The Importance of Forming an Entity for Your Real Estate Business

Speaker - Paul Hodge CPA

I.      Introduction: My name is Paul Hodge

A.   Qualifications: I am a Certified Public Account with degrees in Accounting and Finance from the University of Texas A&M.  I am also getting accredited to teach continuing education for real estate agents.

B.   Experience: I have worked as a Controller and CFO for over twelve years at a variety of companies.  I started my CPA practice five years ago focusing on real estate and I have grown it into a successful business operating in both Houston and Dallas.  I am member of the Better Business Bureau. I am a RICH Club Gold Business Member and a real estate investor with thirteen single family properties.

C.   Subject Matter – The importance of forming an entity for your Real Estate Business.

II.   How an entity is formed? S-Corp or Limited Liability Company (LLC)

A.   Articles of Organization (IT’S A STATE THING)

1.      Filed with the State

2.      Filing fee is $300

3.      Defines type (Member or Manager) and the Members of the LLC

B.   Operating Agreement  (IT’S A LEGAL THING)

1.      Next document required for an LLC

2.      Defines the company

a)    Business activity

b)    Ownership

c)     Rights of members

d)    Operating procedures

C.   FEIN Number  (IT’S AN IRS THING)

1.      Establishes companies existence to the IRS

2.      Increases division between the business and personal transactions

3.      S-Election form 2553

D.   Meeting Minutes (IT’S A GOOD THING)

1.      Necessary to maintain for important decisions

2.      Necessary to accept Operating agreement and establish officers

3.      If the minutes are not maintained the corporate shield may not protect you

III.           Asset Protection – An entity such as an S-Corporation or an LLC can provide you the same protection as a Corporation.

A.   Your Assets Can Hurt You

1.      Protection from lawsuits – especially those filed by your customers.

2.      Protection from lawsuits for those things your customers might do on your property.

3.      Protection from creditors if the debt is in the name of the entity and not personally guaranteed by you.

B.   Do Not Keep All Your Assets in One Basket, Manage Your Risk

1.      Depending on your risk tolerance you should divide your assets into several entities (baskets).

2.      You do not want a lawsuit on one assets to take out all of your other assets (assets in one basket).  Manager your risk by spreading them in tolerable risk groups.

C.    Is Insurance a Solution (Not talking property insurance)

1.       If you have three properties in one LLC with a total combined equity and investment of $30,000 do you need a $2,000,000 umbrella policy?

2.      Does this make you a bigger target for a lawsuit?

IV.           Legitimizing Your Business

A.   Creating an Entity Means Business

1.      Going through the steps and expense of creating an LLC tells the world that this is a real business and not a hobby.

2.      It allows you to be more aggressive when it comes to deductions. Especially if the partners are husband and wife.

B.   Separates Business and Personal Transactions

1.      It distinguishes the separation between your personal life and that of the life your business.  This is important especially to the IRS and their consideration of deductions.

2.      Other businesses (vendors and customers) realize that they are not dealing with an individual person, but a business whose intent is to make a profit.

C.   Creates New Opportunities for Borrowing

1.      Once the entity has some experience and has assets it begins to create its own credit history.

2.      If strong enough the entity can borrow money on its own without a personal guarantee to finance further investment opportunities.

3.      If not borrowed for fraudulent purposes then you will be protected from creditors.

V.  Strategy for Taxes

A.   Create more than one Entity

1.      One reason is to divide gross revenue between entities to keep each below $300,000 and avoid Franchise Tax.  I am not sure how well this will work, but it seems to be a logical solution.

2.      The other reason is to establish a managing entity that can be used to create active losses for you without you qualifying as a Real Estate Professional.

B.   Asset Holder  (Passive Income/Loss)

1.      This company holds the assets for asset protection

2.      The nature of its revenue is rent which is a passive activity and subject to the $25,000 loss limitation for people making less than $150,000.

C.   Asset Manager (Active Income/Loss)

1.       This company manages and maintains the properties, finds the properties, and conducts business for the properties all on a contract basis.

2.      The nature of its revenue is from services provided through a contract and is considered to be active.  No limitations are placed on these active losses.

D.  Reduce Audit Risk

1.       In creating an LLC you reduce your chances of an audit

2.      LLCs are statically less likely to be audited than any other entity.  The amount of resources used in an audit of an LLC far out weigh the benefit of any lost taxes, which are owed not by the entity but by the members.  Therefore an audit then must be made of each member to determine if they have a deficiency in their return.  Too much trouble.

3.      The information from an LLC tax return (1065) is represented by only one line on an individuals 1040 return.  No detail to audit.

VI.           Piercing the Corporate Veil

A.   What does it mean?  This means the corporate protection that you established has been dissolved and that  you can be sued personally.

B.   How to avoid this from happening?   Three common areas of determination

1.      Inadequate capitalization

2.      Failure to adhere to corporate formalities

a)    Keeping up with your minutes and meetings

b)    Over stepping the authority given to you by the operating agreement

c)     Fraudulently signing as an officer that you are not

3.      Committing fraud as an entity

C.   Has it happened much?

1.      No – there have been very few cases through the country where the LLC corporate veil has been pierced.  In almost every one of them fraud was the deciding issue.

VII.       Conclusion

Creating an LLC is a smart business decision.  It will help protect your assets and create tax strategies unavailable to you personally.  An LLC will legitimize your business to IRS and the business world.  LLCs are not hard to maintain and provide a necessary structure for the major business decisions you must make.  Please seek out the assistance of a professional in creating the entity that is right for your business.

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