#64: Entities for Real Estate or Business

 
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Today we’re digging into a more technical and less glamorous topic - but it’s a crucial one if you are serious about having a business. We’re talking all about forming legal entities like Limited Liability Companies (LLCs) and corporations to protect yourself and your real estate & business assets. It’s important to get this right from the beginning, so today’s guest is laying some of the groundwork you need to know.

Michael S. Brady is Executive Vice President of Madison 1031, a national Qualified Intermediary for tax-deferred Exchanges pursuant to Internal Revenue Code §1031. As an attorney, Mr. Brady has over 25 years of experience representing clients in commercial and residential real estate transactions, as well as a wide variety of business transactions and commercial litigation matters.

In this episode Michael walks us through a couple scenarios for owning a real estate business and things you need to think about for your legal entity’s structure. We also talk about the differences between LLCs and corporations, when you may want to work one-on-one with a lawyer instead of just using something like Legal Zoom, and some of the contingencies you need to plan for when setting up your business.

In this episode, we’re discussing…

  • Why setting up an entity structure for your business is critical.

  • Why you would want to get a property you own out of your own name and into an entity.

  • Why you want to operate your properties as a business.

  • Some of the additional questions you need to ask and answer based on which legal entity you choose to form.

  • When and why you may want to use a service like Legal Zoom to file things like articles of organization versus sitting down and speaking with an attorney.

Michael’s Top Tips:

  • Limiting your liability is key – getting a business or piece of real estate out of your own name and into a legal entity is one of the best ways to protect yourself and your assets. Don’t skip this step - run your business like the business it is from the start.

  • Know when to work with a lawyer - sometimes you may not need to pay for a lawyer’s time an expertise, and filing paperwork online will get you where you need to go. But if you’re weighing up several different options for your entity, you may want to sit down with a lawyer and talk everything through. Do your research and make sure you get one-on-one legal help if you aren’t sure.

  • If you’re forming a company with several people, you should probably work with a lawyer – if you are forming a corporation, there are a lot more people involved: a board of directors, shareholders, and more. You need to make sure you follow the formalities of the corporate structure, but also draw up internal documents for things like splitting profits, what happens in the event someone is incapacitated, etc.

Resources:

 

+ Read the transcript

What if you could be doing something smarter with your money that creates income right now? If you're an IT professional who's wanting to get ahead financially and enjoy greater freedom of choice, and if you wondered who else in tech is creating ways to make their money work for them? You want actionable ideas with honest pros and cons and no fluff. Welcome to The Richer Geek Podcast. We're helping IT professionals find creative ways to build wealth and financial freedom. I'm your host, Nicole Stohler and in this podcast, you'll hear from others who are already doing these things and learn how you can too.

Hey everyone welcome back to The Richer Geek Podcast. Today we're going to be discussing a more technical topic, entity structures. While it's not always the most dynamic conversation, just like taxes, understanding entities and options is a key component for real estate investors. If you own a franchise if you're starting a side business etcetera. Today's guest Michael Brady is executive vice president of Madison 1031, which is a national Qualified Intermediary for tax deferred exchanges. So this is basically the 1031 exchange. But Michael also has over 25 years of experience representing clients and commercial and residential real estate transactions, as well as a wide variety of business transactions. So he is a very experienced person to talk about entity structures. In today's show. Let's head on over. Michael, it is great to have you on the show today.

Yes, thank you, Nichole. Thank you for having me on.

Will you share with our listeners a little bit about your background before we get into today's content?

Sure. So my name is Mike Brady. I'm an attorney. practicing law for head scary but over 26 years now predominantly doing business transactions and specifically real estate and Commercial residential real estate transactions as well. I currently serve as Executive Vice President for a Qualified Intermediary company for 1031 exchanges called Madison exchange. But I still do some transactions as well, for clients here and there.

And I'm excited to have you on the show today because we want to talk about entity structure. And it's not always the most exciting topic, but it is a necessity. It's kind of like talking about insurance. Right? So it is a necessary discussion when we're talking about real estate specifically. So tell us a little bit about why setting up an entity structure is critical. Even if you just let me just give you a scenario. Let's say you had a house that you lived in with your family, then you decided to buy another house and you said, You know what, let's just keep this house and rent it out. It'll be a nice income stream for us. Tell us a little bit about why you would want to put an entity structure around that.

Okay, so there are pros and cons in that specific scenario to using an entity structure And one of the big cons that you would have is that once you put that property into an entity, you're going to lose the ability to use a primary residence exclusion for it, right. So under Section 121 of the tax code, if you're selling your primary residence that you've lived in and owned two of the last five years, you can exclude up to $250,000 of gain as a single person and $500,000 as a married couple filing jointly, you lose that ability if you put the property into an entity. So in your scenario, let's assume let's say we lived there 10 years, then like you said, we found another property, we decided we were going to move into the new property and we're going to rent out our old property. And let's say we rent it out for two years. Okay, so we lived in it for 10. We lived in it for two. Now the market all of a sudden gets a very strong we decided to sell that property. Well in that scenario, we could take advantage of two sections of the tax code we could number one and probably most importantly excluded You know, up to $500,000 of our capital gain, because we've lived there two out of the last five years, right. And if the property was stolen our name, we could also do a 1031. Exchange, the extent there was any excess gain, because it's most recently been a rental property. But we would lose that ability to take that exclusion if we decided to put the property into an entity. Okay, so we have to be careful there. But let's assume, you know, the scenario that you're talking about is we're going to keep this property and we're going to rent it for a long period of time, we're never going to be able to take advantage of that $500,000 exclusion, because we're going to hold the property as a rental for 10 years, let's say. In that case, you probably want to look to get the property out of your own name. And there's a couple of reasons why. The main reason is liability. Okay, because you have a tenant, the tenant moves into the property. The tenant has guests, the guests come over there, you know, you're in Arizona. I'm in New York City. But different, but they're coming to the house and it's February in New York, and they slip on the sidewalk and they fall down. They're hurt bad. And so they're going to be looking for compensation for their injuries. So they may start a lawsuit, and they're going to sue you for that. So now by and large, hopefully, you know, your homeowners insurance would cover that situation. So it shouldn't be too much of a liability. But if there was some gap in coverage, they could pursue your personal assets. Okay. Beyond the rental property. So, you know, you may have exposure beyond what the value of the apartment in the house is, and it may go to your other assets. So that's why you typically recommend that you get the property out of your own name. Some of the things that have happened in many markets in not so much on the west coast, but lead based paint was a huge, a huge issue in many rental properties, particularly in in New York City area. So lead based paint was a very adorable paint that was used at Up until I think 1978 in New York City, and then it was outlawed. But it's still there behind the coats of paint and many, many buildings. And the problem is that if it's ingested, if lead is ingested, it could lead to learning disabilities, particularly in children. And apparently, from what I've been told lead based paint that's also tastes very sweet. So you have that combination. So if the paint was peeling, you know, children could eat it, because it was sweet. And could as a result might have had learning disabilities. Likewise, if any work was done on the property, if you went in and you decided to sand the walls when you put lead based paint into the air, and often this was the case that it would be on door jams and things that you would actually send not so much the walls. And so there was a lot of litigation about those those issues with lead based paint. And so if you own that property personally, you'd be on the hook for those last words, you know, potentially beyond your insurance coverage. So that's the major reason you Want to get a property out of your own name? Basically, it's recommended amongst Real Estate Attorneys and then business attorneys that you want to have a bucket for each property that you own. So each property should be in a different entity to kind of isolate them from exposure to the others. And that's really why we look at the structure.

And you know, it's a great point when you talked about the example I gave was probably not the best example. Because there are implications and considerations because it was a primary residence you talked about, and if we flipped it and said, okay, you were from the get go going to buy a property specifically to have as a rental property, then there isn't any question you would 100% want to put it in an LLC. For those reasons that you just described just for protection purposes. There might be are there tax implications or not so much?

Well, it depends, you know, so there really should not be although, typically if you're going to Have an entity, you know, it's important you want to maintain it as a business. And I think that's kind of a psychological reason to put a property in an entity because you know why the liability stuff like I talked about, you can kind of take care of with an insurance, quite frankly. But you kind of want to operate these properties as a business, right? And so, to the extent that you're creating a business, you want to have them in entities, each entity should have its own books, right. So if you have a property and the ABC LLC, ABC LLC is going to have its own accounting, right? And you'll show profits and losses and all that you want to really kind of have a professionalism, about the way you manage your property. I think it kind of ensures that the property is run properly, that you keep track of your expenses, you know, all those things. So that's kind of a psychological reason for doing it. Tax wise, you know, what, we're typically going to see our flow through entities, which means they're not going to have a separate tax existence. So Typically people will set their property up and put it into one of two types of entities or be either a limited liability company, or typically a corporation. And most corporations, you're going to be elected to be taxed under Subchapter S of the Internal Revenue Code, which basically means that it's all going to flow through to your individual return anyway, so you won't have a separate layer of taxation like a C Corp. So there's not really that much distinction, it's all going to flow through to your personal tax return anyway. And, you know, there's some things with, you know, to some beneficial tax rates that are available to non c corpse Now, under Section 199 A the tax code which is part of the tax cut jobs act. So, you know, other than a C Corp, you might get some of those same benefits as a C Corp as a lower tax rate because of these changes to the federal rate, you know, federal tax code, that's something to talk to your accountant about, but otherwise, there's no reason between putting it into an essay and not for tax purposes, but there are some distinctions between it LLC and an S corp that we should talk about.

Well, let's go ahead. Let's talk about what are those key distinctions?

Yes. So I'm old enough - like I said, I've been practicing law for over 26 years - when I first started practicing law, there was no Limited Liability Company statute in the state of New York, only a handful of states actually had limited liability companies. And so everybody put their property into s corpse. Okay. There's some good parts that as I said, they when you have an S corp, you've elected to kind of be taxed at an individual level rather than a corporate level. So you don't take double taxation like you know, C corpse do. But there are some downsides, number one in the city of New York, they do not recognize as corporations and so you would still have to pay double taxation for city taxes. I don't know if that's true elsewhere, but in the city of New York, that would that was one factor. The other factor that became cumbersome is when you ultimately tried to sell the property or, you know, distribute the property through gifts or otherwise you distributions if you want to come out of the corporation to the individual level, that distribution to the individual is a taxable event. You know, you cannot just say, okay, on the ABC Corp. Tomorrow, I just want to put the property in my own name, you cannot do that there's a court the taxation, typically from the distribution from the corporation to the individual. There are cases where that might not be the case. But generally that would be the case. So it's hard to get out of at the score. And I forget the exact year, I want to say it was 96 that they, but I might be wrong. In New York, we had passed a limited liability company statue, and it will limited liability companies, for most business purposes kind of became the preferred entity for particularly real estate because they are so much less cumbersome. Okay, the initial statute was was a little bit cumbersome, there was a whole you had to go through a bunch of hoops to be taxed as at the individual level rather than at the corporate level. But they've done away with that they made a check-the-box essentially. So now LLC s are a true disregarded entity, which means if you set up a limited liability company and you put the property in the limited liability company, you're going to get that entity level tax liability protection, meaning that they will not if somebody you know, Sue's because of something that happens at the building, they cannot go after your personal assets outside of the building that the entity is in. So that's that's great. That's like it like the S Corp. It gives you that great protection. But it's a true flow through entity in that it's disregarded for tax purposes, that entity will not even usually file a tax return if it is a solely owned entity. So that means you have one person is the member of that entity. So it's disregarded for tax purposes. No separate tax return. You don't have to pay your accountant a fee for filing either a partnership or more putting a corporate tax return in that case. So there's some savings there too. Probably not tremendous, but it's a much more simple entity, everything's going to flow through to your individual return. As opposed to an S corp, you're going to have to file a corporation tax return every year. Okay? So that's one of the benefits. And if we want to get out of that disregarded entity, there's typically no tax due from that distribution from the LLC to the individual. That's an LLC is a disregarded entity. So it's a much more, you know, less cumbersome structure. It seems to be the preferred entity because we can go in and out of LLC. Now, it's a little bit different if we have multiple, you know, members, if we have multiple people in our LLC, right, so we have co owners of the property, that then it's not going to be a disregarded entity, it's typically going to be taxed as a partnership. Okay, it's still not the end of the world you file a partnership tax return, it's federal form 1065. But everything's still going to come down to the individuals they'll get k ones and flow through to their their individual returns. not that different from an escort. But again, you will have the flexibility of getting out of that entity and not having to pay taxation by transferring the property from the entity to the individual owners as to who do this as tenants in common. And this is pretty useful if we're doing 1031 exchanges in particular, where we might separate, we want to separate and so we'll go ahead and do something called a drop and swap. And you know, that's a topic for another day. But it gives us that that flexibility, we don't have that flexibility with an S corporation. Those are really the advantages of the LLC. With an S corporation. There are some advantages over the limited liability company typically with other types of businesses, so not so much with real estate. But with if you were operating a restaurant, or hair salon or something else, you might choose an S corp over limited liability company for those more active businesses. And the reason is that one of the best things about having a business is being able to take Take expense deductions, right? So people that own businesses are able to write off a lot of their expenses. If you're an employee, you know, especially under the tax cut jobs act, you're very limited. So your personal expenses that you can write off against your your employee, you know, W two income. If you're a business owner, you can write off things like the cost of your cell phone, you can write off things like, you know, your automobile expenses that are used for business purposes. And it seems amongst accounts that I talked to that you could do this with an LLC or an S corp, but it seems amongst the accounts that I talked to, you're far less likely to be audited. If you're in an in an S corp doing that then if you are an individual, so yes, you should absolutely play by the book and only write off valid business expenses, of course. But if you're not doing that, or you know you have other things in your tax return that may be suspect or you just don't want to be audited. The escort CT might be the better entity. You know, for those purposes for the active businesses where you have a lot of expenses to write off.

I love that too, because you're talking about the auto expense the cell phone. I know within our businesses, we also do internet access, because you know, we need all that to to operate. Okay, so tell us, what's the process for setting up either LLC or S Corp. And I bring this up because, you know, someone might say, well, I just register with the state and it's like $80 and I'm done. Or I can go to LegalZoom. So tell us a little bit about the process.

Yeah, and you know, Legal Zoom provides an I'm not a person that that is necessarily down on Legal Zoom. Many of my my profession are not fans of Legal Zoom, you know, they for various reasons, but mainly because they are somewhat of a competitor. I think you do have to be careful. I think there is a place for legal representation that Legal Zoom doesn't fill but you know, for setting up an entity it might be something to look at. One hidden secret is that most attorneys who are setting up entities, they're not using maybe Legal Zoom, but they're using a service typically to do it anyway. You know, we can certainly do that we can go and we can file with the state, we can file with, you know, whoever that needs to be filed with. But there are services that expedite the service and do it much quicker than we can because usually, like I live in New York, so the capital in New York is Albany. I'm in downstate New York, I'm on Long Island, you know, I cannot run up to Albany to file, you know, a certificate of incorporation, or articles of organization from a liability company, you know, it just wouldn't be cost effective. So I use a service to do that. They do all that filing for me, and they're right there and they can do it. They have expedited services, otherwise, I have to do it by mail. Overnight, it still can get done very quickly. It's usually more efficient to use a service to do it's cheaper for the client and cheaper, more time effective for for me as the attorney, so it's not that different than using Legal Zoom anyway. Okay. But maybe you should, you know, the purpose of having an attorney is that you get to discuss what entity makes sense, right? whether we should do an S corp, or a limited liability company, or maybe we don't want an entity, you know, whatsoever. Maybe in some cases, we want to use a C Corp. So you know, that's, I think, where the attorney really comes in handy. But the process is somewhat simple, you basically will file an organizing document with in New York, it's the Secretary of State, every state probably has a different name for that entity, but you file with the Secretary of State, and you get back a certificate saying that you're a corporation. Now, before that, I should mention you also have to check the name, right. So you want to make sure in choosing a name and this is less of a concern for real estate where names are not necessarily important. But you can obviously not use the same name as an existing business. So there you want to do a name check in advance and you can usually do that on the Secretary of State's website to see if the name is already being used. You also don't want to use a name that would be confusing because then you know, especially in the active business like a restaurant, you know, you can be sued for, you know, copyright infringement. And they can make you discontinue using the name if it's confusing. So you want to take a look into that as well for a real estate project. Typically, you're going to base your name something related to the address, right. So if you're buying 123 Main Street, you're going to set up to 123 Main Street LLC, is not required. But that's typically what you see. It could be something else, but to be unique, that's typically the way it's done. So that process is relatively simple as setting up is relatively simple. One thing I will mention, if you are in the state of New York, setting up a limited liability company tends to be somewhat more expensive than doing a corporation. Because we have this kind of antiquated requirement that it's not enough to just file your Articles of Organization. You also have to publish in a newspaper, notice of your formation and it's not just one newspaper, it's usually two newspapers. Okay, that you have formed this limited liability company. And so there are these legal ads in the newspaper that nobody ever looks at, but they are expensive. They cost, you know, several hundred thousand dollars or if you're unlucky enough to be assigned the New York Times, it could be over $1,000 and has to be published for six weeks. Okay. So this is a really antiquated requirement. It's keeping the newspaper business in business, I guess, since nobody advertises in the newspaper anymore. But it's one of the things we have to deal with in New York. I don't know if other states have this. I don't think most of them do. I know Arizona does not. That's something we're kind of burdened with here in New York. So people do often form their entities and other states other than New York, that doesn't always work. Because if you set up an entity outside of a state, you know, so if I set up a Texas LLC, or typically Nevada is a very popular state for forming entities as is Delaware's kind of the granddaddy Forming entities because ever very management friendly Corporation statute there. The problem is that if you wanted then operate in the state of New York or any other state, you actually have to get authority to do business in that state, which requires a New York State publication of notice. So you don't really get around it. And the downside of not doing it is that if your business ever wants to sue in that state where it's doing business, it has to be authorized to do business there. So if you're a landlord, and you set the Delaware LLC, and it owns a building in Manhattan, and the tenant doesn't pay the rent, you can't go to court to evict them unless you have authority to do business in the state of New York. So just some inside baseball there if you're forming entities and want to get around those costs, so that that's typically the costs that you see and costs tend to be, you know, the formation fees tend to be a couple hundred dollars. Otherwise, if you don't have a publishing requirement, and you do have to file period article you pay those fees, usually by annually some states, I think require Annual Registration. But those are some things to look at as well.

As you're talking about, there's a lot of nuances. And I think the lesson that I take away from this is that you would want to talk with someone, talk with an attorney about your situation, your plans, your goals, what you're trying to do with either the business or the real estate property and decide on your entity structure based on that. And it really is worth it because it depends on your overall goals. And that's hard to just get a cookie cutter approach based on Well, I guess I should say, if you're never planning to grow, and you're just buying one property, maybe not that big of a deal, but it does depend on your end goal. And so I would ask, Where can listeners get in touch with you or learn more if they want to have more conversations or, or your thoughts around this?

Yeah, sure. I just wanted to get into one other issue, why you might want to use an attorney, if we have some time. So the other part of that, so that's the formation, but then the setup of the actual business, you really want to get your team of advisors involved that. Okay, so number one, that liability protection that I talked about, that the corporate or the LLC shield gives you, well to be respected. Okay, you have to actually abide by certain formalities and running the business. So for Corporation, you're supposed to have annual meetings of shareholders, and, and also a board of directors. So you have to put those documents together, you have to have a board of directors, you have to have, you know, minutes of those meetings, things like that. So an attorney will set you up with that. And if you don't do it, it's very, very rare, and I don't want to overstate the risk, but you fail to do that and you got sued and you didn't obey but abide by certain corporate formalities. And you did a lot of commingling of like your personal assets with your business. You might lose that shield of liability, they call piercing the corporate veil. So an attorney can kind of set you straight and make sure that you don't run that risk, although it is a very minimal risk very hard to pierce the corporate veil, but something to think about. More importantly, if you have partners and your business venture, whether it's real estate or operating a business, and you have multiple people, either shareholders in a corporation or members in a limited liability company, you want to set forth what the terms of your arrangement are, right? So you want to have a formal agreement that says that, you know, what happens if somebody gets sick, or they're disabled, and not able to participate in the business? Do they get bought out, somebody passes away, you have the right to buy out the estate, or you're you're going to wind up doing business with the spouse of your partner who may be somebody that you don't want to do business with, or the children etc, etc. How are the profits split? You know, what happens if you can't come to an agreement, right, if it's a 5050 split, what's the tiebreaker so that the business can take action? So you want to have a shareholders agreement or an operating agreement? That sets forth the terms of your relationship. And you should see an attorney for doing those things as well. So that that's a really big point in in using the attorney over just kind of doing yourself you could set it up yourself and make sure you go get those internal documents done as well.

Great point. Any other thoughts on this is just that initial setup in the structure?

Yeah, I would just say you also make sure you have an accountant involved also very important to have an account involved. If you have employees, you have to do a whole bunch of things a whole bunch of hoops you have to jump through you have to have withholding, you know, tax withholding. Even if you're a sole proprietorship, you still might want to have tax withholding done, you know, so you might want it especially in a corporation show a salary coming to you as the employee of the of the entity, and then you could take you know, profits as well. And account we'll walk you through that you want to set up workers comp insurance, you know, all that good stuff. Those are important points if you're setting up any kind of business.

Yeah, great point. There's a lot of moving pieces, speaking from experience, especially on the Hotel side.

Yeah, absolutely.

So Michael, where can listeners get in touch with you or learn more?

Yeah, sure. So, on this side on the under legal corporate structuring side, typically the best place to reach me I am on LinkedIn, you can find me on LinkedIn, but also my email is M. Brady at rady br ad y advisor, that's a d v is o r.com. And that's kind of my legal website that I, you know, I advise businesses on.

Fantastic. Thank you so much for coming on and sharing all of these details with us. I know my head is spinning, and I would just say make a phone call. Thank you.

Okay. Thanks for having me on.

Thanks for tuning in to The Richer Geek Podcast. For today's show notes including links and resources, visit us at therichergeek.com. Don't forget to head over to iTunes, Google Play, Stitcher, or wherever you get your podcasts and hit the subscribe button. Help us spread the word by sharing with others who could benefit from listening and leave a rating and review that'll help us get the podcast in front of more people. I appreciate you. Thanks so much for listening.

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ABOUT MICHAEL BRADY

Michael S. Brady is Executive Vice President of Madison 1031, a national Qualified Intermediary for tax-deferred Exchanges pursuant to Internal Revenue Code §1031. As a Certified Exchange Specialist® and attorney, his responsibilities include consulting with clients and their advisors to provide guidance on the regulations affecting §1031 Exchanges, as well as overseeing Madison 1031 Exchange’s national sales and marketing e orts. His seminars have received rave reviews for being both entertaining and informative, and his audiences have included top law and accounting firms as well as brokerage companies nationwide.

Mr. Brady has published many articles on tax and legal issues and is the primary author behind the Madison 1031 Zone blog. Prior to joining Madison 1031, Mr. Brady headed up other leading 1031 exchange companies, overseeing several thousand 1031 exchange transactions during his career. As an attorney, Mr. Brady has over 25 years of experience representing clients in commercial and residential real estate transactions, as well as a wide variety of business transactions and commercial litigation matters, and has acted as general counsel to a title insurance company

 
 
 
Small Business, Rental PropertiesNichole Stohlerpodcast, season 1