“All men have equal rights to liberty, to their property, and to the protection of the laws.” – Voltaire
Whether you’re a real estate investor, an independent contractor, or a small-business owner, you may want to consider establishing a corporation, a limited partnership, or a limited liability company (LLC). These entities are designed to make your business less risky and more financially rewarding.
An LLC, for example, can provide its owners with personal liability protection. But many people believe they can create an LLC – or file a corporate charter with the state – and automatically have ongoing liability protection. This is simply not true.
You need to learn as much about the limitations of business entities as you do about their benefits. In particular, there are quite a few points you should address during and following the creation of any business entity you choose to establish.
Here are five of the most important:
POINT #1: You Can’t Just “Set It and Forget It.”
Each type of business entity (the LLC, the corporation, and even the limited partnership) requires you to take certain key steps after the structure is created. I like to compare a business entity to a fancy Italian sports car or a new baby: They demand proper care and feeding.
They are fun on the first day, but you had better know how to maintain them. You can’t neglect the baby or take the car for a spin if it doesn’t have oil in the engine. Yet, many new real estate investors and business owners believe that because they hired an attorney or service to create their business entity, the work is done.
What you do after the entity has been created is crucial. There are countless nuisances, details, and traps that you must understand in order to maintain your liability protection.
POINT #2: Be sure to spell out key contingencies.
If you plan on buying a property or going into business with a partner, consider this: What happens if there is a disagreement? Do you have to sue to resolve the problem? Do you use mediation? Do you have procedures in place to require efforts to settle things out of court? What happens if you (or your partner) want to sell your ownership interest? Who will buy it? What will you sell it for?
The way issues like these will be handled should be spelled out in the Article of Organization (for an LLC) or Articles of Incorporation (for a corporation).
Here is a typical scenario: Let’s say you go into business with your best friend, Tom, and you set it up as an LLC. Things are going great until Tom decides he needs to spend more time with his elderly parents. He wants to sell you his part of the business, but you tell him, “Just wait a bit, Tom. Things will get less stressful soon.” He agrees, but shakes his head in doubt.
The next day, you learn he has sold his shares in the LLC to his uncle. You now have a new co-owner. You never would have started the business if you knew you were going to have to work with Tom’s uncle.
Situations like these can be avoided by utilizing proper “buy back” agreements between co-owners and limiting transfer rights. Sadly, most business owners don’t learn about these precautions until it is too late.
POINT #3: Don’t get careless. No business structure protects you from personal negligence.
If you’re a real estate investor, for example, understand that you always assume risks when you decide to make repairs on your property or hire someone to make the repairs for you – even if you have established an LLC or other business entity. A business owner is always personally liable for negligence. In other words, if you (or someone you hire) are negligent when you make a repair, you can be sued personally.
Don’t ever forget these words: “Business owners can be sued personally for negligent acts.”
POINT #4: Tax benefits or asset protection? If need be, what trade-offs are you willing to make?
When you choose a business entity, you are fighting two battles: one to minimize taxes; the other to protect your personal assets. One of the structures you might be considering may be ideal in terms of taxes but doesn’t offer the most asset protection – or vice versa.
That is why it’s always a good idea to seek out the right counsel. For instance, most attorneys will have a good understanding of the legal issues involved in personal liability protection. However, they may not be as informed on the complex tax issues associated with real estate or other businesses. Likewise, an accountant may steer you toward tax savings but recommend a business structure that offers inferior asset protection.
And that brings us to my final point…
POINT #5: Get educated. All professionals are not created equal.
How do you choose a capable attorney or accountant to counsel you? Ask them questions that relate specifically to your business/industry. And to make sure their answers are accurate and up-to-date, you’ll probably have to do some research before you talk to them. I especially recommend browsing through your state laws related to business entities. (You should be able to access them easily online.)
Doing a little groundwork will not only help you choose the right professional, it can save you money. For example, if an attorney does not have to create an entire set of forms for you, you will save several hundred dollars or more. And if you know how to run your business entity properly and understand the IRS requirements, there will be less work for an accountant to do.
With the right information under your belt, you can make your life – and their job – a lot easier.[Ed. Note: Darius Barazandeh is a licensed attorney in Houston, TX. He also holds an MBA and is an active investor in tax liens and a trainer for other tax-lien investors. To learn more about setting up the best possible business or real-estate-investing entity from a tax and asset-protection perspective, register for Mr. Barazandeh’s teleseminar on The Wealth-building LLC. Be among the first 150 to register and guarantee your spot. Free of charge.]