There are many issues to evaluate when determining the best choice of business entity for your needs. If you’re investing in real estate, I always recommend that you take title in the name of an entity rather than your personal name. Whether a limited liability company (LLC) is the right entity for you will depend on a variety of factors.
Benefits of Business Entity Formation
In general, individuals form entities for two primary purposes: liability protection and tax considerations. Certain entities, notably corporations and LLCs, provide that the owners and managers of that entity generally do not have personal liability for the debts of the company, with certain exceptions. In a limited partnership, the general partners will have liability for the debts of the partnership, just as will the owners of an unorganized business (a sole proprietorship). There may, however, be other considerations that favor a limited partnership over an LLC.
Regulatory Requirements for Business Entities
In some instances, the form of entity may be driven by state regulation of a certain profession. For example, the Arizona Department of Real Estate will only allow licensees to hold their real estate license in a professional corporation (P.C.) or a professional limited liability company (P.L.L.C.) because Arizona law specifically provides that a licensed individual rendering professional services through a P.C. or P.L.L.C. is still personally liable for some of their actions, namely their professional responsibilities. There are other professions in Arizona with similar regulations. If you are engaged in a licensed profession in the state of Arizona, you must determine whether there are any specific requirements regarding the type of entity under which you can conduct your business.
Tax Considerations
The most common areas in which I assist clients with entity formation are real estate investments and starting a new business. While a corporation, LLC, or limited partnership will each provide its underlying owners with a layer of protection from personal liability, the tax ramifications to the owners of investment real estate or a business may be significantly different depending on the type of entity chosen. Some tax breaks, like investing in Opportunity Zones or reliance on the small business stock capital gains exclusion, may require the use of certain kinds of business entities to take advantage of those provisions. Recent changes to the U.S tax laws may favor the choice of one legal entity over another. Due to the adjustments in tax rates, the advantages of treatment under partnership taxation is not as great as it was previously. Therefore, you should consult with a tax advisor to evaluate the tax considerations for your particular situation. Our tax team regularly helps clients with this important decision.
Business Entities for Foreign Investors
I work with many Canadian real estate investors who have unique cross-border taxation issues that will affect the type of entity chosen. Unlike a U.S. investor whose income from an LLC is often treated as partnership income, Canada Revenue Agency does not recognize an LLC (or PLLC) for tax purposes. In addition, I’ve worked with Australian real estate investors who also have unique tax issues. If you are not domiciled in the United States, it’s imperative to consult with your tax advisor to determine the most appropriate form of entity in which to hold your real estate investments.
Forming the Business Entity
Once the form of entity is chosen, there is still work to do. Not only must you file the appropriate documents with the Arizona Corporation Commission or the Arizona Secretary of State, but you may also need bylaws, a shareholder’s agreement, an operating agreement, or a partnership agreement. These are the documents that will set out the procedures for management, meetings, voting, transfers of ownership, purchases upon death, buy-sells, etc. There are many issues to consider if the entity has multiple owners, and it’s generally best to get these issues agreed upon and documented when the entity is initially formed and all owners are getting along. There are many ways to approach these issues, so it is important to discuss the options with your co-owners and professional advisors.
The Risks of Doing it Later or Reliance on Insurance Alone
At this point, you may be saying to yourself “This sounds like a lot of work and may cost a lot of money. Maybe I will just purchase liability insurance.” First of all, it won’t necessarily cost a lot of money to form an entity and prepare the underlying agreements between the owners. Our firm has represented numerous business owners who did not spend the money up front to set forth their agreement with their co-owners, only to spend many times what that would have cost in litigation when circumstances change and disagreements arise over their respective rights.
In addition, while it is prudent to purchase liability insurance and your lender may require it, insurance alone is not sufficient to protect you. For example, your liability insurance policy will contain certain exclusions from coverage. If you own the property in your personal name and an event occurs on the property that is excluded from coverage or exceeds the policy limits even if covered, you can be held personally liable for any damages. Finally, insurance companies can deny claims. In the event that you only obtain liability insurance and the insurance company denies the claim, you can also be held personally liable.
Choosing the correct form of entity is an important decision. Take your time, do your homework, and consult with a professional to guide you through the process.
Howard J. Weiss is an attorney at Jennings Strouss Law Firm in Phoenix, Arizona. His practice is focused on counseling clients on the purchase, sale and lease of commercial real estate, as well as business transactions and entity formation. The firm also handles construction law, tax law, corporate and securities law, commercial financing, estate planning, probate, intellectual property, employment law, administrative and regulatory law, commercial litigation and bankruptcy, among other areas of law. Mr. Weiss may be contacted at 602-262-5926 or by email at hweiss@jsslaw.com.
This article is intended for informational purposes only, and should not be construed as providing legal advice. If you have any questions regarding the topics discussed herein, you are advised to contact an attorney.
