Not sure to create corp. Need Advice
I am really confused, My partner and I sat down with a couple of lawyers the other day and they said to different things as to form a corporation. The first lawyer I went to was telling us that we should form an LLP or S corp. The other lawyer was telling us that it would not be worth it to form a corp or LLP first because we would have major problems getting a loan. He stated that if we did get a loan, that it would be extremely high rates. Who is right?
INFO: Just to give you more information so that you know what my partner and I are looking to do and how to invest. We are planning to flip the first house to gain some equity to work with. From then on we were looking to buy and sell immediately using the 1031 act.
PLEASE GIVE ME ADVICE.
thank you. TJ
Unfortunately neither lawyer asked your motives (or you did not clearly express them) so they understood your objectives.
First, for real estate investing and holding real estate, I would forget about a corporation (whether an S or C corp), because it is too hard to get the property out tax-free if you are just trying to distribute it to a shareholder.
Second, I prefer the LLC to hold the real estate (or an LLP or LP if in Texas because of the Texas franchise tax imposed on LLCs).
Third, buying and immediately flipping a property and taking the gain via a 1031 exchange will likely not qualify under Section 1031. To use Section 1031, you must be exchanging property held in a trade or business that is not inventory or investment property. Buying and selling the property could be viewed either as inventory property or at the very least not investment property because you did not hold the property with an intent that it be held for the production of income (i.e., investment objective). Note that making a profit does not mean that the property is held for an investment objective.
Thus, buying and immediately reselling the property will result in either ordinary income (if you are in the trade or business of buying and reselling property; i.e., dealer status) or short-term capital gains. Either way you would be subject to federal income tax rates up to 38.6% and likely not qualify for gain deferral under Section 1031.
I suggest that you find a tax and business attorney to help you with the entity selection issue and the tax issues. He or she can handle both for you with relative ease and probably save you much grief and money from doing it wrong.
If you can find an attorney that has an LL.M. in tax, his or her information and help would be golden to you. An LL.M. is a post-law school degree (i.e., higher than a JD that all attorneys in the U.S. must have). The LL.M. means that the person as studied extensively on the tax laws. If you can find an attorney with an LL.M. from NYU (which many tax practitioners consider the top tax school in the U.S.), you can probably feel at ease that the person knows the tax law better than most practitioners.
Hope that helps,
Taxjunkie
By the way, search for some of my other posts on this website, as I have already explained the difference of using an LLC or corporation for real estate investing to other REIs and the use of Section 1031 exhanges.
Taxjunkie
Thank you so much fo your help. You were very helpful, but I am sure I will have some more questions for you soon. Thanx. TJ
Thank you so much fo your help. You were very helpful, but I am sure I will have some more questions for you soon. Thanx. TJ
TAXJUNKIE, From you opinion, what do you think is the smartest and safest way to start off in this business. My partner and I are very open minded as far as how to start off. I'm sorry to bother you again, but everytime you answer my questions, you are very helpful to us. By the way, my partner and I are from NY.
Thank you.
Personally, I prefer the LLC. Since there are two of you, an LLC with two members will be taxed like a partnership for federal tax law and state law (depending on your state law), meaning only the members and not the LLC is taxed.
Depending on the amount of activity done by you and the other member, you may want to set up 2 classes of membership interests in the LLC to avoid some of the FICA (social security taxes) problem. Ask your CPA or attorney (who is knowledgeable in the tax law) how to do this. Refer them to the Proposed regulations under Section 1402 of the Internal Revenue Code and they should be able to help you. It is a little complicated to try to explain in this short space, so I will leave that to your advisors. If you have an tax attorney draft your LLC documents, he can make sure that the language in the documents is set up as 2 classes of membership interests to deal with this issue.
Hope that helps,
Taxjunkie
Also, a bit of business advise for you. When you say your "partner" I hope that your partner brings something to the business that you don't have. If you both do not have little money for REI, but lots of time, you will have difficulty making money in this business.
The most successful partnerships or businesses ventures are when you team up with persons that have strengths that you do not have. For example, if you have time and knowledge but little money, team up with a person that has $$$, little time and/or little knowledge. That way you are maximizing each others returns and time. That is how you compound your profits. Others may disagree with this, but I have found that trusism to be the general rule, rather than the exception.
Taxjunkie
If you don't have a corporation how do you protect your personal ***ests from lawsuits?
Being an investor without a corporation is like walking around with your financial statement stuck to your head!
Okay let me add this. I didn't read the whole dialouge. Wouldn't an S corp or C corp offer better protection from lawsuits than the LLC or LP?[ Edited by Future-Multi-millionare on Date 03/12/2003 ]
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On 2003-03-12 08:20, Future-Multi-millionare wrote:
If you don't have a corporation how do you protect your personal ***ests from lawsuits?
Being an investor without a corporation is like walking around with your financial statement stuck to your head!
Not really, because any good lawyer can find out all of your assets in a creditors court hearing or a disclosure required by the court. It is not too difficult to find assets. Sometimes it is a little more difficult if you haven't filed a lawsuit. However, once you have filed the lawsuit the "discovery" powers permitted by the court can find out a lot of info.
Okay let me add this. I didn't read the whole dialouge. Wouldn't an S corp or C corp offer better protection from lawsuits than the LLC or LP?
In a simple word, NO! Too many people think a corporation is the best asset protection vehicle around. Quite frankly, it is the offshore trust that is properly structured by a competent lawyer. For real estate in the U.S., the offshore trust is usually not viable, since a U.S. court can compel a U.S. trustee or U.S. beneficiary to turn over the assets of the trusts. Alot of people out there are marketing asset protection trusts. Using a trust for an asset protection vehicle is a misnomer unless you are making it an irrevocable trust and then you may have gift tax problems. Even jurisdictions that have statutes with asset protection trusts are not all that great (e.g., Alaska, South Dakota) because under the "Full Faith and Credit Clause" of the U.S. constitution, a court in say, South Dakota must execute a judgment against a South Dakota asset protection trust.
I know of many lawyers that can easily pierce through a U.S. trust to get at the assets.
That said, my preference for an asset protection vehicle is a LLC. However, to make it as bullet proof as possible, you need more than 1 member, since it is more likely that a court will pierce through a 1 member LLC than a multi-member LLC. The advantage of an LLC is that a creditor of a member cannot execute a judgment against the persons LLC interest, but rather can only get a "charging order." The charging order is the only remedy under most state statues, meaning that a judge cannot execute a judgment or use its equitable powers to compel you to dissolve or terminate the LLC. What is a "charge order?" A charge order means the creditor is only entitled to the profits ACTUALLY DISTRIBUTED from the LLC. If you have set up your LLC with a good attorney that knows how to draft the language properly, you, as the manager of the LLC, can choose to not make any distributions to yourself if you choose. The result is the creditor does not get to the cash in the LLC.
However, there is an even more potentially deadly aspect of the LLC to creditors. Under federal tax law, the partnership tax return statement (i.e., Schedule K-1) is issued to the owner of the LLC interest. If a creditor has a charge order on the LLC interest, it is considered to be the owner. The result is that the creditor pays your taxes on the profits in the LLC but gets NO CASH. Do you think that will piss off the creditor? It certainly did when a creditor was trying to get to one of my client's LLC assets. Unfortunately, the opposing counsel did not head my advice to not get a charge order against my client's LLC (I did not explain way though, because that attorney should have done his research!). When we issued the K-1 to the creditor but the creditor did not get any cash to pay the taxes to the IRS, you can bet the creditor was lividly mad! Eventually we were able to buy the charge order and judgment back at 10 cents on the dollar. Needless to say, my client was very happy with the outcome.
If that situation was a corporation, my client would have had to deed over the stock to the creditor and lose the entire corporation with the assets to the creditor.
So, based on the above information, would you rather have a corporation or an LLC (an LP would be just as good as an LLC for asset protection matters, but causes some problems for management matters)?
Taxjunkie
Taxjunkie,
I am following this discussion on the asset protection aspects of a business entity, as well as other discussions on this topic elsewhere on this board.
One point that I think bears making here, and please correct me if I am wrong. Don't we use a business entity to shield our personal assets from exposure to a lawsuit arising from our business activities? In other words, doesn't the LLC, in particular, limit our liability to the extent of the assets owned by the business?
I understand that personal liability still attaches to directors of a corporation, and to the general partner in a limited partnership, but no personal liability attaches to the members of an LLC. If this is also correct, then this is just one more argument in favor of using an LLC for long term real estate holdings.
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and permit the judgment to attach to the persons individual assets. Now, if you have put your assets into various entities the creditor may or may not be able to get the asset. If the assets are in a corporation, the creditor would have the judgment attach to the stock of the corporation, foreclose on that stock, and then kick you off the board of directors by calling a special shareholder's meeting to elect a new director. Since you no longer own the stock, you have no control over the vote. Thus, the creditor was able to get and own the assets in the corporation. This is why I really don't like corporations that much (although in some non-real estate situations, they are preferable over the LLC).
On 2003-03-16 13:58, DaveT wrote:
Taxjunkie,
I am following this discussion on the asset protection aspects of a business entity, as well as other discussions on this topic elsewhere on this board.
One point that I think bears making here, and please correct me if I am wrong. Don't we use a business entity to shield our personal assets from exposure to a lawsuit arising from our business activities? In other words, doesn't the LLC, in particular, limit our liability to the extent of the assets owned by the business?
That is true, but keep in mind the LLC (as well as the corporation) has "limited liability" with the emphasis on "limited." Notice that it does not say "no liability." Say for example, your LLC contracted with someone to buy some real estate, but the LLC was not adequately capitalized. It is true that in most situations that if there is a breach of some provision in the contract, the person might be able to get a judgment against the assets of the LLC. Most people think that is the end of the story. However, if the LLC is not adequately capitalized, a good attorney will go to court and argue to the judge to disregard the LLC (this is called "reverse piercing the veil"
Now, if the creditor goes after the membership interests in the LLC after getting the court to "reverse pierce" the judgment, there is another hurdle the creditor must deal with. Under most state statutes, the SOLE remedy for a judgment against a membership interest is the "charge order." The creditor cannot foreclose on the membership interest in the LLC as it could with the stock in a corporation.
As I mentioned above, the charge order only permits the creditor to get its hands on distributions actually made to you, the member. You, as the manager of the LLC, will never make such a distribution as long as the charge order is still good. Also, the charge order does not give the creditor any voting rights in the LLC, so the member with a charge order against its membership interest still controls who manages the LLC. If the LLC has real estate with substantial apprecation, the manager of the LLC (you) could still refinance the property (because there is no judgment against the real estate owned by the LLC) and use those loan funds to buy more real estate. You, as a member of the LLC, may have to guarantee the loan, but that should not cause you any grief.
The only way the creditor can get to the real estate in the LLC would be to go to court (again) and attempt to get the court to "pierce the LLC veil." This will be difficult if there is multiple members in the LLC and the state statute provides that the charge order is the exclusive remedy.
I understand that personal liability still attaches to directors of a corporation, and to the general partner in a limited partnership, but no personal liability attaches to the members of an LLC. If this is also correct, then this is just one more argument in favor of using an LLC for long term real estate holdings.
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Personal liability can attach to a member for wrongdoing, etc, the same way it can attach to the director. However, it is much more difficult for personal liability to attach to a member of an LLC than a director of a corporation.
Dave, you can probably see now why I prefer the LLC rather than a corporation.
Taxjunkie
Taxjunkie, having read this post, I have a question on LLC's and Corp. I have a corporation now, so would I be better off to Incorporate an LLC as a subsidiary of my now existing Corporation to provide the extra protection of liability?
Thanks Taz
Taxjunkie,
Is it also true that an LLC only protects your assets before an incident, not afterwards. For example, if someone gets into an accident and injures another party. Over a few months this person acquires investment property or some other asset. If the injured party finds out about the property and opts to go to court for a larger settlement, the LLC would be worthless because the incident happened before hand. Even a partnership couldn't protect the property. I am I correct on this? This is one area I'm not clear on regarding LLCs.