LLC Formation in Texas

Topics Covered

Why form an LLC?
LLCs Versus Corporations
LLCs Versus Partnerships
LLC Formation Process
Traditional LLCs Versus Series LLCs
LLC Documentation
Assets of the LLC
Ongoing LLC Maintenance
Anonymity in LLC Filings

Liability Shield of an LLC

The defining characteristic of an LLC is the liability shield it provides for its members. If the company is sued it is generally true (absent actual fraud) that members and managers are not personally liable for satisfying a judgment against the LLC.

Only registered entities (LLCs, corporations, and limited partnerships) that pay a formation fee and receive a charter from the state have a liability shield.Neithergeneral partnerships nor trusts (which are unfiled) have this benefit.

LLCs comprise the majority of registered-entity filings and are the preferred method of doing business for smaller firms generally and for real estate investors in particular. In Texas, a limited liability company is formed and filed pursuant to Title 3 of the Business Organizations Code (BOC Sections 101.001 et seq.). It is formed by means of a certificate of formation submitted to the secretary of state along with a $300 filing fee.

WHY FORM AN LLC?

Reasons to Form an LLC

Forming an LLC is integral to asset protection, especially for a real estate investor. Although there is no such thing as a bulletproof plan to avoid personal liability or protect assets, one’s goal should be to get as close as possible.Reasons for forming an LLC include:

(1) acquiring a liability shield to protect its members;

(2) organizing and managing one or more businesses separately from one’s personal affairs;

(3) obtaining certain tax benefits including pass-through taxation;

(4) providing a legal mechanism for different persons to own percentages of the business enterprise;

(5) achieving a measure of distance, protection, and anonymity from the public;

(6) credibility and professionalism in marketing and transactions; and

(7) in the case of a series company, compartmentalization and insulation of assets and liabilities within separate series. This last item provides significant benefits to investors who need a holding company to own multiple properties. More on series LLCs below.

The Legal Entity Concept

An LLC is a distinct legal entity—a legal person—with its own rights, duties, and remedies. It has its own employee identification number (EIN or TIN) although the LLC’s tax return may be combined with the members’ personal return (a disregarded entity for IRS purposes). However, an LLC requires continued respect for its independence in order to maintain its separate status. It may be your company, but it is its own legal person and thus should be treated at arms’ length for operational and accounting purposes. Failing to do this is a common mistake of novice real estate investors.

Running business income and expenses through one’s personal account may not be illegal, but it can complicate your defense if you are sued. It will be alleged that you commingled funds or skimmed profits or something similar. Such actions may have been both harmless and legal under the circumstances, but they can still arouse suspicion on the part of the judge and jury.

If suit is filed against an LLC, it is a foregone conclusion that the plaintiff will demand during discovery to see copies of financial and corporate records. Be prepared to show a sound business structure that functions with integrity and is not mixed with your personal activities and assets.

LLCs VERSUS CORPORATIONS

LLCs Versus Corporations

For-profit corporations are governed by Chapter 21 of the Business Organizations Code (BOC Section 21.002 et seq.). A common client question is whether to form a corporation or an LLC. While the corporate format is still available, it has been declining in use by smaller businesses for at least twenty years. Filings at the secretary of state’s office confirm this trend.

A corporation is generally considered to be a more rigid and rule-bound form of organization than an LLC. A corporation has shareholders (instead of members), officers (instead of managers), and a board of directors (usually dispensed with in an LLC). Corporate notions of shareholders’ rights, derivative actions against management, and duties of directors all make a corporation more suitable for a larger enterprise that is publicly traded.

The BOC offers a less formal corporate option (a close corporation) available under Section 101.463, but this is available only so long as the corporation has fewer than 35 shareholders and the LLC is not listed on a national securities exchange or regularly quoted in the over-the-counter market. Even so, the prevailing view is that an LLC is a more flexible and informal entity that is suitable for smaller and family-based businesses.

It is often said that an LLC combines the best features of a corporation (an effective liability shield) and a partnership (informal operation among a small number of owners). Unless there are complex circumstances or one intends to take a company public in the future, there is usually no good reason for a real estate investor to form a corporation instead of an LLC.

Charging Order Protection for LLCs

When it comes to post-judgment asset protection, LLCs have what is known as charging order protection. With a charging order, a creditor acquires what is essentially a lien on LLC distributions (if and when they occur) but cannot force the liquidation of company assets to satisfy a judgment or seize a membership interest. BOC Sec. 101.112.

By contrast, corporate stock may be seized by a creditor and sold at public auction. Stock in a corporation is considered in Texas to be non-exempt personal property (Bus. Orgs. Code Sec. 21.801) that is subject to levy—meaning a judgment creditor can take it. Tex. R. Civ. P. 641, Bus. & Com. Code Sec. 8.112; garnishment, Tex. R. Civ. P. 669; or turnover, Civ. Prac. & Rem. Code Sec. 31.002.

LLCs VERSUS PARTNERHIPS

LLCs Versus General Partnerships

Members of smaller LLCs often loosely refer to themselves as partners. However, an LLC is different from a general partnership in that it is a registered legal entity with a statutory liability barrier. General partnerships do not have these features.

In SJ Med. Ctr., L.L.C. v. Estahbanati, 418 S.W.3d 867, 873 (Tex.App.—Houston [14th Dist.] 2013, no pet.) a Houston appeals court explains:

An LLC does not fall within the ordinary meaning of “partnership” even if the LLC elects to be treated as a partnership for federal-income-tax and state-franchise-tax purposes. Though an LLC may have some characteristics similar to a partnership in calculating its tax liability, an LLC also has characteristics similar to a corporation regarding civil liability. An LLC is a separate type of . . . entity and is not included in the ordinary meaning of the word “partnership.”

There is another key difference between LLCs and general partnerships: LLC members do not have a direct ownership interest in the company’s property as is the case with partners. “An LLC is considered a separate legal entity from its members. And . . . [Business Organizations Code Section 101.106] provides that a member of [an LLC] does not have an interest in any specific property of the company.” Spates v. Office of Atty. Gen., 485 S.W.3d 546, 550-51 (Tex.App.—Houston [14th Dist.] 2016, no pet.). That includes real estate.

An LLC membership is personal property. It does not encompass any legal interest (direct or indirect) in real property owned by the LLC.

LLCs Versus Limited Partnerships

Like LLCs and corporations, limited partnerships are registered entities with a liability shield. They file a certificate of formation with the secretary of state and pay a filing fee. The general partner in a limited partnership (typically an LLC with minimal assets) is supposed to be the only one running things. The general partner has sole full liability to third parties who sue the limited partnership.

By contrast, limited partners are at risk only for the amount of their respective contributions to the limited partnership. However, over-active limited partners who meddle in management can lose this protection. “Personal liability attaches to a limited partner when he takes part in the control and management of the business.” Thompson v. Flintrock Feeders, Ltd., No. 2:09-CV-0010-J, 2010 WL 11561929 (N.D. Tex. May 10, 2010). For more detail on the law governing partnerships see BOC Chapter 152, Section 152.001 et seq.

Even though they are more complex than an LLC, limited partnerships are excellent investment vehicles in the right circumstances. They are commonly used for commercial transactions involving multiple investors—deals involving shopping centers, apartment buildings, and the like—rather than residential rental properties.

LLC FORMATION PROCESS

Name Availability

In forming a Texas LLC, one of the first things to consider is the company name, and this means first determining if one’s name of choice is available. The easy names tend to be taken so a measure of creativity may be required. The old standard was that a proposed LLC name could not be deceptively similar to an existing entity’s name, presumably to avoid confusing the public. The current requirement is that the name of a new entity must be distinguishable from the names of other entities in the secretary of state’s database—a loosening of the rules to more effectively compete with other pro-business jurisdictions like Nevada.

If a preferred name is unavailable, this should not be cause for distress since the better strategy for asset protection purposes is often to use a generic name for the LLC plus an assumed name for public visibility and day-to-day company operations.

Manager-Managed Versus Member-Managed

An LLC is managed by its governing authority which consists of governing persons who act according to the LLC’s governing documents. These are all defined terms in the BOC. The job of the governing authority is to “direct the management of the business and affairs of the company and exercise or authorize the exercise of the powers of the company as provided by: (1) the company agreement; and (2) provisions” of the Business Organizations Code applicable to LLCs. Bus. Orgs. Code Sec. 101.252.

The certificate of formation must state the nature of the new LLC’s governing authority—i.e., whether the LLC will be manager-managed or member-managed. Most new LLCs choose to be manager-managed, although one may form an LLC without managers—in which case the LLC is considered to be managed directly by the members (member-managed).

For a number of reasons, the better choice for real estate investors is almost always to choose a manager-managed format. One reason involves the issue of actual and apparent authority to bind the entity.

If the LLC is managed by its members, then any member may contractually bind the company—even if that member owns only a minority interest—since each member in a member-managed company is considered to have full agency authority to act on behalf of the LLC. BOC Sec. 101.254. In practice, this can present problems, since third parties are entitled to reasonable reliance upon what such a member says and does—at least for purposes of ordinary company business (and even if the company agreement provides otherwise). It is possible to envision a scenario where a rogue minority member binds the LLC to a transaction for which proper internal approval was not obtained.

A second reason to favor the manager-managed format is that it is more readily accepted in business and real estate transactions.

In the real world, as a practical matter, lenders and title companies almost always prefer the signature of an actual manager (rather than a managing member) on transactional documents involving the LLC.

A lender may even insist that a borrowing LLC convert to manager-managed (requiring a certificate of amendment to be filed with the secretary of state) before it will extend a loan.

Traditional LLC Versus Series LLC

Series LLCs allow real estate investors to hold their properties within separate series which effectively operate as sub-companies (Series A, Series B, and so forth). Series are, for operational and liability purposes, isolated and insulated from one another but still remain within the boundaries of the same legal entity. (They are not legal entities unto themselves.) There are three categories of series: registered series, protected series, and ordinary series (BOC Sec. 1.002).

By contrast, a traditional LLC holds its assets in a common, undifferentiated pool. There is no separation between assets. Nothing sets them apart from one another. This has significant consequences for asset protection in the event there is a judgment against the LLC. In the case of a traditional LLC, a judgment involving one asset in a traditional LLC is, in effect, a judgment against them all. Accordingly, an investor with multiple assets may want to consider the classic two-company structure.

The two-company structure consists of a management company dedicated to dealing with the public, tenants, and so forth plus a separate, stand-alone series holding company that owns multiple hard assets, each in a different series. This separation of activities from assets is foundational to asset protection and is what makes the two-company structure so effective.

LLC DOCUMENTATION

Core LLC Documents

The LLC formation process with the secretary of state begins with a certificate of formation and ends with a certificate of filing which is the official approval document. Some states (like Nevada) require that a business license must also be purchased. Texas does not. Unless it falls within a specifically regulated category, a Texas LLC is ready to do business as soon as it receives its certificate of filing.

Core LLC documents include:

(1) a customized certificate of formation (preferably not a standard form) that establishes the company;

(2) the certificate of filing (approval) issued by the secretary of state with the file date and file number;

(3) a proper company agreement (again, not a minimalist template) also called an operating agreement;

(4) an organizational meeting of members to ratify formation, approve a registered agent, elect managers, and establish other basics of governance;

(5) a signed consent by the registered agent;

(6) membership certificates signed and issued to the members;

(7) a signed banking resolution along with an EIN procured at irs.gov; and

(8) executed deeds and bills of sale conveying assets into the company.

These are the minimum documents necessary to get an LLC properly established for purposes of real estate investment and asset protection.

The Company Book

Company documents should be organized and kept in a company book with labeled tabs. These books are heavier-duty looseleaf notebooks produced by printing companies which also include membership certificates and a company seal (decorative effect only in Texas). A lawyer will insert custom-prepared documents (company agreement, organizational meeting, etc.) into the LLC book and then present the package to the client.

This is the traditional and professional way that business lawyers provide LLC documents—along with lots of signature flags, of course, since many documents require execution in order to activate their legal effect.

Classes of Membership

A sound approach is to establish two classes of members and announce this fact in the company’s certificate of formation. Again, this is something that a minimalist online form will not accomplish. One will need an attorney who knows what he or she is doing in this area.

In a setup involving two membership classes, class A members are defined as regular members who have full ownership and voting rights, while class B members are those who acquire their membership interest by some unfriendly or coercive means (as part of a legal settlement, for instance). It is generally provided that class B members cannot vote and are not entitled to distributions except with unanimous approval of class A members.

How better to deter adversaries than to make it clear from the outset that any interest they obtain (or obtain influence over) may be effectively worthless? Asset protection measures can be active or passive. Separating membership into classes is an example of an effective passive measure.

Registered Agent and Required Addresses

The registered agent receives service of process if the LLC is sued and also forwards formal legal notices (but not ordinary business mail) to the managers. The registered agent must have a physical street address which can include a suite number but nota reference to a P.O. Box, PMB, or other obvious indication that the address is not a physical office or residence. The secretary of state occasionally googles a submitted registered agent address and may reject it if it is a postal box.

An attorney is a good choice for both organizer and registered agent because it shows strength and preparedness to potential adversaries. It demonstrates that (1) the LLC is solidly formed and (2) the owner has the financial resources to retain counsel and will not be a pushover in a lawsuit.

If instead one is going to act as one’s own registered agent, listing the home address as the registered address is not recommended, just based on general privacy principles. A physical office address is a better alternative. (The registered agent’s address may not be a postal box.)

The initial mailing address of the company must also be included in the certificate of formation along with the names and addresses of the initial managers (member information is not required in the COF). The company address may be different from the registered agent address. It may be a postal box. Addresses of initial managers are also required. Managers may and generally should use an office address or a postal box rather than a home address.

ASSETS OF THE LLC

Deeds and Bills of Sale

Personally-held assets should be moved promptly into an investor’s holding LLC using deeds and (if needed) bills of sale. This should be done early, rather than waiting until an investor with a dozen properties titled in his personal name is served with a lawsuit. Transfers done after suit is threatened or filed can raise all sorts of thorny issues relating to fraudulent transfers.

Questions about the due-on-sale clause often arise in this context. If a transaction involves a title transfer into an LLC without prior lender consent, then there is a risk of acceleration of the note if the lender’s deed of trust contains a due-on-sale clause. (It probably does.) As a practical matter, however, mortgage lenders are not inclined to use a technical (non-monetary) issue like this to foreclose upon an otherwise performing loan—particularly when a borrower is transferring an investment property into his personal LLC for asset protection purposes. It is possible, but this author has never seen it happen.

Should the homestead be placed in an LLC?

No. The suggestion that real property should be transferred to an LLC applies to investment property, not the homestead. The homestead is already protected by the Property Code (Chapters 41 and 42) and the Texas Constitution (Article XVI, Section 50). Additionally, prudence suggests that the homestead (along with other exempt assets) should generally be kept separate and apart from lawsuit-prone investment assets such as rental properties. A better solution for the homestead is a living trust to avoid probate.

Community Property: Members who are Spouses

Texas is a community property state. All marital assets (including LLC membership interests) are presumed to be owned 50-50 by the spouses. Therefore both spouses are considered equal co-owners of the LLC—at least in the absence of a written partition agreement dividing community property pursuant to Section 4.102 of the Texas Family Code.

As long as a married couple lives in Texas and files a joint return then the LLC may be treated as a single-member LLC and a disregarded entity for tax purposes. If the LLC is set up so that 100% of the LLC is shown as being owned by either spouse, this LLC membership interest is still considered to be community property. Additionally, the IRS states that an LLC owned by either spouse (i.e., where one spouse is shown as sole member of the LLC) in a community property jurisdiction may still be treated as a disregarded entity—thus the spouses and the entity do not have to file separate tax returns.

ONGOING LLC MAINTENANCE

Documentary Maintenance

Routine documentary maintenance should continue after the LLC’s initial formation stage. Annual meetings of members should review and ratify the preceding year’s actions, recognize unusual events or circumstances, and elect managers for the coming year. It is also a good idea to hold special meetings to approve major decisions such as the purchase or sale of an asset, the making of a loan to the company, or acceptance of new members and the associated realignment of percentage interests.

Piercing the Liability Veil

LLC maintenance extends beyond meetings and documentation. Unless the company pays its state and federal taxes, maintains a bank account, conducts regular meetings, keeps records, and the like, then in the event of a lawsuit alleging fraud, a plaintiff may claim that the LLC is not a real company—and therefore the plaintiff should be allowed to proceed directly against the member-owners personally. This argument runs up against Business Organizations Code Section 21.223(a)(3) which expressly eliminates the failure to observe corporate formalities as a basis for piercing,

Unless one has personally guaranteed indebtedness of the company or engaged in actual fraud, veil-piercing allegations should not even be brought in a Texas court. Tryco Enterprises, Inc. v. Robinson, 390 S.W.3d 497 (Tex.App.—Houston [1st Dist.] 2012, pet. dism’d). As a practical matter, plaintiffs’ lawyers make veil piercing allegations anyway. One of the best ways to be prepared for this is with thorough LLC documentation. This often shuts down any talk of piercing the veil.

Texas Franchise Tax Returns

Required annual reports to the Texas Comptroller must be signed and filed before May 15th of each year. Preparing and filing these forms is a task usually performed by CPAs rather than attorneys.

There is a total-revenue threshold below which a tax report need not be filed. A taxable entity whose annualized total revenue is less than or equal to $2.47 million is no longer required to file a No Tax Due Report. However, the LLC is still required to file a Public Information Report (the PIR on form 05-102) or an Ownership Information Report (form 05-167). There is $50 fee for filing late.

Not filing a franchise tax return or paying Texas franchise tax (if either is required) or not filing a Public Information Report can result in the company’s right to transaction business, as well as the right to sue and defend itself in Texas courts, being forfeited. Clearly, this is an undesirable outcome. If the company’s right to transact business is forfeited, the company’s officers, directors, partners, members or owners may become individually liable for debts of the entity, including taxes, penalties and interest which are incurred after the due date. Tax Code Sections 171.251, 171.2515, 171.252, and 171.256.

Public Information Report (PIR)

The annual filing of a Public Information Report on form 05-102 is required by the Texas Comptroller. It is due by May 15th of the calendar year after the year of formation. The PIR requires disclosure of: (1) the name, title, and mailing address of each officer, director, member, general partner, or manager; (2) each corporation, LLC, LP, PA or financial institution, if any, in which the entity owns an interest of 10% or more; and (3) each corporation, LLC, LP, PA or financial institution, if any, that owns an interest of 10% or more in the entity filing the PIR.

The PIR is differs from the Certificate of Formation which required disclosure of only the names of the initial managers. The PIR wants to know the identity of the owners (members) as well. Disclosures made in the PIR have implications for any anonymity strategy one may have, so care is required when filling out the PIR if anonymity is part of your asset protection plan.

There is no annual filing (document or fee) required at the Secretary of State’s office.

FinCEN Filing

The Corporate Transparency Act (CTA, 31 U.S.C. Sec. 5336) is a recent federal law that substantially affects LLC formation and real estate transactions. The goal of the CTA is to crack down on anonymous shell companies used by money launderers, terrorists, foreign dictators, and the like. FinCEN, a division of the Treasury Department, proposed extensive and intrusive rules that would have required LLCs and corporations to self-report their beneficial ownership information (BOI). Under the Trump administration, these rules have been suspended for domestically-formed LLCs and corporations, but not for those based abroad.

ANONYMITY IN LLC FILINGS

Regulatory Trend Against Anonymity

True anonymity has become difficult to achieve due to a more challenging regulatory environment that is beginning to emphasize transparency. Even so, forming an LLC can still provide a basic level of distance and partial obscurity from the public. Such incremental measures matter in asset protection.

Achieving absolute anonymity is becoming next to impossible if one stays within the law (and it has always been illegal to try to remain anonymous from the IRS). So when the issue of anonymity is raised, one must ask: anonymity at what level? Anonymity from whom? And what level of relative anonymity will be satisfactory?

A significant level of anonymity will likely require an expensive layered structure that involves entities in multiple jurisdictions, possibly offshore. Anyone interested in maximizing anonymity would also need to refrain from cash (non-loan) purchases of American real estate if the transaction involves gatekeepers such as lenders and title companies, since FinCEN will definitely be interested in those.

Signing LLC Filings

BOC Section 101.0515 requires that a “filing instrument of a limited liability company or a registered series must be signed by an authorized officer, manager, or member of the limited liability company or the registered series.” This is a significant change from previous practice, since previously such filings could be signed by an authorized person pursuant to BOC Section 4.001, which could include the attorney filing the instrument. However, at least for the time being, an attorney signing as “an authorized person pursuant to BOC Sec. 101.0515” works just fine.

Personal Information Made Public

Being careful about how much personal information one launches into the public domain should always be part of an asset protection plan. Also, one’s personal name should never appear on deeds or leases, and a tenant should never write a check to an investor-landlord’s personal name or deliver a check to one’s home address. There is an old rule that people tend to sue whomever they make their checks payable to. Make sure that is never you in your individual and personal capacity. And it is still worthwhile to avoid plastering one’s home address all over the Internet and public record.

Assumed Names for LLCs

Rules for assumed names are covered primarily by Chapter 71 of the Business and Commerce Code (Section 71.001 et seq.) titled the “Assumed Business and Professional Name Act.”

While not technically an anonymity strategy, the use of an assumed name (DBA) can enhance asset protection by adding a layer of protection. As observed earlier, asset protection is less about forming a magic entity structure and more about including incremental layers of protection whenever it is reasonably feasible to do so. An example: avoid using one’s personal name for the company—“John Jones Investments LLC,” for instance. Why make it not only easy but obvious to potential plaintiffs that Mr. Jones owns the company? Better to obtain a DBA for consistent everyday use.

Conclusion

LLC formation begins with a carefully constructed certificate of formation. Clients who set up their own LLCs will say “I just filled out the standard form.” However, even basic forms available from the secretary of state’s website are of limited value—they will get you a file number, bare legal status as a registered entity, and that is about all. Better law firms file custom certificates of formation that include special provisions that enhance asset protection.

The benefits of professional documentation may not be apparent until the company is sued and the plaintiff demands copies of the LLC documents as part of the discovery process. Junk documents from the Internet or LegalZoom may not look like such a good idea at that point.