The Two-Company Structure for Real Estate Investors

Topics Covered

Separation of Activities from Assets
Role of the Management Company
Role of the Holding Company

Quest for an Ideal Structure

What structure will maximize both business functionality and asset protection? How can one keep things both simple and safe? The answer is often a two-company structure consisting of a traditional LLC acting as a management company in conjunction with a series LLC acting as an asset-holding company.

This two-company structure is suitable for investors who have (or intend to acquire) multiple properties of the same general type–single family rentals, for instance. So for owning and managing such properties, the investor should have two LLCs—a management company and a holding company. Each stands alone. Although the LLCs may move funds back and forth, neither owns an interest in the other.

SEPARATION OF ACTIVITIES FROM ASSETS

Separating activities from assets is the single most important step that a real estate investor can take for asset protection. Any businessperson with significant public-facing dealings should consider a two-company LLC structure consisting of a management company and a separate asset-holding company.

Why? Because:

(1) Business activities–marketing, management, and operations–occur in the context of direct dealings with customers, clients, and the public generally (legal privity).

(2) Such dealings give rise to liability and lawsuits against the entity engaging in such activities.

(3) If the activities entity is sued and a judgment obtained, it is a simple matter for the plaintiff (now a judgment creditor) to execute upon (seize, garnish, or force the sale of) hard assets that are conveniently contained in the activities entity and easily reached.

(4) Therefore, to the extent practicable, the activities entity should be consistently maintained as a shell, and to the extent that hard assets accumulate in the activities entity, they should regularly be moved out.

(5) Substantial hard assets should never reside or be titled in the activities entity, but in an entirely separate entity altogether, relying on the affirmative defense of no privity if the asset-holding entity is sued.

Why is privity important?

The legal concept of privity is a common-law principle that essentially means doing business directly with someone. It is the primary basis upon which liability is generated and lawsuits filed.

Generally speaking, if there is no privity between plaintiff and defendant (meaning that the plaintiff has never done business directly with the defendant), then a lawsuit is subject to being dismissed on a motion for summary judgment.

Arguments relating to privity are heard in the courthouse every day and no privity remains an effective defense. The goal is keep the investor’s holding company (and the assets it contains) safely out of reach of a plaintiff, all based on the concept of privity and derived from the separation of activities from assets.

THE MANAGEMENT COMPANY

Management Activities

The management company is the public face of the business, preferably operating under an assumed name. It is visible and active, collecting rents, signing leases, dealing with third parties like contractors, brokers, and vendors; employing personnel; leasing office furniture, equipment, vehicles, and office space; and otherwise engaging with the public (privity). The management company is a stand-alone entity with no real assets, an intentional target for litigation (no privity).

Tenants, creditors, vendors, and the public generally should be made to understand that checks and payments should all name the LLC’s assumed name as payee.

No privity is a key lawsuit defense. Since payment is an obvious indication of privity, the goal should be to make sure the payee is always the management LLC, never the investor personally and never the holding LLC.

If there is no compelling reason to disclose the proper legal name of the investor’s underlying LLC (and most of the time there is not) then why do it? Also, an investor’s personal name should never appear on an invoice. Why?

Because when a personal name appears as a principal, a plaintiffs’ attorney sees a potential defendant.

Note that if a tenant requests the proper legal name of the landlord’s business—whether management or ownership–then the landlord must provide it. Prop. Code Sec. 92.201.

Cash (always the most vulnerable asset) held by the management company should be monitored so it does not build up excessively. If funds accumulate in the operating account then they can be transferred out at regular intervals to keep the average balance in the management LLC relatively low. They can also be transferred in as needed. A reasonable guideline is to keep cash balances under $25,000.

Disposability of the Management Company

In a sense, the management LLC is designed to be disposable. If the management company is sued, one remedy is to simply walk away, form a new management company, and continue business as usual. So long as the management company was maintained as a near shell, the loss to the investor is minimized. And since there were no hard assets in the management company, there is little of value for a judgment creditor to execute upon, making any judgment next to worthless. The investor loses and wins the lawsuit at the same time.

THE HOLDING COMPANY

The holding company (often but not always a series LLC) is designed to hold title to hard assets and pay ad valorem taxes—and that should be (nearly) all. The holding LLC should stay quietly in the background, avoiding contractual or transactional privity with anyone. Because the holding company does no business with anyone, it has no privity with anyone and therefore (your lawyer will argue to the judge) there can be no legitimate legal basis for a cause of action against it.

Should the holding company own the management company?

No. The management and holding companies must remain at arms’ length if your attorney is to make a successful no-privity argument in court. The two companies can have common ownership and similar management—that’s not usually a problem—but they should not own any interest in the other (no cross-ownership) or the privity argument becomes so muddled that it fails.

The division of function must be built into the structure from the beginning and then maintained throughout the life of the enterprise.

Using a Series LLC as the Holding Company

Holding companies are often set up as series LLCs with multiple compartments or series that are isolated and insulated from one another. This is an excellent use of the series LLC format. The result is that if there is a lawsuit affecting an asset in series A, then series B, series C, and so on are not affected.

The unique benefit of a series LLC is that it is necessary to have only one LLC to safely own multiple assets (each asset being placed in its own series), so long as the assets are generally similar in type. Dissimilar assets should not usually be placed within the same LLC, whether the LLC is a series company or a traditional LLC.

Conclusion

Traditional LLCs are appropriate for the management company in a two-company structure. Traditional LLCs are also suitable for holding a single property, wholesaling or flipping, or as a single-purpose entity (SPE) for businesses such as retail, a restaurant, an apartment complex, or a start-up.

The problem with using a traditional LLC as a holding company is that all of its assets are held in a collective vulnerable pool for purposes of execution on a judgment. Assets are not isolated or insulated from one another in protected compartments. In the case of a traditional LLC, a judgment against one asset is effectively a judgment against them all.

In a series LLC, legal action against an asset in one series does not affect or spill over onto assets in other series. Absent misconduct such as actual fraud (a consistent theme across Texas law) the threat or damage is contained within a specific series.