IN THIS CHAPTER

Protecting your real estate, intellectual property, and personal assets with an LLC

Raising capital with your LLC

Running your business in an LLC

By now, you’ve probably figured out that I think the LLC is the best entity structure around — and for good reason! LLCs are flexible — you can use them for practically any purpose — and they offer more benefits than any other entity type. They have a favorable pass-through tax status, and with the dual liability protection that LLCs offer, corporations and limited partnerships can’t compare.

What I love most about LLCs is that they are completely customizable. You can draft pretty much whatever rules you want in your operating agreement, even overriding many state laws with a simple paragraph. You can also choose whichever tax structure you want; LLCs can elect to be taxed like corporations or even S corporations.

Too many people simply form an LLC without realizing its power. They adopt a fill-in-the-blank operating agreement (yuck!) — if they bother to make one at all — and they rarely look critically at their tax situations to see where money can be saved. So much can be done with LLCs, and yet most people don’t know or don’t bother because they stick to their comfort zone, either avoiding going the extra mile to learn about all their benefits or mentally limiting their LLC to the same restrictions as, say, a sole-proprietorship. This chapter reminds you of the awesome capabilities of LLCs so that you never forget to make the most of a good situation.

To Customize Your Small Business

LLCs are great for small businesses because they’re adaptable to all situations. Whether you have 100 silent investors or are a two-person small-business operation, the LLC is so flexible that you can pretty much write the operating agreement to suit your needs; you can make your own rules and tailor your entity to suit the intricacies of your business. With a corporation, you’re limited to stiff corporate formalities and the weighty, unbending infrastructure of shareholders, directors, and officers.

If you’re operating as a sole proprietorship (which is how most small businesses are initially structured) or general partnership, I do not doubt that reading this book will convince you to form an LLC today because a sole proprietorship or general partnership is the most dangerous form of doing business. It offers zero protection from creditors and lawsuits and leaves your personal assets on the table for anyone to grab. Not to mention that neither of these entities can raise capital (and you won’t go very far when it comes to impressing people).

By combining many of the advantages of corporations and S corporations with their special attributes, LLCs have become exceptionally attractive to small-business owners. They take the liability protection that corporations offer and build on it, adding an extra layer of protection by way of the charging order (see Chapter 16). They also offer a pass-through tax structure similar to that of an S corporation but with zero of the ownership restrictions. Any person or entity can be an owner, and your LLC can have an unlimited number of them.

What’s more is that, unlike corporations, there is a very good chance that your small business LLC will benefit from the (up to) 20 percent tax deduction on your qualified business income! Flip back to Chapter 13 (Making Cents of Taxes) for details. So, go forth and conquer, my entrepreneurial friends. And don’t forget to enjoy that sweet, sweet tax break!

To Protect Real Estate Assets

The LLC is a perfect entity for real estate holdings in almost all situations — you just can’t beat it! One advantage is that an LLC has dual liability protection that shields your investments from the frivolous lawsuits filed against people like you every day. So, if you rear-end someone in a parking lot and they sue you personally, they can’t simply seize and liquidate your investment properties to settle the claim if they’re held in an LLC. If that’s not reason enough to convince you to form an LLC, turn to Chapter 17, where I show you all the powerful ways a limited liability company can protect real estate holdings.

Another huge benefit of the LLC over other entity types is its taxation. With an LLC, you can easily transfer your property in and out because taxes aren’t imposed on contributions or withdrawals of assets as long as no money changes hands. Individual members can also gain a tax benefit from recourse loans that they’ve guaranteed for the company. Considering that there’s a good chance you’ll have a mortgage on your property, that provision is a very good thing! Of course, before taking any big steps, speak with your CPA about any hidden tax issues that could crop up. After all, with more than 2,500 pages of federal tax code, you never know what you could be walking into.

LLCs are so great at holding real estate that I advise my clients to form one LLC per property they own. This way, each property is isolated from the others, so if one property is sued, the others are safe from being seized. With the ease of operation and the limited recordkeeping requirements, having multiple LLCs isn’t as difficult as you may think.

To Shield Intellectual Property

I firmly believe in keeping your intellectual property as far away from your operating business as possible. After all, what’s more valuable than the brand you have worked so hard to build? Or the patents around which you centered your business? You need to protect those things with your life — or with an LLC. Your choice.

Placing all your intellectual property in separate LLCs is overkill unless you have a bunch of important patents. You don’t want your intellectual property to operate with the public; that’s your operating company’s job. So, how do you link your intellectual property in your LLC to your operating company? Have the LLC that holds your intellectual property lease the patents, trademarks, or copyrights to the operating company for its use. You need to sign paperwork and transfer money to make the arrangement official. After all, if it doesn’t look legit, then there’s no point in doing it in the first place.

Because of the charging order protections (see Chapter 16), it doesn’t really matter too much who owns the LLC with the intellectual property. But investors generally like to have the business’s intellectual property owned by the business; therefore, the best setup is for the operating company to own the LLC. To be on the safe side, a common holding company can be the owner of both the operating company and the LLC with the intellectual property. The investors invest in the holding company, and voilà! They’re happy, and the property is safe from lawsuits and angry creditors.

Only LLCs should be used for holding intellectual property, not corporations. If that corporation is owned by the operating business and the business is sued, then the corporation that owns the intellectual property is considered an asset of the business and is subject to seizure and liquidation. Corporations don’t have the same charging order protections that LLCs have. Therefore, if the intellectual property is in a corporation and the owner (in this case, the business) gets sued, then the intellectual property is toast. If the intellectual property were instead held in an LLC owned by the operating company, then this wouldn’t be a concern.

To Raise Seed Capital for Your Business

The LLC is quickly becoming the entity of choice for raising seed or angel capital — early-stage investments, especially those under $1 million. Whereas venture capital firms — I’m talking about the big, big guys here — generally prefer to invest in corporations because they’re most familiar with them and are easier to take public, smaller investors love limited liability companies once the time comes. The partnership pass-through taxation allows investors to deduct their contributions, and if your little startup doesn’t turn a profit, they can use the losses to offset other income. That is a huge benefit to investors. If the business fails, they may not get their investment back, but they’ll still get a nice deduction.

S corporations also offer pass-through taxation; however, the result and implications aren’t even close to being the same. Investors can deduct their contributions only if the business fails, not immediately, and S corporations restrict who can and can’t be an investor. Why limit yourself? LLCs can have as many investors as you choose — even hundreds of thousands! — and anyone can invest. One investor can be a small business in Wichita; another can be a newly formed hedge fund based in London.

According to most states’ laws, the entire membership interests in an LLC cannot be transferred freely (meaning you can transfer without any formal approval from other members or managers); only the economic interests can. This is the foundation for LLCs’ second layer of liability protection — charging order protection. Although a bit of restriction on membership transfers can be a good thing, it can be a bit intimidating to old-school investors who are comfortable with the corporation’s ownership structure.

If you’re dealing with a wary investor, you can simply remind them that an LLC is incredibly flexible. Assuming that the laws of your state allow it (most do!), you can structure your membership shares to be freely transferable as they are in a corporation. Granted, if you’re ever sued personally and rely on the charging order protection, you may face some problems in court. (The jury is still out on these topics in many ways.) In the worst-case scenario, your LLC is treated as a corporation. In the best-case scenario, you get the best of both worlds: freely transferrable ownership interests, favorable pass-through partnership taxation, and dual liability protection.

With an LLC, you can have different classes of membership. For example, you can give members with Class A membership full voting rights and members with Class B membership absolutely no voting rights. Or you can allow one class of membership shares to be transferable, whereas the other class of membership shares can’t be transferred without the approval of all the members. I go over how to create these different classes in Chapter 9.

To Plan Your Estate

Don’t overlook the value of the LLC when you plan your estate. Although it’s a simple entity compared to some of the über-complex trusts that your attorney may recommend, the LLC provides powerful asset protection. LLCs protect you from creditors, probate lawyers, and court costs. They allow you to avoid probate altogether, which means that your estate isn’t subject to the nickel-and-diming (I wish they were just nickels and dimes!) that probate attorneys siphon from estates as the court divvies up assets.

With an LLC, you can structure the management however you like, which is useful if you’re minimizing your estate (to reduce or eliminate estate taxes) while you’re alive by gifting a few of your assets to your heirs each year. An LLC is especially convenient for the gifting property; you can just gift some membership interests. This gets even better when you can start early and keep the total gift each year under the taxable amount. Not only does this beat having to retitle the property each year, but you can protect your estate from taxes along the way!

When setting up your LLC for your estate plan, you can be the LLC’s sole manager because the membership interests are transferred, meaning you control the property, but your heirs get to own it. Set it up so that when you die, your heirs become managers, or name someone else as a temporary manager until your heirs reach a certain age.

Additionally, you can structure your LLC so that the membership interests have less value than the underlying assets you are gifting. This means you can squeeze more into the $16,000 the IRS lets you gift each year tax-free. You do so by putting all your assets into an LLC, then devaluing the membership of that LLC (usually by taking away voting and management rights) before slowly gifting it away to your children.

LLCs are commonly used with different types of trusts. Trusts are great and have their place in most estate plans, but don’t look at your estate only from a tax-saving perspective. Most trusts don’t offer liability protection, and if you don’t use an LLC to cover your assets, you may not have anything left to leave your heirs. Those assets may go to the dogs (er, I mean creditors)!

To Do a Short-Term Project

LLCs were made for short-term projects. When these entities were first introduced, they were never supposed to live forever as corporations do. While they have long since left that antiquated requirement behind, one thing hasn’t changed: the ability to give your LLC a specific lifespan. This potential scheduled company termination is convenient for short-term projects such as real estate development and film financing.

Because of their pass-through taxation for investors, LLCs are especially great for flash-in-the-pan projects for which you must raise money. Investors can come together, pool their money, do the project, make the profit, and then dissolve the company. Upon dissolution, all the assets are liquidated, the creditors are paid off, and the remaining profit is split among the members according to their ownership percentages. All profits flow through to the investors’ personal tax returns, so they don’t have to worry about double taxation. (Chapter 15 covers the dissolution process in more detail.)

In the meantime, you and the other members can allocate the company’s profits and losses however you like. This makes investors happy because you can get more creative with the investment structure. For example, a common agreement for LLCs raising financing for a film is that, upon earning revenue, each investor gets their money back plus 10 percent. Afterward, all members share profits according to their membership share in the company. The limited liability company is the only entity offering this flexibility.

When doing a short-term project, all members must be on the same page from the get-go. When bringing on members, make sure that you give plenty of information about the project, specify that the LLC will be liquidated and dissolved (preferably in the operating agreement!), and tell them when you expect the dissolution to take place. Remember that you need a vote of the members to dissolve on a date other than the dissolution date specified in the articles of organization. If all members don’t agree, you’ll have trouble moving forward with your plans when the time comes.

To Segregate Assets

Segregating assets is vital in business. By segregating your business assets into individual LLCs, you put them out of the reach of your company’s creditors or people who may want to sue you.

Many people incorrectly think that their assets are safe if they’re operating as a corporation or an LLC, but that’s not necessarily true. If you’re like most entrepreneurs, your business is your biggest asset. If you lose the ability to operate, you’re doomed. Your business may be protected from your personal creditors, and you may be protected from your business’s creditors; however, what protects your business from its own creditors? If your LLC gets sued, everything inside it could end up seized and liquidated. Even worse, before you’ve lost the lawsuit, the courts can do an asset freeze, which means you have zero access to your operating capital — you can’t write checks or receive funds from clients. How stable will your business be after three months or more of an asset freeze?

The best way to fully protect your assets (and your access to them) is to keep no assets in the operating company. Instead, the company uses leased assets. I don’t mean you must start looking for furniture- and equipment-leasing companies. In this case, you own the leasing companies (or your business does). Each asset is put into a different LLC, and each LLC then leases these assets back to the operating company. When the operating company is sued, it has no assets with which to settle the claim. So, in the worst-case scenario, you dissolve the operating company and form a new one. You again set up the lease agreements with the various LLCs and are back in business!

The leasing aspect of this strategy needs to be legitimate. There needs to be an official transaction record, which is vital if the strategy is ever questioned in court. One of the biggest benefits of this strategy is that it is a legitimate way to pull extra cash out of your operating company; that same cash that otherwise could be frozen or seized in a lawsuit against your business. In Chapter 16, I go into all the ways an LLC can be used to protect your assets, including business assets.

To Minimize Your Tax Burden

When you first go into business, chances are your company won’t be profitable right away. Building up a business takes time, and in the first year or two, you probably will incur thousands of dollars in losses. Many entrepreneurs, eager to soften the financial blow of the startup phase, decide to form an LLC. With an LLC and its default partnership taxation, the losses of the business flow through to the members so that they can use them as deductions for other income.

Say, for example, that your business incurs $40,000 in losses in the first year of operation. If you and your partner each own 50 percent of the company, each of you gets a $20,000 business deduction on your personal tax returns. That could save each of you as much as $6,000 in federal income taxes alone! When starting up your company, every dollar counts — and an extra 6,000 of them can really help get things off the ground.

And don’t forget that you likely qualify for up to 20 percent federal tax deduction on your business income if your LLC has stuck with the default pass-through taxation. The IRS rarely gives a gift like this to small businesses, but it just goes to show our government truly does support entrepreneurship.

To Change the Profit Distributions

An LLC’s profits can be paid out disproportionately to the actual ownership percentages, so you and your partners can set up the company to receive all the profits and losses — even if you own only 10 percent of it. Why would you want to do that? Well, a common reason for changing the distributions is to provide an extra incentive for investors. For example, if one investor contributes all the capital, they get 50 percent of the company. However, the profit distributions can be varied so they receive 100 percent of the profits until their investment has been paid back (plus 10 percent in some cases). Then the profit distributions return to normal, and the profit is split equitably among the members.

The only contingency the IRS places on altering the allocations is that it must deliver substantial economic effect. This is a fancy way of saying you need a decent reason to change the allocations. In the above example, you have proven substantial economic effect; that is, you aren’t varying the allocations for any reason other than to egregiously avoid taxes. Another good example of the substantial economic effect is giving a higher portion of the allocations (and thus, distributions) to a particular investor because they invested during a riskier time in the business’s life.

You can get into serious tax trouble if you act without considering the whole picture. So, if you want to vary your profit distributions, work with an accountant who knows all the applicable IRS rules. Tax law is complicated, so it’s better to pay someone who spends all day learning and understanding it than trying to grasp it all yourself.

When varying your allocations, always document such arrangements in your operating agreement, separate buy-sell agreements, or by resolution of the members. After all, you can’t refuse to send a minority partner a check one year simply because you and most members suddenly decide to take all the profit. Well, okay, you can do that, but only if that sort of power is afforded to you in the company’s operating agreement, which has to be signed off on by all members, even the one getting shafted. For more on the very important topic of creating membership rules in your operating agreement, flip to Chapter 9.

To Protect Your Personal Assets

If you have substantial personal holdings — especially things like real estate, which bring liability with them — I recommend separating them into separate LLCs. When you spend your entire life saving for retirement, your children’s education, or even that second home you’ve long dreamed about, nothing is more crippling than losing it all in a lawsuit.

Rockefeller once advised people to own nothing and control everything. You don’t have to be a billionaire to walk in his footsteps. If you’re like most people, you currently hold all your personal assets in your own name: your savings account, your cars, your real estate, and your mutual funds, stocks, and bonds. This means that the reverse of Rockefeller’s advice is true — you own everything yet control nothing, and it can all be taken away.

If you really want to follow in the footsteps of financial giants, start by forming an LLC. Better yet, form a series of LLCs if you have decided it is right for you. Then contribute all your personal assets to those LLCs and make sure they’re isolated from one another. That way, if a debt arises for one of your assets — for example, you get a margin call that you can’t quite pay for — then all your other assets are safe. LLCs are cheap in comparison; I form them for clients every day for less than $300. You don’t have to be a millionaire to take advantage of the strategies of the rich. After all, whatever your net worth is at the moment, you have worked hard for it and deserve to keep it safe.

You’ll want to make sure the LLC in which you place your personal assets is formed in a state that allows LLCs to be formed for “any lawful purpose,” not “any lawful business purpose” or some variation. You want to make sure that the court cannot simply set aside the protections of your LLC because of a statutory hiccup like this because holding assets is not technically transacting business. If you have been planning on forming in one of those states, you may also want to keep in mind whether your operating agreement can overwrite this. For a list of each state’s rules on the allowed purpose of an LLC, see www.corpassure.com/dummies/llc-purpose.