Asset Protection: A Rational Approach

“You’re going to lose everything you own,” the speaker solemnly warned the audience at a recent real estate investment program.  “We live in a very litigious society,” he continued; “you need asset protection.”

Real estate investors, as a group, will flock to hear speakers talk about the need for what is commonly known as “asset protection.”  They will spend hundreds, if not thousands of dollars setting up elaborate business entities (the LLC – “Limited Liability Company” – being the most popular), in an effort to avoid “losing everything.”  Ironically, many new investors spend more money on “asset protection” than they do on real estate.  Sometimes they end up with all sorts of asset protection entities, but no assets to protect.

There is a more rational and practical approach to asset protection.  Setting up the correct business entity to allow you to achieve your real estate investing objectives is both important and necessary.  The correct entity will allow you to take full legal advantage of tax benefits and provide a structure for running the business.  Properly established and registered, the entity will allow the investor to work with investment partners, obtain financing, and provide a basis for determining the relative percentages of ownership and allow for succession and continuity for a successful operation over a period of time.  And yes, the entity will provide a measure of “asset protection” for the benefit of the principals, if the entity is properly established and capitalized, and has complied with the appropriate level of corporate formalities.

However, no form of entity is a substitute for good risk management.  The fundamental components of a good risk management program are (1) good management practices, (2) adequate insurance coverage, and (3) regular review and oversight.  For real estate investing, good management practices include using the services of a reputable, licensed, professional property management company.  The relatively small cost (usually 6 – 8%) will be more than justified by the savings from avoiding disasters.  Good management includes proper screening of tenants; regular and thorough inspection of the investment property, arranging for prompt and competent repairs, and if necessary, timely initiation of eviction proceedings.

In addition to standard form “all risk” fire insurance policies, adequate insurance coverage should include, where appropriate, flood, earthquake and other forms of disaster coverage.  I recommend that tenants be required to carry renters insurance, which can cost as little as $12 per month, but will cover the tenant’s personal belongings, relocation costs (if necessary), and injuries sustained by their guests.

Last, but not least, good risk management practices includes regular review and oversight.   “File and Forget” is not a smart way to manage anything.  Prudent owners make sure they manage their property managers, and take steps to ensure that their expectations are met.  Do not just sit back and hope the checks roll in every month.  Be proactive. Pay attention.  Ask questions.

But what about “asset protection.”  What if something “bad” happens, the tenant sues, and the investment property is in your name and not buried under an onion’s worth of layers of special entities?  What can happen?  Indeed, what DOES happen?

First and foremost, the type of liability that owners need to be concerned about involve claims resulting from personal injury, either to the tenant or their guest.  Injuries can range from a sprained ankle caused by a crack in the walkway to serious brain injury (or death) resulting from a collapsed balcony or similar structural failure.  There are also potential claims based on acts of discrimination, for example, but in terms of monetary damages, the “big ticket” issues usually arise from personal injury cases.

In such cases, the first and best line of defense is good property management, as discussed above.  In terms of avoiding catastorphic loss, investing in good prevention can yield a very high rate of return!  The next line of defense is your insurance policy (or policies), which should include comprehensive general liability coverage.  In the event of a claim, the insurance company will provide legal counsel and will pay for investigation and other costs arising from the incident.  If early settlement does not resolve the issue, and the matter proceeds to litigation, your insurance company is most likely under an obligation to provide a defense in most cases.  There are general exceptions, such as for willful or deliberate acts, and specific exceptions, such as where the policy does not cover certain types of loss unless a special “rider” has been obtained; i.e. flood, earthquake, etc.

Statistically speaking, it would be extremely rare if you found yourself facing a full-blown lawsuit with a prospect of a large jury verdict that might exceed the limits of your insurance coverage — the type of catastrophic “lose everything” outcome that promoters of “asset protection” programs use to sell their services.

Let’s look at the reality — not the hype.  It is fairly well established that close to 90% of all lawsuits that are filed will settle before going to trial.   So, if your insurance company has not been successful in resolving the claim and the plaintiff (i.e., your tenant) proceeds to file a lawsuit, the probability of the matter going to trial before a jury is 1 in 10.  Arbitration, mediation and other forms of formal dispute resolution are mandated by most State rules governing litigation.   In California, the parties are required to participate in a Mandatory Settlement Conference the week before the start of trial.  Statistics vary, but in one County, the Court noted that one-third of all remaining cases settle at the Settlement Conference, usually held on the Wednesday before the start of trial; another one-third settle on the Friday before trial, and a percentage settle even after the jury has been seated.  Again — as a statistical fact — very, very few cases make it all the way to the end of trial.  And even after the Jury renders a verdict, there are appeal procedures, that work to modify the outcome.  Many headline-grabbing jury awards are often reduced — drastically — by these types of procedures.

Real estate investors should consider the actual threat of “losing everything” in considering how best to protect their investment and their personal assets.  Sadly, many new investors spend more time focused on so-called “asset protection” measures than they spend doing their due diligence in relation to the investment itself.  Investors pay money to set up elaborate LLC entities only to find themselves locked into a bad investment with other partners they did not take time to know.  If one added up all the personal injury jury verdicts that exceeded insurance policy limits over a 10-year period in the United States, I wonder if the total amount would come close to matching the losses caused by Bernie Madoff and his scheme.

This is not to say that forming a LLC or a C-Corporation is not a good idea.  Properly done, the appropriate business entity provides the means to manage your investment assets, entitles you to certain tax benefits, and manage your investment partners.  But a business entity should never, ever be a substitute for good management practices.

Is your LLC Doing Business in California?

Do you use an out-of-state or “foreign” LLC for your real estate investments? Due to recent changes in California law, you may be considered to be “Doing Business” in California, and must register your foreign LLC with the State and pay the $800 tax anyway!

Many people ask me “What state should I register my LLC in?”  “I don”t want to pay the $800 tax in California.  Are there any disadvantages of registering my LLC in another state?”  No matter what, you must register your LLC in any State where you are “doing business.”  Up until recently (2011), this meant – in most cases –  if you were a California resident, had formed a Nevada LLC, and owned an investment property in Arizona, you would only need to make sure you registered your Nevada LLC in the State of Arizona.  Many investors seek to maximize their returns, and avoiding the $800 franchise tax levied by California is a common reason given for forming out-of-state or “foreign” LLCs.  However, in 2011, California changed the rules in 2011 as to how it determines whether or not you are “doing business” in California.  Be sure to review the Examples below – they may surprise you!

California defines doing business as “actively engaging in any transaction for the purpose of financial or pecuniary gain or profit” (R&TC § 23101(a)). In addition, LLCs are considered “doing business” in California if:

•   It is a nonregistered foreign LLC that is a Although you may come across as a superficial person owing to your gemini horoscope Ascendant, you actually seek the true meaning of your life, and you value meaningful interpersonal relations. member of an LLC that does business in California.

•   It is a general partner in a partnership or limited partnership that does business in California.

•    Any of the LLC”s members, managers, or other agents conducts business in California on behalf of the LLC.  (Emphasis added)

For tax years that begin on or after January 1, 2011, a taxpayer is also doing business in California if any of the following apply:

•   The casino online taxpayer is organized or commercially domiciled in California.

•    Sales, as defined in subdivision (e) or (f) of R&TC § 25120, including sales by the taxpayer”s agents and independent contractors, in California, exceed the lesser of $500,000 or 25 percent online pokies of the taxpayer”s total sales.

•   Real or tangible property of the taxpayer in California, exceed the lesser of $50,000 or 25 percent of the taxpayer”s total real and tangible property.

•    The amount paid in California by the taxpayer for compensation, as defined in subdivision (c) of R&TC §25120, exceeds the lesser of $50,000 or 25 percent of the total compensation paid by the taxpayer.

For the preceding conditions, the sales, property, and payroll of the taxpayer include the taxpayer”s pro rata or distributive share of pass-through entities (R&TC § 23101(d)).

Regardless of where LLCs primarily conduct business, if any of their members, managers, or other agents conduct business in California on behalf of the LLC, the FTB considers the LLC as doing business in California (R&TC § 23101). [Go to ftb.ca.gov and search for doing business for more information.]

Example 1

Paul is a California resident and a member of a Nevada LLC. The Nevada LLC owns property in Nevada. The LLC hires a Nevada management company to collect rents and provide maintenance. Paul has the right to hire and fire the management company. He occasionally has telephone discussions with the management company regarding the property. He is ultimately responsible for the property and oversees the management company. Paul conducts business in California on behalf of the LLC. The LLC must file Form 568.

Example 2

Rachel is a California resident and member of an Oregon LLC. The Oregon LLC has a retail store in Oregon. Rachel uses a California address for the LLC”s tax filings and a California accountant to prepare the LLC”s tax returns. Rachel conducts business in California on behalf of the LLC. The LLC must file Form 568.

Example 3

Sara is a California resident and a member of a Texas LLC. The Texas LLC receives royalties from Texas oil wells. Sara maintains a California business bank account and secures financing in California for the LLC”s Texas investments. Sara conducts business in California on behalf of the LLC. The LLC must file Form 568.

(The foregoing is taken from FTB Form 3556 LLC MEO 4-2011.  For more information, go to www.ftb.ca.gov, and consult with your Attorney or tax professional.)