Limited Liability Company (LLC) Definition
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What is a Limited Liability Company (LLC)?
The first decision most entrepreneurs face when they start a new business is how to organize their business entity.
Although a sole proprietorship is perhaps the simplest business structure, it opens the door for unlimited personal liability because, under the law, there is no distinction between the individual and the business entity.
An LLC puts a protective barrier between the business owner or owners, known as members, and their personal assets. If the business goes bankrupt, the members are not personally responsible for business debts or any claims against the business. They can only lose money directly invested in the business.
Similarly, if the business is one at risk of lawsuits, an LLC protects the members from personal liability.
There are some limitations to the liability protection of an LLC, however. Certain activities can “pierce” the corporate liability shield. Tax liability is one common example: If the business doesn’t pay its federal or state taxes, the members may be held personally responsible for payment. Additionally, if the business commits tortious conduct (intentionally reckless or negligent activities), members may be held personally liable in a civil suit.
Unlike an S-corporation or a C-corporation, an LLC does not need to issue stock, pass bylaws, hold shareholder meetings, or file annual reports. An LLC is a more flexible structure that works for small businesses with a single owner or larger ones with multiple members.
It’s important to note that not all states allow all types of businesses to use the LLC structure. For example, California doesn’t allow professionals such as accountants and architects, to form LLCs, and some states have special rules about single-member LLCs.
How is an LLC Taxed?
REtipster does not provide tax, investment, or financial advice. Always seek the help of a licensed financial professional before taking action.
When it comes to taxation, the LLC is perhaps the most flexible business structure. An LLC is not recognized as a distinct federal tax classification; it can assume the tax status of a sole proprietorship or an S-corp or C-corp.
For tax purposes, the IRS considers an LLC either a sole proprietorship or a partnership, depending on the number of members. Members can take advantage of pass-through taxation, which means income and expenses pass through the businesses and are reported on the owners’ personal tax returns. Profits are taxed at the owners’ personal tax rate.
An LLC can also elect to be taxed as a corporation. This status does not change the organization of the entity; it remains an LLC. Corporate filing status simply changes the way income and expenses are reported and taxed.
Pros and Cons of Starting an LLC for Real Estate Investment
Since Wyoming enacted legislation enabling the formation of LLCs in 1977, the LLC has emerged as one of the most popular business structures to hold real estate investments in the country. Before that, real estate investors had to form a corporation to acquire title.
Despite its popularity and obvious advantages over other more complex structures, the LLC has both advantages and disadvantages for real estate investors.
Pros of an LLC for Real Estate Investors
- LLCs limit personal liability. Although many investors can purchase liability insurance at reasonable rates, insurance policies have limits and exceptions. If a tenant was injured in a rental property, a sole proprietor owner would have to defend their personal assets in court. With an LLC, liability is restricted to only those assets owned by the business.
- LLC members can take advantage of pass-through taxation. Corporations are exposed to the risk of double taxation. Profit is taxed first at the corporate level, and shareholders are taxed again when distributions are made. By default, the IRS considers an LLC a “disregarded entity,” so rental income and capital gains pass through to the individual members’ tax returns. Also, in a single-member LLC, mortgage interest is deductible.
- An LLC has a much lower administrative burden. Corporate structures carry administrative and reporting obligations—along with additional taxes and fees—that do not apply to the LLC. Instead of appointing officers and directors to oversee the business, owners can easily manage an LLC. In addition, an LLC does not have to withhold payroll taxes and file payroll tax returns.
- LLCs have flexible rules for distributing profits. Members can structure the LLC operating agreement to suit its unique needs. For example, members can reward extra efforts and sweat equity by increasing cash distributions for certain members. In a corporation, distributions are pro-rata according to ownership.
- An LLC enables foreign ownership and investment. Corporate structures such as an S-corp prohibit ownership by non-U.S. citizens. Anyone can form an LLC regardless of country of citizenship.
- An LLC streamlines estate planning. Under current law, an LLC owner can gift portions of their membership interest each year to their heirs. This means that, over time, property ownership can be transferred to heirs without executing a new deed and paying transfer taxes and recording fees.
Cons of an LLC for Real Estate Investors
- There are fewer financing options for LLCs. Many lenders will not make a residential loan for properties held in an LLC. LLCs also are not eligible for many loan programs such as VA and FHA, and typically pay higher interest rates than individual borrowers.
- Members of an LLC are liable for self-employment tax. Income derived from an LLC and reported on the individual tax return is subject to the 15.3% self-employment tax based on the LLC’s total net earnings. This can be avoided by the LLC electing a corporate tax status.
- An LLC only applies to the investor’s home state. If a business owns property in multiple states, it will need to form an LLC for each state in which it operates.
How to Form an LLC
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Most states simply require investors opening an LLC to file Articles of Organization with the Secretary of State. Many states permit filing online or by mail. There is usually a small filing fee to form an LLC.
Here’s a quick overview of how to do it:
As with anything, when it comes to incorporating your business, there is more than one way to skin a cat. I’m not saying you need to use a service like Rocket Lawyer, it just happens to be a vehicle that makes the process very easy and inexpensive.
It is vital to create an LLC operating agreement if there are multiple members. It should spell out how profits will be distributed, define the financial relationship between the members, and specify the process for exiting the entity.
An Operating Agreement is typically required for an LLC to close a real estate transaction or obtain financing because the closing agent and/or lender will need to verify which individual(s) has/have the authority to sign documents and make financial decisions on behalf of the LLC.
A real estate investor who currently operates as a sole proprietorship or partnership can convert to an LLC by filing the appropriate paperwork with the Secretary of State. There are also plenty of incorporation services like Rocket Lawyer, MyCorporation, and CorpNet that will make the process easier for the user.
If you want to create your own Operating Agreement through the method I explain above, you can get started right here.
Most real estate investors are actively looking for ways to protect their personal assets from liability resulting from actions taken by their business ventures. An LLC, or limited liability corporation, is a legal structure that provides a legal barrier between personal and business assets and liabilities. It is the most popular choice for investors because it offers maximum flexibility and a low administrative and compliance burden.
- IncorporationAttorney.com. (n.d.) Best Legal Structure for Architecture Firms in California – Can Architects Form an LLC? Retrieved from https://www.incorporationattorney.com/california-attorney-professional-corporation-requirements/legal-structure-architecture-firms-llc-pc
- Hamill, S. (n.d.) The Complete History of the LLC. Wyoming LLC. Retrieved from https://www.wyomingllcs.com/history-of-the-llc/
- Haman, E. (2020.) Why You Should Form an LLC. LegalZoom. Retrieved from https://www.legalzoom.com/articles/why-you-should-form-an-llc