LLC is the shorthand for “Limited Liability Company. Many clients ask me: “Should I own my apartments and other income property in an LLC?” Like most questions you ask a lawyer, the answer is: It depends on your situation and what you want to accomplish.
Many lawyers push clients to pay fees to form LLCs, touting supposed asset protection features. But, often, such lawyers fail to advise their clients about the limited asset protection provided by LLCs, while ignoring the costs and other disadvantages LLCs can bring.
Instead of touting the use of LLCs, let me give you my unbiased views. If you have attended one of my seminars, you will know that I am believe that the benefits of LLCs will usually NOT outweigh the costs and disadvantages.
What Is an LLC?
LLCs are created under state law. They were developed to provide a legal entity with more flexible rules than a corporation, limited liability for the members, the ability to separate management from ownership, and tax consequences like partnerships.
LLCs began with legislation in Wyoming 40 years ago in 1977. Since then, all states have adopted laws to permit LLCs, some with more favorable structures than others.
Generally, to maximize flexibility, asset protection and low costs, I think that Wyoming now has one of the best legal structures for an LLC, although Nevada (with slightly higher fees) can also provide good law. California LLCs do not generally provide optimal flexibility and asset protection.
While LLCs were originally intended to be taxed as partnerships, later the tax law allowed them to be taxed as Subchapter S corporations They can also be treated as disregarded entities if they have just one member (husband and wife can be counted as one). For Federal income tax purposes, disregarded entities are ignored, with their property and operations treated as owned directly by their member and reported on Schedule C or Schedule D in a form 1040.
The Good (?)
Liability Protection? Most of the clients we see who have LLCs formed them because they were told the LLC would protect the members’ assets from liabilities that could result from the operation and ownership of investment property. Unfortunately, such protection is often illusory. If operation of the property results in liability, the LLC will usually protect the members from liability in their capacity as members.
But, liability protection breaks down in two ways:
- FIRST, the LLC faces the loss of any equity in its property to the extent of the validity, and costs of defense (after insurance) of the liability claim.
- SECOND, if the plaintiff establishes liability greater than the equity in the property and any liability insurance, a smart plaintiff will impose such liability on the legal Manager of the LLC. Usually, that is also the owner, in which case protecting the Member becomes meaningless.
At my seminars for the AOA, I have asked nearly 1,000 apartment owners if they have ever incurred, or know another owner who incurred, an actual liability from the operation of their property that exceeded the equity and insurance coverage. I have yet to have a single owner answer “Yes.”
While many owners have been sued by tenants and others related to their rental property, none have identified a single case where an LLC would have prevented liability.
So, I think that the perception of liability risk outweighs its reality in most cases.
Instead of LLCs, I recommend good insurance, both with regard to limits and coverage. Use a good insurance agent, buy a little bit larger umbrella, and see what you can do to reduce or eliminate exclusions for large risks that concern you. Let an experienced insurance agent show you how little it costs to get better coverage.
[Many of my clients get good insurance coverage and advice from GS Insurance Solutions, which works with the AOA and brings a lot of important expertise insuring apartment owners.]
Property Tax Benefit
When it comes to property tax protection for your heirs, LLCs have both a good side and a bad one.
The good comes when property was acquired by the LLC in a transaction that was not excluded from reassessment due to the “proportionate interest” exception. This usually applies when the LLC buys the property directly from a third party (which results in reassessment). It also applies when, property is contributed to the LLC and the interests of the contributors of the property differ in the smallest fraction from the percentage ownership of the members.
In this case, the property will not be reassessed after the LLC acquires it until a member (that was not a majority owner at that time) becomes a majority owner by a transfer of member interests.
In a typical family LLC, so long as no one of your heirs becomes the owner of more than 50% of the LLC, the property can then escape reassessment for generations. But, see the next section.
Sadly, the potential estate and gift tax benefit will not apply in most formations of family LLCs which involve property already worth more than assessed value, unless you are willing to have the property reassessed when it is contributed to the LLC.
Potential Estate Tax Saving
When there is more than one member of the LLC, the interests of each member should be valued at a discount from the value of the underlying property for estate tax purposes.
This “discounting” should cause the LLC membership interest to be worth less for estate and gift tax purposes than a pro rata portion of the LLC’s net asset value. However, discounting will be worth nothing if you will not exceed your lifetime estate and gift tax exclusion. The exclusion protects $5.49 million for a single person, and $10.98 million for a married couple as of May, 2016, and Trump may eliminate estate and/or gift taxes, at least for a while.
Unfortunately, any saving from discounting may be offset by a reduction in the “step-up” in basis for income tax purposes. This result follows since the value for estate tax purposes is used to measure the value used to reset the income tax basis for your heirs.
Remember, that “discounting” saves no gift or estate tax until you exceed your lifetime exclusion. On the other hand, if you have enough to worry about estate or gift taxes, there are strategies that use LLC discounting to both reduce estate and gift taxes, but then allow your heirs the benefit of a full step-up in basis. At the AOA seminars on June 21 and 22 in San Jose and Oakland, I will explain these concepts in more detail.
If you have a mortgage or deed of trust on your property, it likely includes “due on transfer” provisions that would allow your lender to call the loan, or impose a penalty, if you transfer the property to an LLC without consent of the lender.
Many times, that consent can be obtained at little or no cost, by going through a little paperwork. And, many owners ignore this provision, finding that lenders rarely enforce it. But, if you choose to ignore the provision, you do so at your risk. If a lender calls the loan and forecloses at the wrong time, the transfer to the LLC can go from “Bad” to “Ugly.”
While owners rarely worry about this, when you transfer property to a new owner (even a family LLC), the new owner will not be protected by old title insurance. If the LLC later discovers a title problem, the old policy will not apply. Of course, if you have owned the property for a long time, the old title policy probably has limits that are way less than the property is now worth. So it may provide little practical protection anyway.
In some cases, you may be able to get the title company to issue an endorsement covering the LLC for a small fee. Or, if you are concerned enough, you may want to purchase a new title policy.
LLCs are not free. It costs money to set one up (doing it well takes some legal work and fees to the state). It costs nearly $1,000 in fees to the state of California and (if not formed in California) to the state of formation to maintain the LLC. And, it usually adds something to your annual tax preparation fees. It also costs some of your time and effort to maintain proper LLC records. In most cases, if you save those costs, you can buy better insurance with the savings and still have a bunch of money leftover.
And The Ugly
Increased Property Taxes – Most LLCs create Property Tax problems for their members. This results from the rules that apply when one contributes property to an LLC and the membership percentages are exactly proportionate to the prior ownership of the property.
In this case, once more than 50% of the member interests have changed hands, the entire property will be reassessed, and the parent-child exclusion will NOT apply!
This can happen if Mom and Dad own the LLC in the beginning in equal shares after they both die. Or, maybe they give 10% to their heirs while they are alive, then another 45% is transferred when just one of them dies (10% + 45% = more than 50%). Even if none of the heirs winds up a majority owner, in this case the property will be reassessed.
This can be a real property tax trap. I just completed a case for an elderly couple that set up an LLC (with another lawyer) just a few years ago. The property in their LLC looks like it may be worth more than TWENTY TIMES the assessed value. The property tax increase to their heirs could cost up to 40% of their positive cash flow!
Fortunately, I was able to help them transfer the property out of the LLC while they were alive. Over the life of the children and grandchildren, whom they hope will keep the property, this may save more up to $1,000,000!
The Bottom Line on LLCs for Apartment Owners
LLCs can produce both good and bad results for your family. On balance, for most families, I think an objective analysis will produce a conclusion that an LLC is not a good idea. LLCs provide just one great example of my estate planning motto: “If you fail to plan WELL NOW, plan to FAIL”
I have been representing primarily apartment owners for years now. I have reviewed hundreds of apartment owner estate plans. In the vast majority of cases, those plans turned out to be “Hazardous to Family Wealth.” Fortunately, in most of those cases, I was able to help owners eliminate these hazards by “planning well now.”
On June 21 and 22, the AOA will again present my “Estate Planning for Apartment Owners” Free Seminar in San Jose and Oakland. I hope to meet a lot of AOA members there and help them understand the hazards their estate plans may contain.
In our June seminars, we will cover basic hazards produced by outdated estate plans. We will also give you a better perspective on planning to protect you and your estate from impoverishment due to long-term care needs.
Finally, we hope to give you an idea of how the Trump income tax proposals will effect planning and operations for apartment owners.
Customize Your Estate Plan So It Works
Well for You and Your Family
The real key to make your estate plan work is good planning that is customized to fit your needs and desires. Good planning is flexible, and designed to take into account likely changes in tax law, your wealth and the financial environment.
In order to prevent your estate plan from being a HAZARD to you and your family, get your estate planning reviewed now by a lawyer who will help you articulate your goals, and then put your goals first in any planning you want done. You will get peace of mind, and your heirs will gain substantial benefits.
Please register to attend one of the below seminars on “Estate Planning for Apartment Owners”. Call (510) 769-7521 or register online at www.aoausa.com. Space is limited so register today!
- June 21st – Courtyard by Marriott San Jose North/Silicon Valley, 111 Holger Way, or
- June 22nd – Holiday Inn Hotel & Suites Oakland – Airport, 77 Hegenberger Rd.
If you want to learn more about protecting yourself from liability exposure without needing an LLC, we expect a representative from GS Insurance Solutions will be in attendance to answer questions as well. Ken also offers FREE consultations for AOA members if you cannot attend a seminar or want your situation to be used as a private case study.
Kenneth Ziskin, an estate planning attorney and AOA member, works with his wife Hinda to provide integrated estate planning for apartment owners to save income, property, gift and estate taxes, and to protect apartment owners from impoverishment due to exposure to long-term nursing care. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, a perfect 10 out of 10 rating from legal website AVVO.Com, and is multiple winner of AVVO’s Client Choice Award. See Ken’s website at www.ZiskinLaw.com. It includes reviews by many of his clients. This article is general in nature and not intended as advice for clients. Please get advice from counsel you retain for your own planning.