trusts and estate planning. Call any time and I can answer your questions for free. 303-945-4606.