This article discusses forming traditional and series LLCs, although our preference is clearly for the series LLC which provides significant benefits to real estate investors who own multiple properties. We favor LLC formation in Texas and Nevada, which have similar statutes and are both among the best states for asset protection.
What is an LLC?
How is an LLC different from a partnership? A corporation? A Houston appeals court case gives a good answer to these questions: “We conclude that [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.'” SJ Med. Ctr., L.L.C. v. Estahbanati, 418 S.W.3d 867, 873 (Tex.App.—Houston [14th Dist.] 2013, no pet.). In other words, although members of an LLC may loosely refer to themselves as partners, that is not quite correct, even though an LLC offers an informal form of management similar to a partnership. But unlike a general partnership, an LLC has a liability barrier protecting the members from personal liability. This makes it an excellent vehicle for investing in real estate.
Another difference from a general partnership is that LLC members do not actually have a direct ownership interest in the company’s property. “An LLC is considered a separate legal entity from its members. And . . . [Business Organizations Code §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.).
Chapter 101 of the Texas Business Organizations Code (“Limited Liability Companies”) is the operative statute in the case of LLCs. The statute governing partnerships can be found at Chapter 152.
Why form an LLC?
There are lots of good reasons to form an LLC including (1) using the liability barrier to minimize personal exposure and maximize asset protection; (2) organizing and managing one or more businesses; (3) tax benefits including pass-through taxation; (4) achieving a measure of anonymity; (5) investor credibility in marketing and doing creative transactions; and (6) 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 own multiple properties.
Separation of Business from Personal Affairs
An LLC is a useful device in separating business from personal affairs. Failing to do this is a common mistake of novice 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” which may arouse the suspicions of the judge and jury and result in your failing the “smell test.” This sort of error can result in an investor being held personally liable for damages.
Why risk it? Set up an operating account in the name of your LLC in which all income and related expenses are clearly shown, coded separately for each series or property. In the case of investors who are landlords, a separate account for tenant security deposits is always the best practice. If suit is filed, a plaintiff will likely demand an accounting and production of bank statements. Be prepared to show a sound business structure that functions with integrity. This is an essential part of any investor’s asset protection strategy.
Anonymity, at least in a certain amount, is a key aspect of asset protection and a primary reason for forming an LLC. Ideally, your personal name should never appear on any deeds or leases, and a tenant should never write a check to you personally. There is an old rule that people tend to sue whomever they write their checks to. Make sure that is never you.
It has been reported that a new lawsuit is filed every 1.3 seconds. Literally millions of lawsuits will be filed this year. At least some courts will award huge damages for such things as serving coffee that is too hot. In this legal environment, asset protection is a serious matter, and an LLC is an excellent tool for achieving it.
Although there is no such thing as a bulletproof plan to avoid personal liability or protect assets, one can get close. Forming an LLC is an important step.
Asset protection is like a cross-country horse race: the more fences a plaintiff and his attorney have to jump, and the more effort and money they have to spend in order to get to you personally, the better protected you are. One way or another, plaintiffs have to pay their lawyers, and that means either cash or contingent fee—and lawyers may hesitate to take a real estate fraud case on a contingency fee if they know they will have to penetrate a bona fide LLC before getting to any real assets.
Setting Up an LLC
In forming a Texas LLC, one of the first things to consider is a company name, including whether or not it is available. The easy names tend to be taken, so one needs to be creative. Name availability information is available by calling the Texas Secretary of State at (512) 463-5555. In any case, do not be distressed if a favorite name is unavailable, since the better strategy is to use a generic name for the LLC and an assumed name (“DBA”) for day-to-day company operations. Also, avoid using one’s personal name for the company—”John Jones Investments LLC,” for instance. Why make it easier for potential plaintiffs to know who owns the company? Better to seek out preferred DBAs for everyday use.
The old requirement was that a proposed LLC name could not be “deceptively similar” to an existing entity’s name, presumably to avoid confusing the public. The new 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—an apparent loosening of the rules to more effectively compete with Nevada and other jurisdictions. Nonetheless, one should probably not expect a significant change in the Secretary of State’s willingness to approve a new name that is very close to that of an existing entity. The agency has administrative discretion, and habits die hard.
After determining that a name is available, let your attorney know who the original members are going to be and what percentage of ownership each will have. Generally, LLCs have a managing member or co-managing members (common for husband and wife teams), although it is also possible to hire a manager who is not a member. An LLC may also have officers if the company agreement so provides. Who will be serving in these capacities? The client will also need to choose a registered agent with a physical street address, which can include a suite number but not a reference to a P.O. Box, PMB, Box, or other obvious indication that the address is not a physical office or residence. The Secretary of State occasionally googles a submitted address and may reject it if they think it is a POB.
The registered agent will receive and forward official company mail from the Secretary of State, the Comptroller, and anyone who is putting the company on formal legal notice. The registered agent is also the person who is served with process by the constable if the company is sued. For privacy reasons, listing the home address as the registered address is not recommended. Use of a physical office address is a better alternative. Note that the certificate of formation in Texas also requires listing the initial managers and their addresses. These addresses may (and should) be a POB rather than a home address.
All LLCs Are Not Created Equal
Basic one-pager, no-frill filings do not contain key asset protection provisions and should never be used by a serious investor. One’s goal should not be to merely “set up an LLC” and consider the job done. The goal should be to establish an LLC that includes sophisticated asset protection provisions beginning with the very first documents filed with the state (the certificate of formation in Texas or the articles of organization in Nevada). The need for quality documentation continues with the company agreement, the minutes of the first meeting, and so forth. These documents work together to build a wall against lawsuits and creditors. The company should also have a formal record book with a seal and membership certificates that are dated and issued.
Clients sometimes report that “I already have an LLC.” Often, they mean that the minimum initial paperwork has been filed (by an Internet service), the filing fee paid, and nothing else done. In terms of sound business practices and thorough record-keeping, this is obviously insufficient; also, legally speaking, minimalist filing may not be sufficient to maintain the company’s liability barrier if the LLC is challenged in court. If the LLC is not sufficiently independent and fully established, a court could use its discretion to find fraud and “pierce the corporate veil,” holding individual members personally liable despite Texas’s rather tough rules on the issue of piercing.
Clients will go on to say the following about the formation of their LLCs: “I just filled out and filed the standard forms.” That is the point. There are no “standard forms” for establishing and properly documenting an LLC, regardless of what Internet services may say or imply in promotion of their highly simplistic products. Even the very basic forms that are available at the Secretary of State’s website are of minimal use—they will get you a file number, minimal legal status, and that is about all. Will they get you real asset protection? Will they document the establishment of your business and your relationship with your partners in a clear way? Do not count on it.
If it is worth setting up an LLC in the first place, then it should be done with maximum effectiveness relative to the company’s purpose and the desire of its members for asset protection. As for Internet forms, an entire article could be written on how they often do more harm than good. Here is what Internet services do not provide:
NO comprehensive advice on how to structure business and investments to achieve an overall asset protection plan;
NO attorney to serve as organizer, initial member, and/or registered agent in order to maximize anonymity;
NO sophisticated company agreement that deters creditors from taking control of your company;
NO advice on how to move the property into the LLC after it is formed;
NO advice on how to use the LLC in conjunction with a land trust;
NO advice on how to set up and arrange the LLC’s finances, including LLC accounts, injecting capital, or loaning money to the LLC
NO advice on how to maintain the LLC liability barrier to prevent a plaintiff from piercing the veil; and
NO follow-up questions answered by a lawyer after the LLC is formed.
The documents provided by such services are so simplistic as to be barely above the level of junk. Business lawyers spend a fair percentage of their time cleaning up inadequacies in companies formed this way and offering asset protection guidance that the client should have received from the beginning.
The Series LLC
The series LLC allows an investor to hold assets and liabilities within separate compartments or series which effectively operate as sub-companies. It shares characteristics with the traditional Texas LLC, including the benefit of informal management, an effective liability shield, and pass-through taxation; but the series format also adds the unique ability to segregate assets and insulate them from liabilities arising from other assets within the same company.
Member-Managed vs. Manager-Managed LLCs
The better choice is almost always to be manager-managed, for a number of practical reasons. If the LLC is managed by its members, then any member may contractually bind the company—even if that member owns only a 1% interest—since each member-manager (or managing member) is considered to have full agency authority to act on behalf of the LLC (Tex. Bus. Orgs. Code §101.254). This means that third parties are entitled to rely upon what a member-manager says and does, at least for purposes of company business, even if the company agreement provides otherwise. A second practical reason to favor the manager-managed format is that it is more readily accepted in business transactions to execute documents in the capacity of manager. Lenders and title companies prefer this. A lender will occasionally require than an LLC convert to manager-managed (requiring a certificate of amendment with the Secretary of State) before it will extend a loan to the company.
The certificate of formation must state which type of management will occur. Texas requires that the managers and officers of a company (“governing persons” in Texas terminology) be a matter of public record, both in the COF and for purposes of annual reporting (in the Comptroller’s public information report). Even foreign companies that register to do business in Texas must disclose this information. However, neither the Secretary of State nor the Comptroller collect ownership information. To the extent that certain members of an LLC wish to remain in the background, then a manager-managed LLC is a better choice for this reason as well.
Alternative Business Structures
Clients occasionally ask if they should form a corporation instead of an LLC. While the corporate format is still available, it has been declining in use, a trend that can be verified by examining the filings at the Secretary of State’s office. The LLC combines the best of a corporation and a partnership. Generally, a corporation should be considered in the case of real estate investing only if an investor eventually plans to take the company public.
General partnerships, including a variation called “TICs” (for tenants-in-common), are also the subject of inquiry by clients. So are trusts. These may be useful structures in the right circumstances, but should be generally be used in conjunction with an LLC. Why? Because an LLC has a liability barrier. General partnerships, TICs, and trusts do not.
Limited partnerships (usually with a shell corporation or LLC as general partner) have an effective liability shield but are more complex structures commonly used for commercial transactions—acquiring shopping centers, apartment buildings, and the like—rather than residential flips or rentals. The general partner, who is supposed to be the only person running things, has sole full liability. The limited partners are at risk only for the amount of their contribution to the LP, but over-active limited partners 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).
Fiduciary Duty of the Entity’s Governing Persons
Managers and officers are fiduciaries, meaning they have an obligation to act ethically, with respect to the company and its members. Super Starr Int’l, LLC v. Fresh Tex Produce, LLC, 531 S.W.3d 829 (Tex. App.—Corpus Christi 2017, no pet.). Breach of fiduciary duty (usually involving an alleged misappropriation of funds or assets) is a common cause of action in litigation involving the break-up of small business LLCs.
Separating Assets from Activities: The Two-Company Structure
If an investor has (or intends to acquire) five to ten properties or more, a two-company structure is recommended. This should consist of a shell management company to interact with the public and a separate, stand-alone holding company to own hard assets. The fact that the holding company exists quietly in the background and does not enter into contracts or business dealings makes it nearly impossible to sue successfully. Few investors or business persons need anything more exotic than this.
It is critical that your attorney draft LLC governing documents so that they discourage creditors from even contemplating going after your membership interest. Asset protection provisions should be included from the outset in the certificate of formation and then extensively set out in the company agreement.
Classes of Members
The owners of an LLC are referred to as members rather than shareholders or partners. We suggest establishing two classes of members and announcing this fact in the company’s certificate of formation. Class A members are “regular” members who have full ownership and voting rights; Class B members are those who acquire their membership interest by some unfriendly or coercive means, including debt collection. They cannot vote and are not entitled to distributions except with the unanimous approval of the 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 nearly worthless?
In order to properly document your business and maintain the company as a separate legal entity that provides a liability barrier for its members, a certain amount of maintenance is advisable. The members should meet at least once a year. The first meeting of members (also called the organizational meeting) should include approval of the details of the certificate of formation and the company agreement. Annual meetings in successive years should review and ratify the preceding year’s actions, recognize unusual events or circumstances, and elect new managers. It is also a good idea to hold special meetings to approve major decisions, the purchase or sale of real property, a loan to the company, or acceptance of new members and the associated realignment of percentage interests.
An LLC, like a corporation, is a distinct legal entity with its own rights, duties, and remedies. It has its own employee identification number (“EIN”), although the LLC’s tax return is combined with the members’ personal return (similar to a partnership). However, an LLC requires continued respect for its independence in order to maintain its separate status. It may be your company, but it should still be treated at arm’s length for legal purposes. This is important if one wishes to avoid personal liability for the actions of the company or its agents and employees. 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 court could possibly decide an LLC defendant is not a “real” company—and allow the plaintiff to proceed directly against the members-owners personally. It will be alleged that the company is a sham and nothing but the personal alter ego of its owners, designed to shield them from the consequences of their wrongful conduct. Needless to say, this could be a disaster and entirely defeats the purpose of forming an LLC in the first place.
Remember, plaintiffs’ lawyers are looking for deep pockets and hard assets wherever they can be found. If there is a hole in your company’s liability shield, an aggressive lawyer will likely find it.
What if an investor operates with an LLC but is still sued personally?
Even if one has a properly constituted and operating LLC, it is still possible to be sued in a personal capacity. In fact, this happens alarmingly often in spite of the Texas bias against piercing in the absence of actual fraud. Unless one has personally guaranteed indebtedness of the company or engaged in wrongful or illegal conduct, this is a form of lawsuit abuse—yet plaintiffs’ lawyers commonly do it anyway. The defense attorney should respond by sending out written discovery (including interrogatories and requests for production) to find out if the other side has any basis for insisting on personal liability. If no basis can be shown, a motion for partial summary judgment should be filed to have personal names removed as defendants. The LLC’s attorney should also ask for fees and costs for having to go through this process. If the LLC has been properly maintained and there is no evidence of wrongdoing or actual fraud, then the motion should be successful. If not, this defense can be reasserted at trial.
The presence of fraud or a statutory violation changes things. A manager or officer may be held liable in his or her individual capacity based on conduct involving wrongful or illegal actions. State v. Morello, 2018 WL 1025685, ____ S.W.3d ____ (Tex. 2018). This is true even if the manager or officer was acting in furtherance of official duties. Operating with an LLC provides an effective liability shield only if one acts legitimately.
Moving Property into the LLC
Any and all investment property acquired or currently held in a personal name should be moved into the LLC by means of general or special warranty deed without delay. It is not necessary or advisable to transfer a Texas homestead into an LLC since the homestead is already protected by the Property Code and Texas Constitution. Keep in mind the general rule: personal and homestead-exempt assets should be kept separate from investment assets, and an LLC is a good mechanism for doing this.
Information in this article is provided for general informational and educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. No attorney-client relationship is created by the offering of this article. This firm does not represent you unless and until it is expressly retained in writing to do so. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well.
Copyright © 2019 by David J. Willis. All rights reserved. Mr. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, www.LoneStarLandLaw.com.