How-To Guide: Form an LLC
Real estate investing can take numerous forms, but as a general matter, using a business entity to invest (rather than investing directly in your personal capacity) is a prudent choice. Consult with an attorney or accountant that can help you determine which form of business entity is ideal for your personal circumstances. In most cases, the answer will be some form of a pass-through entity, or PTE, in which to hold property. Any form of business entity can keep investments separate and safeguard property purchases from personal liability to a certain extent, and a PTE in particular has an added advantage of not being subject to double taxation of a corporation.
Investors who want to use a PTE often choose a limited liability company, or LLC. LLCs are standalone entities for legal purposes but are reported on an individual’s personal tax return and thus, only taxed once.
If you are considering purchasing property through an LLC, it is important to understand how LLCs work, how to form them, and how to use them most effectively as a real estate investor.
What Is an LLC?
As stated, an LLC is a limited liability company. LLCs can be formed in any state for virtually any business purpose. This type of business entity is popular because it is easy to establish, is flexible to manage, and combines the best aspects of sole proprietorships and corporations in a way that is avoids certain drawbacks of an S-corp or C-corp.
LLCs can be formed by an individual or by a group of people. This flexibility means that this type of business can be utilized whether you are an individual investor or you want to pool money and other resources with other investors. Unlike sole proprietorships, an LLC can protect against loss of personal assets if you are sued. This liability protection is generally the most important factor for those considering an LLC or other form of business entity. If, for example, a tenant sues based on a problem with a rental property, your personal assets will not be at risk if the rental property is properly held in an LLC rather than by you as an individual.
In addition, LLCs:
- Can be owned by another business
- Are not required to have annual meetings like a corporation
- Are created by state-level registration
- Allow for income and loss reporting on personal income taxes
- Offer limited liability protection
- Can elect to be taxed as an S-corp
- Are permitted to issue stock
While some of these factors may not be relevant to a standard real estate investor, investors in certain circumstances may find the added flexibility to be a benefit.
The Benefits of Forming an LLC
For most investors, property protection is paramount. While the risk of liability in property purchases, sales and management is relatively low, this does not mean there is no potential for problems. Purchasing property through an LLC can reduce the potential magnitude of these risks, making it less likely that a lawsuit will be personally devastating should an issue arise.
Keeping assets separate and secure is an additional benefit of an LLC. Commingling personal finances, like money earned from a job, with business finances, like yields from investments, can complicate financial reporting and taxes. When property is purchased through an LLC, it is less likely that errors in accounting will occur.
Further, tax benefits can also be a point of consideration. Some tax breaks may be available to real estate investors who have formed a business entity that could not be utilized by an individual tax filer. As such, purchasing property through an LLC can save money at tax time while simultaneously simplifying the filing process. Your accountant can advise regarding any tax benefits for your particular circumstances.
Other opportunities may be available to business investors rather than individuals as well. For example, PPP loans at the start of the COVID-19 pandemic were available to qualifying LLCs, but were not an option for individual investors. For investors who also operate as property managers, like those who hold rental properties and employ staff, this had the potential to be a serious benefit.
Disadvantages of Forming an LLC
The benefits of opening an LLC far outweigh the disadvantages, but LLCs are not perfect and will not be the best choice for all investors at all times.
In general, functioning as a PTE is to an investor’s benefit, but not always. Because LLC business activity flows through to an individual’s tax return, this means that the LLC owner is responsible for paying taxes associated with the LLC, even if the LLC did not make any cash distributions to owners or investors.
In addition, there are costs associated with establishing an LLC, like formation fees and annual fees. There are also professional fees in connection with utilizing attorneys or a filing service to ensure that the LLC is established correctly.
How to Form an LLC
Forming an LLC is not a significant undertaking, but it does require a basic understanding of the law and the legal processes involved in forming a business entity and using it to make real estate transactions.
Choose a Name
Unlike a sole proprietorship, which can share a name with the owner, an LLC needs a unique name under which to be registered. This can be as simple your last name or a topic or idea that relates to your real estate investing business. Note that some states place limits on what an LLC can be called based on other LLCs registered in the same area. Most states require LLCs to include the abbreviation “LLC” at the end of the business name.
Choose a State
Many newcomers to LLC establishment are surprised to learn that an LLC does not have to incorporated in one’s state of residence. As there are some states that have more advantageous tax or business laws than others, it may be worth doing homework on ideal locations before signing paperwork. California, for example, does not permit LLCs to be used for professional businesses, or any business that requires a professional state license; instead, LLPs are encouraged. Wyoming is a common choice for LLC incorporation due to the low costs, limited restrictions, and straightforward filing process.
Some investors use an LLC service to handle the incorporation process. This can take the onus off an investor and ensure that the process is handled in the best way possible.
File Articles of Organization
For those who do not choose to use a third-party service to establish an LLC, articles of organization will have to be filed independently. This is the document that establishes an LLC as a legal entity. There are fees associated with creating an LLC, which average several hundred dollars in most states.
In California, the filing fee to incorporate an LLC is $70.
Select a Registered Agent
If you choose to incorporate in a state other than your state of residence, you will need to select a registered agent that lives in your designated state. If you file through a service, this will usually be handled for you; if you file independently, you can use a contact in your chosen state or a private company that offers registered agent services. If you incorporate in your state of residence, you can be your own registered agent.
If there is no substantial benefit to incorporating in an outside state, some LLC owners choose to establish an LLC in a state of residence simply to avoid the extra complication of choosing and using a registered agent.
Choose a Management Style
LLC management comes in two forms: member management and manager management. If you, or you and your spouse, are the sole participants in an LLC, member management is the simplest choice. If you plan to involve others in your LLC, manager management gives you control over your business while still allowing non-manager members to take part in operations.
Prepare an Operating Agreement
An operating agreement, while not required, can be a good way to demonstrate that your LLC is operating as required by law. This agreement can be a simple document that outlines the roles of those involved in the LLC, how the LLC will operate in a business capacity, and how income will be distributed.
File for an Employer Identification Number
An employer identification number, or EIN, is the business equivalent of a social security number. An EIN will be required when you file taxes on an annual basis and to take any associated business credits. EINs can be applied for on the IRS website and are available immediately after application, assuming all criteria are met. There is no fee to file for an employer identification number.
Evaluate State and Local Tax and Business Obligations
All areas have different laws related to state and local tax and business licensure. Before participating in transactions using your business entity, be sure you understand the laws related to buying, selling, or holding property within an LLC. This can involve additional income taxes or filing requirements. In addition to tax consideration, some localities may require businesses to apply for business licenses to legally operate.
In California, all LLCs, whether registered in the state or simply doing business in the state, must pay an annual minimum franchise tax of $800 to the local Franchise Tax Board. Additional taxes are owed for any LLC with net income over $250,000, but the amount will vary based on the specific amount of annual income reported. In addition, California Form 568, Limited Liability Company Return of Income must be filed on an annual basis by the 15th of the fourth month after the close of the taxable year. For LLCs operating on a calendar year basis, this will be April 15th, the same as the individual filing deadline.
Review Annual or Semi-Annual Report Requirements
Most states have requirements related to annual or semi-annual reporting. These reports can be very complicated for larger companies or simple and straightforward for small single-member LLCs.
In California, all LLC owners are required to file Statement of Information, Form LLC-12 within the first 90 days after successfully filing organization paperwork. Moving forward, additional Statements of Information must be filed every two years. This statement must include general information related to an LLC’s operations, like the address of all managers in the business and a description of the LLC’s principal form of business.
Real estate investment can be a great way to diversify a portfolio, but it is not a one-size-fits-all opportunity. For investors who want extra protection against potential legal liability, forming an LLC with which to buy, sell, and hold property can be the right choice. However, an LLC is not required to succeed in real estate investment, so the decision to incorporate is personal and variable.