Limited Liability Companies (“LLCs”) are powerful and flexible tools in business and estate planning. They are especially well-suited for holding real estate. Many of our clients’ businesses are separate from, but dependent on a real estate base. There are often good reasons to use a separate entity to operate a business. We typically use LLCs for both purposes. However, the LLCs may be structured and operated differently for these different purposes. I will focus here on ownership of real estate. I will briefly review the characteristics that make LLCs effective for protecting assets, maximizing tax benefits, and transferring wealth.
Asset Protection
In many cases, the initial purposes of forming a business entity is protecting the personal assets of the owners of a business from the potential liabilities of the business. The creditors of the business are known as “inside creditors.” Both corporations and LLCs can protect the owners of a business from inside creditors. Limited partnerships can also protect the limited partners, but not the general partner, from inside creditors.
Courts will disregard the business entity and “pierce the corporate veil,” in certain circumstances. There are several factors that courts look at when deciding if the corporate veil should be disregarded. A full explanation of this is beyond what we can discuss in this short summary. But one factor is non-compliance with corporate formalities. Corporations have a lot of rules that are often ignored. In a recent mediation over a business dispute, one of the lawyers said the business’s corporate record book was “as naked as a newborn baby.” That describes most that I have seen. North Carolina’s LLC Act specifically states that one of its purposes is to “provide a flexible framework under which one or more persons may organize and manage one or more businesses as they determine to be appropriate with minimum prescribed formalities or constraints.” The argument that you failed to observe formalities is not as strong when the legislature has specifically said that they type of business structure you are using was created in part so there would be minimal formalities.
Another often overlooked issue in asset protection planning is protecting the assets held in a business entity from the owner’s other creditors. These are known as “outside creditors.” This can be more important for real estate holdings than other businesses, especially those who provide service. One of the attractions of real estate investment is that it has value independent of its cash flow, and that value tends to increase over time. That investment may be just as attractive to your creditors as it is to you.
This issue highlights an important distinction between LLCs and corporations. Stock in a corporation is vulnerable to claims of the shareholder’s judgment creditors. Your creditor could foreclose on your stock, take control of the business, and force the liquidation of the business’s asset. For corporations with multiple owns, the shareholder agreement can be designed to help mitigate this problem. But LLCs have a better asset protection feature. The creditor of an LLC owner is entitled only to a charging order. A charging order is a court order directing the manager of an LLC to pay distributions that would otherwise go to the debtor member to the member’s creditor. That is still not a great outcome. But the creditor does not get the management and voting rights that may go along with the LLC membership interest.
The North Carolina Court of Appeals has specifically disallowed a creditor’s attempt to seize and sell the debtor’s LLC interest. The Court, citing the charging order statute, said that forced sales are prohibited under North Carolina law, and that the plaintiff’s only remedy was to have the defendant’s LLC interests charged with payment of the judgment. Because a charging order is not an attractive remedy, creditors may settle on more favorable terms than if there were other alternatives. The terms of the operating agreement are critical. I have seen several operating agreements that greatly limit charging order protection.
The protection from outside creditors may be stronger for multi-member LLCs than for sole member LLCs. As of August 2019, North Carolina Courts have not questioned the effectiveness of charging orders for sole member LLCs. However, they have been questioned in other states. One perhaps important distinction between North Carolina and other states is the specific statutory language that a charging order is “the exclusive remedy by which a judgment creditor of an interest owner may satisfy the judgment from or with the judgment debtor’s ownership interest.”
If you own property in your individual name, an LLC is an obvious choice, because individual owners have no creditor protection. The decision becomes a little more difficult if you are married and own property with your spouse. Tenancy by the entirety provides a great deal of asset protection for married couples. However, there are often other reasons to use LLCs, even for married couples.
I have not discussed general partnerships, because they are dangerous from a liability perspective. Limited partnerships can overcome most of these dangers, but we can generally accomplish all of the benefits of a limited partnership plus more with an LLC. Based on all of these issues, when creditor protection is a goal, LLCs are often the best way to structure ownership.
Tax Efficiency
One of the benefits of using an LLC is that you can choose how it is taxed. This means that asset protection is often the primary factor in determining how to structure ownership. Therefore, we are usually starting with the LLC structure. Then we have to decide how to tax it. Sole member LLCs can be disregarded or taxed as a C-corporation or an S-corporation. Multi-member LLCs can be taxed as partnership, a C-corporation, or an S-corporation. In most cases, sole member LLCs that hold real estate are disregarded and multi-member LLCs that hold real estate are taxed as partnerships.
Corporations taxed under Subchapter C can be a great tool for certain businesses. But holding real estate in a C-corporation can be a disaster. When C-corporations sell real estate, the corporation must pay tax on the difference between the sale price and the tax basis in the property. If a distribution is then made to the shareholders, each shareholder then pays tax on the proceeds. This double taxation of the appreciation in real estate is a serious problem that can’t be fixed. In addition, losses do not pass through to the shareholders. Therefore, they can’t be used to offset a shareholder’s other income.
S-corporations avoid the double taxation problem. However, they have other limitations. For one, there can only be one class of stock. You must be careful about this, because a second class may be deemed to exist in certain situations. Also, an S-corporation shareholder is not allowed to add his or her proportionate share of the corporation’s debt to the shareholder’s stock basis. This is often not the case for a partnership. This ability to use the debt of the entity to increase the owner’s basis and therefore utilize a proportionate share of loss from the entity is sometimes very important to real estate investors.
Another issue with corporations is that when your heirs inherit the stock of a corporation that is a part of your gross estate, they receive a basis adjustment in the stock. However, they do not receive a basis adjustment in the assets of the corporation. Many real estate investors intend to continue deferring capital gains until their death and “reset” the tax basis for their heirs at the value on the date of their death. This is an attainable goal for most people in the current estate tax era. However, it doesn’t work for assets held in a corporation.
Multi-owner LLCs that will own farmland, rental properties, or other income-producing real estate usually elect to be taxed a partnership. One of the many reasons for this is that when an LLC owner dies, his or her heirs can request a basis adjustment on the asset held in an LLC.
Twenty-five years ago, it was often important to get assets out of the parents’ estate to avoid estate tax. In our current tax environment, there are few instances in which my clients are making yearly gifts to children of LLC interests. Now we usually want to make sure that the LLC interest is included in the parents’ estates so we can get a basis adjustment. However, if you have a taxable estate and wish to establish a gifting program, LLCs facilitate this as well.
Family Protection
LLCs are often an appropriate structure to use to leave assets to individual owners. However, I will focus here on assets that will be left to multiple owners. Dividing ownership of real estate is appropriate for some families. Two brothers who won’t speak to one another probably shouldn’t own a farm together. But keeping property together as a unit makes sense for others. You can’t split an apartment building. Managing 500 acres of timberland or five single- family rental houses will produce more regular income, mitigate risk, and achieve greater economies of scale than dividing them.
When making these long-term plans, it is also important to consider what could go wrong. If one of your two daughters passes away and leaves her 50% interest to her husband, that could have a negative effect on your other daughter. If your son-in-law then remarries, the problem could be worse. The list of potential problems is endless. Your farm, rental houses, or commercial property could end up auctioned on the courthouse steps. All of these problems can be avoided. But you can’t prevent them or even make a reasoned decision not to prevent them, if you have never considered that they could occur.
Summary
LLCs taxed as a partnership are often the right choice for owning real estate. They offer flexibility, tax benefits, and asset protection that no other ownership structure can provide.