Did you know that you can create legal entities that you can use to protect you real estate assets? This article is a summary of the common ways of vesting title in legal entities that real estate investors use for asset protection.
Three legal entities that you can create are C-corporation, S-Corporation, and Limited Liability Company (LLC). Both C-corporation and S-corporation are formed by filing legal documents with the Secretary of State of California. Both of these corporations are distinct entities from the owners and thus shield the owner-shareholder(s) from personal liabilities stemming from the corporations. The difference is that the S-corporation is able to be taxed directly to the shareholders and avoids the double taxation that a C-corporation brings.
Most people who form a corporation will start off with an S-corporation. An LLC is also formed by filing with the State of California. The owners of a corporation are called shareholders but the owners of an LLC are called members. The LLC also provides personal liabilities protection stemming from the LLC (if formed correctly). An important point to remember if you have an LLC is to elect to be taxed as an S-corporation to escape the self-employment tax that is imposed on an LLC.
The final item, a living trust, does not require any legal filing with the State of California. Most people have a living trust to avoid probate and to carry out their estate planning wishes. The LLC and corporations can both be owned by the living trust and provide more extensive asset protection. You should consider one of these for you asset protection.
An important question: Is an LLC or S-corporation better for asset protection for real estate investors? Both LLC and S-corporation will shield you from personal liability because they are a separate entity from you personally. These entities act like a “bomb-box”, a bomb-proof box, shielding you from liability explosions (law suits) within an LLC or an S-corporation. If a child drowns in your rental property swimming pool and there is a $5 million dollar judgment, then all you stand to lose is the asset in your LLC or S-corporation because they serve as “bomb-boxes” shielding you personally from the $5 million dollar judgment explosion within your LLC or S-corporation. That type of creditor we call “inside” creditor because the liability emanates from inside the real estate property. However, an equally threatening liability is from “outside” creditors. If you are personally sued and there is a judgment of $5 million dollars against you, then an “outside” creditor will seek to get inside the LLC or S-Corporation, where your real estate asset is held, to satisfy the judgment.
If your real estate assets are held inside an S-corporation, then the creditor who owns the $5 million dollar judgment will seek to get inside the S-corporation by foreclosing on your stock and taking ownership of it. They can do that because your stock in your corporation is considered your personal property. Once they get control of your stock, they then have voting rights as a shareholder, and they will vote to liquidate your real estate assets and vote to distribute the cash from the liquidation to satisfy the $5 million dollar judgment. And, there is ABSOLUTELY NOTHING YOU CAN DO ABOUT IT.
However, if your real estate assets are held in an LLC then the remedy of the $5 million dollar judgment against you is a "charging order". A charging order is a court order that says if any distribution is to come out of the LLC then that distribution will go to the creditor. There is a way you can out maneuver this charging order. The secret is in the distribution provision of the operating agreement in the LLC. IF another member of the LLC chooses and agrees not to distribute any money from the LLC then your assets will be protected because, in this situation, there will be no cash distribution for the creditor to take. Thus, if you own a real estate asset, an LLC is a better form of vesting because nearly every States’ remedy against an LLC’s member is a “charging order”.