Hear from business attorney Adam Walker of Full Circle Business Law, PC on the best way to hold title to your multifamily property, the process for forming and maintaining an LLC, different types of LLCs, how to add members to your LLC, and common mistakes to avoid.

Kiran Dhillon, SIG Commercial:

Hi, everyone, welcome to our series called "Simply Multifamily." My name is Kiran Dhillon and I am a Broker-Associate at KW Commercial, specializing in multifamily sales. I work with buyers and sellers of apartment and multifamily properties all throughout the greater Los Angeles and Inland Empire areas. The purpose of this series is to highlight issues and introduce strategies that affect and benefit owners of multifamily properties. Today, we're going to be speaking with Adam Walker, attorney at Full Circle Business Law, about how to hold ownership of investment properties. Welcome Adam, it's great to have you.

Adam Walker, Full Circle Business Law, PC:

Hi Kiran. Thanks for inviting me and giving me the opportunity to speak to some of your listeners and viewers.

Kiran Dhillon, SIG Commercial:

Yeah, of course. So tell us briefly about the types of services that your law firm provides for real estate owners.

Adam Walker, Full Circle Business Law, PC:

Yeah, so we're a general business transactional and litigation firm, and we also manage things to kind of touch on the peripheral things that small and established businesses deal with. So employment, guiding them through corporate counsel, and the structure of their business. Where it dovetails with what we're talking about today, that includes dropping real property into an LLC or other kind of investment vehicle.

Kiran Dhillon, SIG Commercial:

Okay, great. So with that, what are the most common ways that real estate is held by owners?

Adam Walker, Full Circle Business Law, PC:

So let me, and we were talking about this just a moment ago, let me add the caveat and the disclaimer. So nothing we talk about today will be attorney/client communication, nothing will create an attorney/client relationship or privilege or anything like that. Don't rely on this information. Consult with your own attorney first.

So with that, the first question being common ways that real estate is held. So the most obvious way is to hold it yourself as an individual. You can also hold it as part of a marriage or as part of a partnership. That can be within or without a living trust. So it can be dropped into a living trust or treated in a number of different ways that are perhaps beyond the scope of what we're currently talking about. So tenants in common or tenants by the entirety. If you have more questions about that, that's something we can talk about offline, or talk to a real estate attorney about what that might look like, or a trust attorney. But the main vehicle we see for holding investment property, particularly, is in an LLC to give you the limited liability protection that you'd ordinarily see in a corporation, but with the flexibility that you really want for an investment property that an LLC will afford you.

Kiran Dhillon, SIG Commercial:

So are there any disadvantages to holding real estate in your own name or in a general partnership or in a trust, as compared to holding it in an entity?

Adam Walker, Full Circle Business Law, PC:

Yeah, so let's knock out the trust aspect first because the trust can hold an LLC within it. So the trust can hold property in whatever form, under whatever name makes sense for you. But the real challenge for holding investment property as an individual, or as a partner, is that you have unlimited exposure to liability. So you can insure the property, you can insure your operations on the property as much as you want, but my guidance is always that insurance companies don't like to pay out claims. So don't necessarily rely on insurance alone to shield you against potential problems that might come your way in the future.

And the biggest challenge when you have some kind of investment property is that if you don't protect it properly, if you don't build up the limited liability network or framework around that, all your personal assets, your own house, your other valuable assets might be exposed as well based on whatever's going on in your investment property.

So this is why the main disadvantage for holding something as an individual is that you're exposed entirely to any liability that might arise on the investment property.

Kiran Dhillon, SIG Commercial:

So your liability is not just limited to the property, it can extend to anything in your personal life?

Adam Walker, Full Circle Business Law, PC:

Right. Subject to the Homestead Exemption that protects your own personal residence, to some extent, this is why we always see and I always recommend that people consider an LLC, because it provides you that protection, which I am sure we'll talk about in a moment.

Kiran Dhillon, SIG Commercial:

Got it. So that goes along with what are the advantages of forming an entity to hold your income property?

Adam Walker, Full Circle Business Law, PC:

So the reason anybody forms a corporation or an LLC generally, whether it's a business or to hold real property as a holding company, is because it creates that layer of separation between you as a person and the business operations. You create kind of this fictitious person to manage the business in the form of a corporation or an LLC. And that LLC takes on all of that liability, and your personal exposure is limited to beyond what the LLC can take on.

Kiran Dhillon, SIG Commercial:

So you've mentioned LLCs, but what are all the entity types that can be utilized for holding real estate?

Adam Walker, Full Circle Business Law, PC:

So we've talked briefly about general partnerships. There's also a concept called limited partnerships. The challenge with that is that someone in that chain is going to have to take on that exposure that we talked about. General partners are not shielded in same way that LLC members would be shielded.

For limited partnerships, one person is going to be the general partner. They're going to have all the management obligations, but also the associated liabilities. And the limited partner in that structure is just kind of a passive investor. Their exposure is limited, but in that system, someone's always going to be potentially in the line of fire for liability.

So those are different things you can consider if the liability profile is reduced, for whatever reason. We see that in some businesses where there's not a lot of consumer exposure and there's not a high likelihood of liability. When you're dealing with real estate, that's always got to be in the back of your mind.

A couple other vehicles... We've talked about LLCs; we'll get into that more because it is the way to hold real property. You can always hold it as a corporation, but there are serious tax problems with doing so that come up just in the internal revenue code. Dealing with how the taxation based on distributing appreciated property, there's taxation on two levels. It creates a real tax burden that you want to try to avoid as much as you can, which is why an LLC, which is taxed generally as a partnership -- and speak to your CPA about how it ought to be taxed under your circumstances – but that’s one way of avoiding that major tax hit that causes so many people to drop their property under an LLC umbrella, as opposed to a corporation.

Kiran Dhillon, SIG Commercial:

It seems like LLC is the winner here. What's the process for forming an LLC, and what are the typical expenses involved with that formation?

Adam Walker, Full Circle Business Law, PC:

Forming an LLC in California, so if you have real property in California, this is where you want to form, it's a super easy process. And technology has made it really so much easier. The Secretary of State allows you to file your Articles of Organization, which is kind of the first filing you do to form an LLC. You can do that all online. And it's a simple form you fill out on their website. It costs about $75 to do. And their turnaround time, as we're sitting here in June of 2021, has been about two business days. It's really quick. Used to be several weeks; you used to have to file through a filing service or mail it in. That's all changed now and it's a really easy process. The real challenges with forming an LLC then is picking a name that's not already chosen in the Secretary of State database. You can do a search for your name on, I think it's businesssearch.sos.ca.gov. You can see what's out there, see if there's anything that's obviously a conflict. Your filing will be rejected if the name's already chosen, and then you can just turn around and try it again. But it's a simple process. You can get an address that make sense for you, a physical address. And then you're kind of off to the races.

Kiran Dhillon, SIG Commercial:

So it's just that one filing to get your LLC formed with the Secretary of State?

Adam Walker, Full Circle Business Law, PC:

So that's how it gets started. And then you'll have to file a second Statement of Information that details who the members of the LLC are, what are their addresses, how are they contacted, what kind of business are you doing. That's a $20 or $25 filing that takes five minutes, also online, also easy to do.

Kiran Dhillon, SIG Commercial:

So in my world where I'm working with buyers and sellers of multifamily properties, a common question is, when should a buyer start thinking about forming the LLC? Does it need to happen before they're in escrow, while they're in escrow, or can it happen after they've already purchased a property, maybe in their own name? And which is the best case scenario?

Adam Walker, Full Circle Business Law, PC:

It's always my thought and my goal to limit the number of transfers you have to make, or the number of deeds of trust or other filings you have to record whenever you're dealing with real property. So the ideal would be, have the LLC, or the ultimate entity you want to own the property, have that entity own the property from the outset whenever possible, so you don't have it in your name and then you have to fill up the deed of trust, or send it to your living trust or a trust transfer deed, and deal with all of the excess headache and costs associated with those transfers.

If you intend to hold it under an LLC, have it under the LLC from the outset. And as we just talked about, it's really easy to set up, and it's a quick process. So unless you need a 24 hour turnaround time, you can either expedite with the Secretary of State if you need to, our general guidance is get it into the form you want it to be in from the beginning so you don't have to make these transfers, and worry about that later on.

Kiran Dhillon, SIG Commercial:

So for somebody who's looking for a property, and as you know, it takes time to find something that you want to purchase, would it make sense to go ahead, set up your LLC, even though you might not find the property that you actually want to put in it for another six months or a year, and your LLC is just sitting there waiting?

Adam Walker, Full Circle Business Law, PC:

Generally, the maintenance costs for an LLC are pretty low. Typically the Franchise Tax Board fee, which every LLC has to pay, is at least $800 a year. Because of the Coronavirus, they have waived that for the first year for LLCs. And that'll be true for a couple more years, at least, if that program continues. So you are off the hook for the $800 for the first year, at least as the law stands right now.

So if you do need to form something and then sit on it for a bit, the maintenance costs are pretty low. You file the Statement of Information we talked about every two years for LLC, so even that fee is pretty low. And as long you're not paying yourself a salary or something like that, then it's something you can generally form, wait on, and when the time is right find the real estate you're looking for and drop it into the LLC.

Kiran Dhillon, SIG Commercial:

What if you have more than one income property? Do you just keep adding them all to the same LLC, or should you have separate ones for each property?

Adam Walker, Full Circle Business Law, PC:

That depends on the risk profile of each property. And I like to use the analogy of someone who owns a couple of different restaurants. So imagine if you have a couple of different franchises, or you have two restaurants with different locations. And if you drop them under one entity, let's say an LLC, and one restaurant, there's a slip and fall, or there's an employment, wrongful termination or discrimination suit, or a fire or something that insurance doesn't cover completely, there's a lot of liability there.

And the concern is that if both properties are under one umbrella, the liability from one property, one restaurant, will flow to the other. To solve that problem, you drop the two properties into two different LLCs and create kind of a silo between them. So the liability gets stuck in one place, doesn't flow over to you as a person and your personal assets, and also it doesn't flow over to the other restaurant or the other business, the other real property.

So that's why we always say, look at the risk profile. So much money, especially in California, is invested in real estate. And the expense of forming an LLC is so low, we always counsel people that, consider just doing a separate LLC for each location, each building. The benefits are tremendous and the costs are low, so that we always recommend that course of action.

Kiran Dhillon, SIG Commercial:

Can you ever have too many LLCs if you have a lot of properties or a large portfolio, and they're all in separate LLCs?

Adam Walker, Full Circle Business Law, PC:

It can become an administrative burden a little bit. You can have kind of a parent-subsidiary relationship between LLCs, as long as you maintain the integrity of that separation. So what we see sometimes is there's an operating company that deals with collecting rents and maintenance on buildings and things. And then the actual ownership is held by holding companies. And a contractual relationship between all those entities is developed and fleshed out and maintained appropriately.

So when I say maintained, all the operating agreements that govern the LLCs are all in place. The statement of information is being filed consistently and timely. Corporate books and bank accounts are all separate, all being observed and watched over to make sure that you avoid what we call alter ego liability. So the idea that you have a bunch of shelves, but they're all owned by the same people. The formalities that we just talked about are not being observed. So if someone sues one, they argue that I should have the right to attach assets from all of these companies because, effectively, they're not independent entities, not the way they've been treated.

So if you're going to have a lot of different LLCs, you want to make sure that contractual relationship between them is really solid, you're observing your formalities, you have everything in place. The reason you set up LLCs in the first place is to avoid the overflow of liability. If you're not going to follow the rules, then there's really no point. You won't receive that advantage.

Kiran Dhillon, SIG Commercial:

So I think you just touched on a bunch of these factors, but for the sake of clarity, what does a property owner need to do to maintain their LLC over time?

Adam Walker, Full Circle Business Law, PC:

Right, make sure you don't intermingle funds personally, or between LLCs. That means maintaining a separate bank account for each LLC. And that's really vital. You don't want multiple properties falling under the same bank account. That's an obvious red flag that these are not legitimate, separate businesses.

We also recommend you, in either manager-managed forms of LLCs, and maybe we can touch upon that later, but make sure the manager is elected every year or however often the operating agreement calls for, and you're recording major transactions, you're voting on major transactions among the members, and documenting it all and keeping it all in the LLCs record books so that you can hand it to someone one day, either if you're selling the property or you're engaged in some kind of dispute and say, "We're a legitimate business, we're separate from these other companies. We have shared ownership, but we have a contractual arms-length relationship between ourselves and we document everything we do. We deserve to be afforded the protection of limited liability." So that's how you maintain those formalities.

Kiran Dhillon, SIG Commercial:

Got it. So an LLC can have one member or multiple members, and you also mentioned a manager. So, what about if you want to bring in additional individuals into an existing LLC? What does that process look like and what complications might arise?

Adam Walker, Full Circle Business Law, PC:

Yeah. So let's talk about the two different management structures real quick, because that's going to be really pivotal in how you bring someone on. So the default, and what we see generally, is a member managed structure where all the members of the LLC, all the owners of the LLC, have an equal right to manage the business. They have an equal right to bind the company, do agreements and make decisions, expend resources, subject to the limitations of the operating agreement of course.

But that's a good system when you know the other people, you have kind of a commonality of interests, you're family members, husband and wife, that kind of thing. Where it becomes challenging is when you're bringing on purely passive investors who want to contribute money, they want to receive distributions, they don't want to touch the management. They just want to be passive.

And if that's the case, we recommend a manager-managed structure where the manager is almost like a member of the board of directors of a corporation. They have the right to run the operations of the business and make major decisions, while the shareholders, the kind of passive investors, sit back. Their only obligation is to vote on major decisions like dissolving the company or bringing on new members. But otherwise, they're just around to collect distributions. You don't want them signing contracts. You don't want them making major decisions.

So that kind of two-tiered hierarchy is called manager-managed. So one of the questions you have to ask, whenever you're bringing on someone new, how involved do I want them to be in the business? Do I want them to have management type authority? And if the answer is no, this two tiered manager-managed structure, where you're the manager and they're just a passive member, might be the way to go.

So as far as conceptualizing bringing someone on and how you want to do it, that's always the first question you want to ask. And then the rest is paperwork. An LLC Interest Purchase Agreement, so that they're buying into the business, signing off on the Operating Agreement, that to join that Agreement so that they have to comply with the same terms as all the other members. And that's generally how it's done.

Kiran Dhillon, SIG Commercial:

Got it. What happens if an LLC has one property and that property is sold?

Adam Walker, Full Circle Business Law, PC:

So you look at the Operating Agreement to determine how the proceeds of that sale are going to be distributed. The LLC form is interesting, in as much as it gives you maximum flexibility. So you can own 25% of the company and have the right to receive 75% of the proceeds, either through ordinary operations or as a result of a major transaction like a sale of the only property of the business, or substantially all of the business's assets.

So in a corporation, if you own 25%, you get 25% of the dividends. LLC, you have the flexibility because it looks more like a partnership, and you have the opportunity to adjust allocations of profits and losses for tax purposes. And people can join without contributing anything if you want them to be part of the company.

So on the sale of an important asset, look through the Operating Agreement, see what it says. The default rule, if you don't have an Operating Agreement, is that everything is distributed proportionally. But that's generally what that looks like. And when you distribute those proceeds, you often see the LLC dissolve after that because it has no other business to conduct.

Kiran Dhillon, SIG Commercial:

Got it. So it's pretty common nowadays to see online services that will form LLCs for you. What are your thoughts on using those types of services versus coming to an attorney for LLC formation?

Adam Walker, Full Circle Business Law, PC:

Yeah, so almost by definition, these other services don't have attorneys. They might have attorneys on staff, but those attorneys don't have hands-on a touch point with your business and what you're trying to do. So we often see these template agreements that aren't really tailored to what our clients need, and so we have to redraft them, or we have to redline them in some way, or provide them counsel that they didn't receive upfront.

So I do appreciate the advantage of the cost savings when it comes to forming a company. We totally understand that, but we provide the counsel all along the way, educate our clients. For example, I know other business law firms to do the same. So you understand why you're making certain decisions, why you chose the LLC form in the first place, why member-managed, why manager-managed, are you giving up too much equity? These are conversations you can have with an attorney on retainer that you can't with Legal Zoom, or some of those other ventures that do things cheaply, efficiently, as a mill, and can give you template agreements and things like that. So the question is, what do you value? Do you value that relationship and the licensed legal advice that I or another associate could give, or are you just looking to get it done quickly and maybe have an attorney review it after the fact?

Kiran Dhillon, SIG Commercial:

Right. And given the value of real estate in California, it almost seems like a no brainer that property owners should be speaking with an actual attorney because everyone's situation is different, and there's so much at stake with the real property value.

Adam Walker, Full Circle Business Law, PC:

Speak to an attorney, but also have a team of professionals, so not only the people in the real estate world, the agents and brokers, etc. But have a CPA on your team who understands the tax elements of everything you're going to be going through. Potentially have a trust and an estate attorney, if you're going to be dropping this under a trust to deal with the disposition of the property in the future to your heirs or wherever it might be going to, and then naturally a business or real estate attorney to deal with the formation, to deal with the structuring of the entity, so that you get the maximum advantage from owning property in the first place.

Kiran Dhillon, SIG Commercial:

Absolutely. That's fantastic advice. So what are some mistakes that you see in the way that people manage their LLCs?

Adam Walker, Full Circle Business Law, PC:

People sometimes set up LLCs and then forget about them. So we see that people are not being elected as necessary, Statements of Information not being filed. Operating Agreements are just in a template form that don't accomplish what they're hoping to accomplish with the building and the profits that are generated from it. We sometimes see liability dumped into one bucket, when we recommend it's separated into multiple LLCs. Particularly if you're taking in a lot of rents and you want to separate kind of those operations from the actual holding of the property, that's a strategy conversation that some people don't have when they set up the LLC for the first time around.

Adam Walker, Full Circle Business Law, PC:

There are also employment issues when you're a manager-managed structure, because the manager should be on payroll and should be a salary employee. And that's something people don't always realize. They don't always have those arm's length contracts that we talked about between an operating company and a holding company. So these are some of the mistakes that we see, and it stems mostly from just not being aware of what your obligations are. We don't counsel people on the financial aspect of running their business; we let them do what they think makes sense. But as far as the legal mistakes we're seeing, those are the broad categories.

Kiran Dhillon, SIG Commercial:

Got it. Well, Adam, thank you so much. That was a lot of information, and great information, great advice for multifamily owners. For our listeners who have follow up questions or maybe want to inquire about having you help them with their LLC formation, what's the best way for them to reach you?

Adam Walker, Full Circle Business Law, PC:

Yeah, so they can call our office. Our number is (818) 247- 2036. I'm sure we'll put this up. And they can email me at adam@fullcirclebl.com directly, and we'll put that all together. So those are the two best ways to reach out.

Kiran Dhillon, SIG Commercial:

Okay, perfect. And I will add that to the bottom of the transcript so that it's easy for people to access. Thank you again so much, Adam. This was really great.

Adam Walker, Full Circle Business Law, PC:

Yeah. Thanks Kiran. Thanks for having me. And I hope people got value from this, and thank you so much for the invite.

Kiran Dhillon, SIG Commercial:

Of course.

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