In Texas, a limited liability company is a state-registered entity filed pursuant to Title 3 of the Business Organizations Code (the “BOC,” Sections 101.001 et seq.). It is formed by means of a certificate of filing submitted to the secretary of state and signed “by an officer, manager, or member of the limited liability company.” BOC Sec. 101.0515. The defining characteristic of an LLC is that it provides a liability shield for its members, meaning that 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 state-registered entities (LLCs, corporations, and limited partnerships) have a liability shield. Other forms of business organization (sole proprietorships, general partnerships, and trusts) do not. For example, neither a general partnership nor a trust agreement is recorded or required to be filed anywhere. Participants in these other types of businesses are therefore personally exposed to liability on a judgment.
Two types of LLCs are in common use in the real estate investing business: traditional LLCs and series LLCs. The latter are distinguished from the former by having individual series or compartments that are isolated and insulated from one another for liability purposes—all within the same LLC. These series exist and operate separately but inside the same framework. For example, in the case of a series LLC that is used as a holding company for investment properties, it is common to hold a different property in each series (one in Series A, another in Series B, etc.). In this way, the liabilities and lawsuits associated with one property do not spill over onto other series or the company at large. This contrasts with a traditional LLC which holds its assets in a single undifferentiated pool.
The recommended two-company structure for real estate investors consists of a traditional LLC that is used as a management company and a series LLC that owns the hard assets. The two LLCs are divided from one another in organization and function so as to clearly separate activities from assets, which is a fundamental principle of asset protection.
LLCs comprise the vast majority of registered-entity filings at the secretary of state’s office and are the preferred method of doing business for small to medium-sized companies. Unless there are complex circumstances or one intends to take a company public in the future, there is usually no good reason for a small businessperson to form any other type of business organization.
Why form an LLC?
There are lots of good reasons to form an LLC. These include: (1) acquiring a liability barrier to minimize personal exposure and maximize asset protection; (2) organizing and managing one or more businesses separately from one’s personal affairs; (3) obtaining certain tax benefits including pass-through taxation; (4) achieving a measure of anonymity; (5) investor credibility in marketing and 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 need a holding company to own multiple properties.
Forming an LLC is integral to asset protection. Although there is no such thing as a bulletproof plan to avoid personal liability or protect assets, one can get reasonably close. Forming an LLC is an important step in a more comprehensive strategy.
Think of asset protection as being similar to 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 your personal assets, the better. One way or another, plaintiffs have to pay their lawyers, and that means either cash or contingent fee—and lawyers may hesitate to accept a case on a contingent fee if they know they will have to penetrate a bona fide LLC.
Lawyers look for deep pockets and hard assets wherever they can be found. If there is a hole in your structure’s liability shield and you have hard assets worth taking, an aggressive lawyer will likely find that weakness. It has been reported that a new lawsuit is filed every 1.3 seconds. Literally millions of lawsuits are filed each year. Courts 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 starting tool for achieving it.
Separation of Business from Personal Affairs
As noted above, an LLC is a useful device in separating business from personal affairs. Failing to do this is a common mistake of novice real estate investors.
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, same thing), although the LLC’s tax return may be combined with the members’ personal return. 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 arms’ length for legal and accounting purposes.
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. This can arouse suspicions on the part of the judge and jury and result in your failing the “smell test” which is nearly always fatal in a jury trial. This could result in a real estate investor being accused of fraud and held personally liable for damages.
Why risk it? Set up an LLC with its own operating account in which all income and related expenses are clearly shown and separately coded for each asset and series. In the case of investors who are landlords, a separate LLC account for tenant security deposits is 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 and is not mixed with your personal assets and activities.
Total anonymity is becoming difficult to achieve due to a changing legal regulatory environment that now includes FinCEN beneficial ownership rules. Nonetheless, forming an LLC can provide a basic level of distance.
Being careful about how much personal information one puts into the public domain should certainly be part of any asset protection plan. Ideally, your personal name should never appear on deeds or leases, and a tenant should never write a check to you personally or deliver a check to your 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. And try not to plaster your home address all over the public record. People are crazy now and bad things can happen. A disgruntled Florida tenant recently found his landlord while at home, standing in her driveway, and shot her.
The LLC Formation Process; Core Documents
The LLC formation process begins with a certificate of formation and ends with a certificate of filing which is the approval document issued by the secretary of state. Since the goal is asset protection, customized, advanced provisions should be included in LLC documentation from the beginning. This should include the certificate of formation and continue as a consistent theme throughout other LLC documents.
Most experienced business lawyers are not satisfied with using the fill-in-the-blank forms promulgated by the secretary of state. These accomplish only the bare minimum in order to get an LLC formation approved. Failure at this early stage to include custom provisions to enhance asset protection is a missed opportunity.
Core LLC documents should include a customized certificate of formation; the certificate of filing issued by the secretary of state with the file date and file number; a proper company agreement (not a minimalist template) also called an operating agreement; an organizational meeting of members to approve a registered agent, elect managers, and establish other basic features of the new company; a signed consent by the registered agent; membership certificates signed and issued in the appropriate percentages; and lastly, deeds and bills of sale conveying assets into the company. Correctly done, the foregoing are the documents necessary to get the LLC properly up and running and ready to do business. Company documents should be organized and kept in a company book with labeled tabs.
There is most definitely a difference between a minimalist one-pager-type LLC filing and one that is professional grade in terms of documents and its ability to protect members from personal liability. The benefits of the latter may not be apparent until the company is sued, and the plaintiff (as always occurs in the discovery process) asks for the defendant’s company book and documents. Only then does one see if the LLC’s documentation is up to the task. Junk documents from the internet or LegalZoom may not look like such a good idea at that point. For further details, see our companion article of LLC Governing Documents.
Documentary Maintenance and Piercing the Veil
Company maintenance over the years is also important, since it can help avoid personal liability for actions of company managers, employees, or agents. 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, the purchase or sale of real property, a loan to the company, or acceptance of new members and the associated realignment of percentage interests.
Maintenance extends beyond 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 will likely claim that the defendant LLC is not a real company—and therefore the plaintiff should be allowed to proceed directly against the members-owners personally. The plaintiff will assert that the LLC is a sham and merely the alter ego of its owners, designed to shield them from consequences of their wrongful conduct. Needless to say, this could be a disaster and defeats the purpose of forming an LLC in the first place.
Even if one has a properly constituted and maintained LLC, it is still possible to be sued in a personal capacity. Lawsuits seeking to pierce the veil occur alarmingly often in spite of the clear bias of Texas law against piercing in the absence of actual fraud. BOC Sec. 21.223. 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 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 actual fraud, then the motion should be successful. If not, this defense can be reasserted at trial.
The presence of actual fraud or a statutory violation changes things. BOC Sec. 21.223. A manager or officer may be held liable in his or her individual capacity based on conduct involving wrongful or illegal actions. State of Texas v. Morello, 547 S.W.3d 881 (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. See our companion article on Piercing the Veil in Texas.
LLC Name; Assumed Names
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 may need to be creative. Name information is available by calling the 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 that Mr. Jones owns the company? Better to obtain a preferred DBA for everyday use. Rules for assumed names are covered by Chapter 71 of the Business & Commerce Code (Section 71.001 et seq.) titled the “Assumed Business and Professional Name Act.” See our companion article, Assumed Names in Texas.
As to the proper registered name of the LLC, the old requirement was that a proposed 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 merely 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 pro-business 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.
The registered agent receives service of process if the LLC is sued and also forwards formal legal notices (but not ordinary business mail). The registered agent must have 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 registered agent address and may reject it if it is a postal box.
An attorney is a good choice for registered agent because it shows strength and preparedness to potential adversaries. In any case, if one is going to act as one’s own registered agent, listing the home address as the registered address is not recommended. Use of a physical office address is a better alternative.
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). These addresses are different from the registered address where the registered agent can be found. They may and should be a POB rather than a home address.
Member-Managed vs. Manager-Managed LLCs
The better choice for real estate investment LLCs is always to be manager-managed. There are 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 is considered to have full agency authority to act on behalf of the LLC. Bus. Orgs. Code Sec. 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. So it is possible to envision a scenario where a rogue minority member binds the LLC to a transaction for which proper approval has not been obtained.
A second practical reason to favor the manager-managed format is that it is more readily accepted in business transactions for purposes of document execution. Lenders and title companies prefer it. A lender will occasionally insist than an LLC convert to manager-managed (requiring a certificate of amendment to be filed 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 BOC terminology) be a matter of public record, both in the COF and for purposes of annual reporting (in the comptroller’s public information report or PIR). However, the certificate of formation does not require inclusion of ownership information (i.e., the names of members). To the extent that certain members of an LLC wish to remain in the background for the time being (at least until the first PIR is filed), then a manager-managed LLC is a better choice for this reason as well.
Note that managers and officers of an LLC 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.
Classes of Membership
It is a sound approach to establish two classes of members and announce 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. It should be 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 can be active or passive. Separating membership into classes is an example of a passive measure that can provide useful deterrence.
How is an LLC different from a corporation?
For-profit corporations are governed by Chapter 21of the 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 around twenty years. This trend can be verified by reviewing filings at the secretary of state’s office.
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). 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 more informal 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, making it suitable smaller and family-based businesses. It is often said that an LLC combines the best features of a corporation (an effective liability barrier) and a partnership (informal operation among a small number of owners).
On the asset protection side, LLCs have what is known as charging order protection. The creditor acquired what is essentially a lien on LLC distributions, if and when they occur, but cannot the force 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 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.
How is an LLC different from general and limited partnerships?
An LLC is different from a general partnership in that it is a distinct free-standing registered legal entity with a statutory liability barrier protecting its members’ personal assets. A Houston appeals court elaborates: “[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 and conduct themselves as such, that usage is not correct terminology in a legal sense.
There is another key difference between LLCs and 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.).
Limited partnerships (usually with a shell entity as general partner) do 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 others—the 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.
Separating Assets from Activities: The Two-Company Structure
A two-company structure is recommended for most real estate investors. 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 holding company exists quietly in the background and does not enter into contracts or business dealings, which makes it nearly impossible to sue successfully (due to the legal concept of “privity”).
Few investors or business persons need anything more exotic than the two-company structure. The effectiveness of a structure can be increased by the layering of liability barriers (one LLC behind another, as in our hub-sub structure); even so, the essential division of assets from activities must be preserved if one is to achieve adequate asset protection.
Moving Property into an LLC
Assets held in a personal name should be moved promptly into an investor’s LLC. Note that this applies to investment property only, not the homestead. It is not necessary (or even advisable) to transfer a Texas homestead into an LLC since the homestead is already protected by the Property Code (Chapters 41 and 42) and the Texas Constitution (Article XVI, Section 50).
Keep in mind the rule that personal and homestead-exempt assets should be kept separate from investment assets, and an LLC is a good mechanism for doing this.
All LLCs Are Not Created Equal
Clients who set up their own LLCs will tell their attorneys “I just filled out 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 in promoting their simplistic products that may not even be specific to Texas. Even the very 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. No one of any legal sophistication uses these forms.
The goal of an intelligent real estate investor should not be merely to form an LLC and consider the job done. The goal should be to establish a structure that includes sophisticated asset protection provisions and documents that will survive a legal challenge. The need for quality documentation commences with the certificate of formation and continues with the company agreement, the minutes of the first meeting, and so forth. These documents should work together to build a wall against lawsuits and creditors.
Clients sometimes report that “I already have an LLC.” Usually they mean that the minimum initial form has been filed DIY, the filing fee paid, and nothing else done. In terms of sound business practice, this is insufficient for many reasons not the least of which is that a one-pager filing may not be sufficient to maintain the company’s liability barrier. If the LLC is not sufficiently independent and fully established, a court could use its discretion to find fraud and “pierce the veil” as discussed above. Unfortunately, the existence of Texas’ actual fraud rule does not stop plaintiffs’ attorneys from demanding this extraordinary remedy. They do it in Texas courts every day, regardless of the actual fraud rule. (Asset protection advisors who have never tried a case are stunningly unaware of this). It is the way the legal system works in the real world. Best to be prepared with a well-documented professional-grade LLC.
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 registered agent as part of a strategy to maximize anonymity;
NO sophisticated company agreement that helps deter creditors from taking control of your company;
NO advice on how to move property into the LLC after it is formed;
NO advice on how to use the LLC in conjunction with other LLCs or trusts;
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 seeking to pierce the veil; and
NO follow-up questions answered by a lawyer after the LLC is formed.
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—except now, with the cost of clean-up, the process is more expensive. Given that an LLC is given the vital job or protecting one’s assets, the more prudent course is to handle matters professionally from the beginning.
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 © 2022 by David J. Willis Attorney. 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.