By Jason Watson, CPA
Posted Sunday, May 25, 2025

Here are some FAQs you might find helpful from our chapter on other entity considerations beyond what entity type to deploy-

What’s the difference between equity and economic interests in an LLC?
Equity interest refers to ownership and voting rights, while economic interest relates only to sharing in profits and losses, not control (generally). Lots of creativity can be implemented with these interests.

Can I give someone an economic interest without making them a co-owner?
Yes. You can allocate profits and losses to someone without giving them formal ownership or voting power.

Is angel investor money a loan or capital injection?
It depends on intent and documentation. Loans must have repayment terms; capital injections convert into equity or profit-sharing.

Can LLCs simplify real estate ownership for multiple properties?
Yes. LLCs allow you to compartmentalize properties, control ownership transfers, and manage liability across assets.

What is a tiered structure in real estate?
It involves creating a holding company that owns property-specific LLCs, improving anonymity and wealth transfer.

Do I need separate LLCs for each property?
Ideally, yes. It limits liability to that asset, but increases complexity and costs.

Do Operating Agreements matter in real estate entities?
Absolutely. They define control, profit splits, exit strategies, and are essential when disagreements or life events arise.

Are Nevada or Wyoming LLCs better for asset protection?
Not always. Courts often look through out-of-state entities when local activity occurs, limiting their protective value.

Is it a bad idea to hold rentals in an S Corp?
Yes. S Corps don’t allow step-up in basis on death and force gain recognition on asset transfers.

What’s the risk of trapping assets in an S Corp?
When distributing property, it’s treated as a sale, creating tax liability—even if you’re just moving the rental property around (i.e., changing title from the S Corp to you).

What is a waterfall distribution in an LLC?
It’s a method of allocating cash flow where investors get paid in a specific order, often after preferred returns.

Can I still use cost segregation in a C Corp?
Yes, but the benefits are limited if your personal tax rate is higher than the corporate rate.

Is it better to gift LLC interests or property directly?
Gifting LLC interests can allow valuation discounts and control over timing—often better for estate planning.

Do entity structures affect 1031 exchange eligibility?
Yes. The entity holding the property must also be the one completing the exchange—changing this may disqualify the deferral.

Can I take depreciation on property owned in a trust?
Yes, if the trust is a grantor trust and the property is rented out. It works like individual ownership.

By Jason Watson, CPA
Posted Sunday, May 25, 2025

Chapter 2 expands on ownership strategies by exploring more nuanced, advanced structures that real estate investors and rental property owners might consider beyond the basic LLC or sole proprietorship. This chapter addresses issues like equity versus economic interests, structuring deals with outside investors, using trusts, and forming tiered or multi-entity structures such as holding companies owning property-specific LLCs.

The chapter also dives into common misconceptions—such as overreliance on charging orders or assuming Nevada/Wyoming/Delaware LLCs provide foolproof protection. It emphasizes aligning legal structure with practical function, cautioning against complex setups without clear purpose. The illusion of precision.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

As the only shareholder of an S Corp, you might think that everything the business owns you also personally own. Not true. The relationship you have with your S Corp is not a marriage where mine is mine and yours is mine too.

Part 1

If you want to move assets out of an S corporation or convert them to personal use, you will trigger a taxable event. A potentially big one. When assets are distributed to the S Corp shareholders, they are distributed at fair market value. Cash is easy. An automobile is generally not a big deal. But real estate can kick your butt.

We recently had a consultation with an S Corp owner whose business owned a hotel building. On the advice of an inexperienced CPA he revoked his S corporation election. This triggered a distribution of business assets at fair market value. The basis in the hotel building was $400,000 and the fair market value was $2,000,000. This sparked a $320,000 capital gain tax event reported on his K-1. Capital gains is a success tax, right? But when you don’t actually get the cash from the transaction, this tax could be impossible to pay. Keep appreciating assets out of an S corporation people (or at least have eyes wide open on the risk)!

Sole proprietors and garden-variety LLCs enjoy a bit more flexibility under certain circumstances when distributing property or assets out of the business.

Part 2

Assets within your S Corp can also be problematic upon death. If you own an asset at the time of death, the asset is re-valued and your heirs get a step-up in basis (cost). So, when they sell the asset their gain is lower. For example, you buy a painting for $5,000 and when you die, the painting is valued at $20,000. If your heirs sell the painting for $22,000, they will only realize a $2,000 taxable gain.

If the asset is sitting in the S Corp upon your death, the S corporation’s stock value might get a step-up in basis through an appraisal. However, it might prove harder to demonstrate than the increased value of one particular asset. Look at it another way. S Corps don’t die, and therefore assets within the business don’t get a step-up in basis upon a shareholder’s death.

We’ll acquiesce. This trapped asset problem is super rare yet so many owners love to have personal stuff owned by the S Corp.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Since this chapter is about owner arrangements in consideration of your rental property or real estate investment, there’s no better place to talk about self-directed IRAs. What the heck is a self-directed IRA? Just because you make investment choices within your retirement accounts, does not mean they are self-directed. Sure, in a practical sense they are. But a self-directed IRA in the context of this section is about a very specific investment vehicle.

Why would you consider this option? Let’s assume that you want to invest into rental properties (which is a great augmenting retirement strategy by the way… we are huge fans), but all your money is tied up in an IRA. You are 50 years old and can’t touch it without penalty. The bank won’t let you borrow against it. You might be hosed.

However, if you set up a self-directed IRA and roll your existing IRA into it, you can have the IRA invest into the rental property. But there is another reason why this might make sense. The S&P 500 index since inception has returned 9.22%. Not bad. Yet in some situations, rental properties might beat or in some cases, crush, the returns of the stock market. And it creates some diversification within your financial planning.

If you want to expand your horizons into real estate notes, equipment leasing, livestock, private debt and equity placements, and oil and gas you can also use a self-directed IRA. Be careful here. Suitability might be your biggest hurdle. Talk to your financial team before squandering your life savings on ocean front property in Arizona.

A 401k may be used as well but it is slightly more complicated. At times you might hear the term ROBS (rollover business startup) plan.

Here is a blurb from the IRS website–

A ROBS transaction therefore takes the form of the following sequential steps:

An individual establishes a shell corporation sponsoring an associated and purportedly qualified retirement plan.

The plan document provides that all participants may invest the entirety of their account balances in employer stock.

The individual becomes the only employee of the shell corporation and the only participant in the plan. Note that at this point, there is still no ownership or shareholder equity interest.

The individual then executes a rollover or direct trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan.

The sole participant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.

The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise.

After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.

A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to promoter.

The IRS is also quick to point out that self-directed IRAs and 401k plans including ROBS face a lot of compliance concerns and are generally very risky. The funded businesses also have a high failure rate (while ROBS that purchase rental properties do quite well).

These steps all seem straightforward. What’s the catch? There’s always a catch. Here are the things to look out for.

No S Corps or Partnerships

The way these entities are structured, business profits are returned to the shareholders. Profits cannot fall into the hands of the IRA account owner or 401k plan participant (you). Tainting of retirement dollars is the big thing here.

Prohibited Transactions

The funded entity cannot invest directly in collectibles, art, rugs, antiques, metals other than gold, silver and palladium bullion, gems, stamps, coins (except certain U.S.-minted coins), alcoholic beverages, and a few other tangible items related to personal property. Ok- there goes half your list for sure. Yup, cross palladium off your list.

In addition, friends, business associates and siblings may invest in the entity via a self-directed IRA or 401k plan, but your parents, children or spouse may not. The strict arms-length perspective of the business dealings must be maintained.

Key Employee / Investor

You cannot be the key employee and key investor in the business. Nor can you own a controlling interest in the business. Basically, someone else must have the right to hire or fire you such as a Board of Directors. The “someone else” is the grey area in all of this and warrants more discussion.

Having said all this we must fully disclose that WCG CPAs & Advisors are not experts. While we could be, we choose not to and leave a ton of room for exceptions and other workarounds to these rules. There are several trust and wealth advisor firms who do this work all day every day, and are full of competent people. We have worked with Equity Trust and New Direction Trust in the past, and also use KKOS Lawyers.

As you work through all this, the net-net is that the IRS does not allow you personally to receive money that was slated for retirement (at least without penalty until you are 59.5 years old).

To reiterate, a self-directed IRA or 401k is very cool. It allows you to move money you normally could not use into an account that can now be used to get yourself into a rental property or a hot franchise. All without having to find cash elsewhere.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

If you are financially in trouble, and a creditor wants to take your assets, your multi-member LLC and its assets might be safe. Instead of taking the LLC directly, a court can issue a Charging Order which allows the creditor to receive any distributions from the LLC. The theory is quite simple- if you are in business with another person, and that person has financial trouble, why should it be your problem? Your only problem should be where to send the profit distribution check for that person’s distributive share.

A Charging Order puts the creditor in line for any financial rights that the debtor has but does not convey any management rights. Therefor the creditor cannot order the LLC to make a distribution. However, many states have allowed the creditor holding the Charging Order to foreclose on the membership interest of the debtor. Yuck. This is done under the auspice that the debtor will not be able to re-pay his obligation. So now the creditor is the permanent owner of the financial rights of the debtor’s portion of the LLC, but the creditor still does not own any member interest in the LLC. This results in the debtor owning a portion of an LLC that he will never receive any money from since his financial rights are now in the hands of the creditor.

It doesn’t stop there. Some states and certain courts can also assign the full interest (ownership and financial, or some would say equity and economic) to the creditor. This creates a big mess for the other members of the LLC who suddenly need to scrape up enough money to pay off the creditor so as to not be tethered to them as a co-owner.

What does all this mean? Some attorneys want to automatically add a spouse to the LLC so it suddenly becomes a multi-member LLC with the financial protection of a Charging Order. Sure, why not? There is some protection there with very little effort.

As a side note, here is Delaware’s verbiage about Charging Orders under Title 6, Section 18-703–

(d). The entry of a charging order is the exclusive remedy by which a judgment creditor of a member or a member’s assignee may satisfy a judgment out of the judgment debtor’s limited liability company interest and attachment, garnishment, foreclosure or other legal or equitable remedies are not available to the judgment creditor, whether the limited liability company has 1 member or more than 1 member.

Makes you want to run out and form your LLC in Delaware doesn’t it? Again, if you are marching into court with a boatload of financial woes and hanging your hat on Charging Orders for your financial protection, you might have bigger problems. Creditors are wise to this, and they usually make you personally guarantee the financial obligation as an individual.

Also, if you form an LLC in Delaware and operate in Colorado, you will need to file as a foreign entity in Colorado. If you receive process of service in Colorado for a lawsuit, you are now asking a Colorado court to interpret and enforce Delaware law in your matter. Courts and judges are not fond of this ask. We keep mentioning this concept is several spots just to drive it home (and because small business owners jump into our book at various spots).

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We just listed out the three most debtor-friendly states, but that’s where it ends. You might have heard that you can avoid taxes by forming an LLC in Wyoming or Nevada- is that true? Sure, if tax fraud comes easy to you. Sorry Charlie, your profits will technically be apportioned (fancy accounting speak for allocated or assigned) to the states in which you operate.

While this book is aimed at real estate investors and rental property owners, here is a super basic rubric on apportionment which some states use to calculate your tax liability-

• Payroll- One third of your profits are allocated based on payroll. So, if you have payroll expenses only in Colorado and California, but are incorporated in Nevada, one third of your LLC’s profits are split between Colorado and California after applying California’s crazy rules. Nothing is allocated to Nevada.

• Property- The second third of your profits are allocated based on property ownership and where it is located, such as real estate, inventory, etc.

• Sales- The last third of your profits are allocated based on sales and sales nexus, but this can get extremely sticky since the definition of where a sale occurs is grey- is it point of sale (seller’s location), point of purchase (buyer’s location), title transfer, fulfillment centers, etc.? Where a sale actually occurs is an argument which states and taxpayers can go around and around with- you can only imagine how it will end fighting a state with virtually unlimited resources and time coupled with their presumption of being right.

So, yes, under nexus rules perhaps a small portion of your profit can be attributed to Nevada- yet, this is not because you were incorporated in Nevada, it’s because you had a presence in a state that does not impose an income tax. Same would be true for all your sales in Wyoming, Washington, Texas, South Dakota, etc. where strict corporate income taxes do not exist. In addition, several states impose a gross sales receipts tax and other forms of taxation (such as franchise tax) although their corporate income tax rate is zero.

Note: This is a super simple sample. Some states give sales a larger weight. Others ignore payroll and property entirely. Talk to your apportionment buddies at WCG CPAs & Advisors. As gray tax positions go, income apportionment is right up there with the best of the “well, it depends” accountant responses.

State Nexus

State apportionment boils down to nexus, and states are getting much more aggressive with claiming nexus so that the income generated in that state is taxable. This might make people unhappy, but the reasoning behind it is fair in our opinion. You target a certain group of customers who live in a certain jurisdiction, and you sell computers. Why would Best Buy in the same tax jurisdiction have to pay income taxes in that jurisdiction while you do not? Please don’t use the “it’s just little ol’ me versus the big box store” excuse. Seems a bit unfair if you are Best Buy, or Wal-Mart, or Apple. Go and compete, just make it a level playing field.

Those customers in that jurisdiction perhaps enjoy a smaller tax rate and can have more purchasing power. That smaller tax rate might be offset by higher tax rates for the businesses. Business A (Best Buy in this example) must subsidize the customers in the taxing jurisdiction while Business B (you) does not. Best Buy would be a bit upset in this example.

Avoiding taxes is the American way. We get it. But something about the 14th Amendment and equality and pursuit of happiness comes to mind. Then there’s that darn 16th Amendment. Keep in mind that while you are a smart person, you are not the first person with tax avoidance on the brain; they closed the loops.

States define economic presence differently. Some states, such as California, use a sales dollar threshold (sometimes referred to as a bright-line) to determine nexus. WCG is getting close to having enough California business to necessitate filing as a foreign entity there just based on revenue. Yuck, since the income tax rate is twice as much as Colorado’s. California also has a presence test where if you have an agent working for you in California, then you have income tax nexus.

Remember, this is only income sourced to that taxing jurisdiction. About half the states have nexus rules and thresholds. Can’t get enough? Here is a Journal of Accountancy article from 2010 (yeah, it’s a little old but so are most accountants, and it provides a good base to learn from)-

wcginc.com/1515

Don’t forget the basics such as bank accounts, licenses and permits. If you must be licensed in another state to legally conduct business such as an agent for an insurance business, this in itself might create nexus.

Foreign Qualification

This has nothing to do with international business. When your business has either a physical or economic presence in another state, you must register as a foreign entity. This is usually a formality, but some states might require your business to be in good standing with the home or “domicile” state. Therefore, keep up with your annual filings with the Secretary of State.

Conversely, you might simply want to create another LLC in the satellite state. This allows you to separate financial liability- for example, you might get sued in one state with unfavorable tax laws yet protect your interests in the other state (separate LLC). Bankruptcy laws change by state as well. Something to consider and be reviewed by a competent attorney.

Sidebar: It is common to have domestic LLCs that are owned by another LLC domiciled in Wyoming or some other LLC friendly state. We expanded on this earlier on page xx, but to repeat ourselves in a succinct way, you basically have a Texas rental owned by a Texas LLC which is wholly owned by a Wyoming LLC which is then wholly owned by you, or you and your spouse. The Wyoming LLC would generally not be considered doing business in Texas and therefore would not have to register as a foreign entity (foreign qualify).

Nevada Fallacy Recap

So, don’t believe the Nevada hype. You can probably get away with not paying state income taxes on your own, but as tax and accounting professionals WCG CPAs & Advisors is bound by such inconveniences like ethics and law. Sorry.

Here is another example to chew on- you have a home office in Maryland. You commute to Washington, D.C. to work for your only client. You incorporate in Maryland since that is where your home office is, and you pay yourself a wage subject to Maryland income taxes. Wait there’s more. You also have a presence in D.C. requiring a D.C. corporate tax return as a foreign entity in addition to your Maryland corporate tax return. Thankfully these and other jurisdictions have reciprocity rules, and we can help navigate.

The bottom line is that Nevada tax laws benefit business owners with a presence in Nevada. As Zig Ziglar would say, “You might get a free lunch on consignment, but eventually you’ll have to pay.” We encourage you to not game the system, and if you want to, WCG cannot be a part of it- we have too many clients relying on us to do the right thing. Please pay your fair share of taxes, just not a dollar more.

Having said that, there are a zillion reasons why forming a corporation or an LLC in a tax friendly state does make sense. But those are case-by-case scenarios. Nothing is a slam-dunk or carte blanche either way. The right questions must be asked and answered to reach the best decision.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Can you be sued personally if you operate an LLC? Yes. And you can easily lose on both a business and personal level. There are several myths out there regarding the use of an LLC as a shelter from potential lawsuits and litigation. Some of the hype has been created by attorneys who used to charge upwards of $1,000 to form an LLC. Need to pay for condos in Maui, presumably. We accountants tease attorneys that LLC really means Lawyer’s Likely Choice.

Sidebar: LLCs are quite powerful. As we’ve already discussed, the deal structures within the entity are endless and the flexibility is strong within multi-entity arrangements. Let’s not forget solid estate planning can be achieved with an LLC as well.

Back to picking on attorneys. Remember, attorneys are not necessarily smart because they went to law school. People are smart, and smart attorneys are people who were already smart and then chose law as a profession. To be fair, the same is true for accountants and doctors.

While consultation with an experienced attorney is strongly recommended for your unique situation, as business owners ourselves we feel the excitement of the LLC has overshadowed the reality of our litigious society. In other words, if your acts, errors or omissions injure someone even though it was under the auspice of your LLC, there is a good chance you will be personally named in the lawsuit and held liable as the owner of the LLC.

The word liability in the LLC truly refers to financial liability. Please read on.

For the matter of this liability discussion, LLCs, S Corps, C Corps and limited partnerships are considered the same. No liability protection is asserted for sole proprietorships, general partnerships and general partners in limited liability partnerships (don’t forget the old timer LLLP which limits everyone’s liability even the general partner). Sure, this is a huge generality, and exceptions always exist depending on agreements and state law.

Types of Liability

There are three areas where you can be held personally responsible- criminal, contractual and torts. Torts is probably most people’s concern, and torts can either be-

• negligence where you have a general duty to act in a reasonable way and you didn’t (like drive your car safely), or

• intentional torts where there was a purposeful act to harm.

There are other tort buzzwords like gross negligence, careless disregard, defamation, etc. Remember, negligence is the opposite of diligence.

Piercing the Corporate Veil

Officers and directors of corporations are routinely held liable for the actions of the corporation. This is called piercing the corporate veil. Can you say Enron?

Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which the corporation has-

• a small number of shareholders (owners),

• limited assets, and

• separating the corporation from its shareholders would promote fraud or an inequitable result.

While this refers to a corporation, the same philosophy is applicable to a limited liability company. Does that sound like your LLC? Yes. Could it happen to you? Yes. Is there a small chance of this happening? Who knows? We say risk it, put it all on red and let it ride. Just kidding. No one bets on red.

Even a two-member LLC would easily be considered a closely held entity. If those members were grossly negligent in the way they managed the entity, separating the corporation from its shareholders (or LLC from its members) would certainly promote unfairness from a liability perspective. This is our opinion of course, but we want to share with you some of the behind-the-scenes perspectives from the courts and law that might not be readily considered when forming an LLC.

Another perspective- if you owned shares of Ford Motor Company, you were not personally responsible for the damage caused by the Ford Pinto even if you were a shareholder. However, if you were a corporate officer who ignored (gross negligence) the potential for harm, you could be held responsible, even criminally. In other words, fix that loose railing before your tenant hurts himself (using an LLC owning a rental as an example).

The general rule across the country is that individuals acting on behalf of a business are personally liable for their tortious conduct even if they did so on behalf of the business. So, to protect your personal assets you need to fund the LLC with enough resources to pay for a lawsuit. This defeats the purpose of not having to pay personally since you are personally doing the funding.

There might be situations where a real estate investor has a lot to lose personally as compared to his or her smaller co-investors. Therefore, perhaps funding the LLC on an equal basis to hedge against potential lawsuits or to have similar language in an Operating Agreement or Partnership Agreement can mitigate some exposures.

Furthermore, if you own multiple investments and LLCs, and you think you can protect the other assets in the event of a lawsuit on one, think again. In our non-legal opinion and observation of surrounding events, if you face a credible lawsuit arising out of your acts or omissions there is a chance everything you have is going to be pursued by the injured party’s attorney including your personal residence, cars, college funds, LLC’s assets, Snuggie collection, etc. Yes, even the leopard one.

Other Things to Think About

You are a reasonable person. Does it seem reasonable for someone to hide behind the auspice of an LLC or a corporation when they do bad things? Of course not. Public policy shouldn’t allow this. Therefore, it follows that if you maintain an unsafe rental property or if you are reckless while driving the business car, you should be sued, and you should lose.

Some attorneys will argue that if you mix personal and business funds together, even accidentally, you might erode the separation of you, an individual, and the entity. For example, an owner will pay for car insurance through the entity. The car is owned personally by the entity’s owner, and the owner is getting reimbursed for mileage. On the books, the car insurance is not a deductible expense, and is coded as an owner draw or shareholder distribution. In this scenario, a court might determine that the “veil” between you and the entity is getting thin, and might be determined to be too thin.

Same with minutes and other business governance. Some argue that if you do not keep up with the housekeeping of your entity, you can chip away at the corporate or LLC protection. There is a natural human response to pile on once a defect is discovered. “In closing your honor, on top of Exhibits A through AJ, this LLC failed to record basic business governance.” While we doubt how much weight this would be given, it certainly helps buttress a level of carelessness or disregard. As mentioned elsewhere, LLCs generally do not document meetings or minutes unless the state requires it.

Protecting Yourself

After all the gloom and doom, there are some small elements of protection. If your employee’s conduct creates a liability for himself and one for the LLC, the owner of the LLC may be absolved. This can get tricky depending on the conduct, and any instructions the LLC provided to the employee. This is attorney type stuff.

So, what do you do? In addition to your general business liability insurance, you should secure a decent umbrella policy both at the personal and commercial level. This is our strong recommendation for liability arising from your acts, errors and omissions. General umbrella policies are $1,200 to $2,000 per year depending on the limits. Something to note is that your liability limits on the underlying assets such as buildings, rental properties and cars might have to increase to reach the floor (starting point) of the umbrella policy. This prevents gaps in insurance.

It appears that many credible lawsuits will sue to the limit of coverage to avoid lengthy and expensive trial litigation. Again, please consult your attorney and insurance agent for your unique situation.

LLC Protection in Borrowing

In addition to the above, there is also a small element of financial protection. LLCs and corporations protect the owners from being personally responsible for the business’s debts and obligations unless the owners or officers personally sign for the loan (called a recourse loan).

However, in today’s lending climate it will be very difficult to get a business loan in the name of the LLC without having to sign a personal guarantee on the note. In other words, you will more than likely need to sign twice- first, as the person directing the entity to borrow and second as an individual promising to pay should the entity fail to do so.

Business debt without a personal guarantee is called a non-recourse loan since the bank or lender does not have recourse against the individual. Tough to get, expensive at times and requires significant equity (60% loan-to-value is the general rule of thumb using real estate as an example).

Quick Recap: In personal worlds including small businesses and rental investments, loans are typically collateralized twice. First, real property is attached with a lien so you cannot sell it without paying the lender. Second, your promise to pay. Lenders can sue to foreclose on the real property, and they can also sue based on your now-broken promise to pay.

How this works is straightforward. Let’s say you own three businesses, one is an LLC operating a pizza joint, another LLC owns a rental with a ton of equity, and another LLC is used to trade stocks, bonds and options. The rental property was purchased with a non-recourse loan. The rental house has extensive mold, is un-insured for mold, and eventually is foreclosed leaving some creditors holding the bag. Picture the poor guy in Monopoly. Those creditors cannot attach or seize your pizza joint or your portfolio since they are held in other LLCs. This is an overly simplified example, and there are probably some rare and narrow instances where you could still be in trouble, but generally this strategy affords some protection according to most attorneys.

A common arrangement is the self-rental which is discussed in more detail later, but here’s a glimmer. You operate an LLC as a business and you also buy the office building with another LLC, of course with a non-recourse loan (the only collateral is the building itself and not your personal promise to pay). The business also has a line of credit. Depending how all the debt is structured, each of these assets (the business and the building) has a Chinese Wall between them. Don’t laugh; that wall served well for nearly 3,000 years.

Again, banks are smart. You are not the first Tom, Dick or Harry to come around. We should probably update the names to reflect the current smattering- how about you’re not the first Parker, Logan or Dakota to come around with your androgynous name and lofty schemes. Most lenders require personal guarantees on every loan.

Asset Protection in Equity Stripping

Another asset protection strategy that is older than dirt is equity stripping (it does not necessarily need an LLC either). It is a process of encumbering your assets to the point where there is no value for lack of equity. In the simplest of forms, you pull cash out against your assets, and separate your cash from the assets. Be very careful. There are “bogus friendly lien” triggers where a person will use a Nevada corporation to file a lien against the asset, however the asset and corporation are owned by the same person (or some related party). This lien is subsequently pierced or tossed as self-serving or deemed to lack commercial merit.

Equity stripping can be a good asset protection strategy, but it requires careful planning with a skilled attorney. And No, it is not older than dirt but it has been around for quite some time.

LLC Protection in Contracts

There is some wiggle room on financial shielding using a limited liability company. If you sign a contract for internet service, or for a copier lease, or some other commitment, you might be able to get away with executing the agreement under the LLC. So, if your business or real estate investment fails, the LLC might be liable for the remaining contract obligation but not you personally. Keep in mind, however, the judgement and foreclosure process could still get you- if someone gets a judgement against the LLC, they can later attempt to foreclose on the distributions or future income of the LLC, and they can also later foreclose on the equity (ownership) of the LLC. On top of all that, your business bank account might be seized to the amount of the lien.

How about we just keep our promises and pay our bills, huh? See Charging Orders for expanded information.

Liability and State Nexus

We chatted about nexus from an income tax perspective earlier- this little tidbit is about nexus from a liability perspective. Several business entities are created in what some people perceive as business friendly states, such as Delaware or Nevada. But when it comes to liability especially tort liability, you will generally be sued in a jurisdiction where you have an economic and / or physical presence.

Yes, an attorney will show up and attempt to fight jurisdiction. But he or she might lose. Now you must hire an out-of-state attorney to fight your out of state lawsuit. Sounds like a grand plan.

So, if you file Articles of Formation, Organization or Incorporation in another state such as Delaware, maintain a presence in Kansas and cause damages in Kansas, you will probably be sued in Kansas. Yes, you can write contracts that clearly dictate the forum of law, but now you are asking a Kansas court to possibly understand and enforce Delaware law. According to several attorneys that we work with, if you march into court pinning your hopes on Delaware law being enforced by a Kansas court, you have already lost. Mediate, settle and move on down the line.

Also, most parties will want the jurisdiction to be in their backyard. You trip and fall in a Wal-Mart and sue Wal-Mart, you are not having to fly to Bentonville, Arkansas to file the lawsuit. Although Table Rock Lake to the north of Bentonville is amazing, you want to sue in your local town, using local courts and jurors. After your big fat judgement, fly to Table Rock Lake in your private jet. Good stuff!

Yet another example. A lot of real estate investors will incorporate or form an entity in Nevada (for example) because of the seemingly friendly business laws, and then buy rental properties in Colorado. This requires a foreign entity registration in Colorado. It is a near guarantee that if you are grossly negligent in the maintenance of your rental property, you will be sued in Colorado. So why the heck are we forming in Nevada? Or Wyoming? Or Delaware? The theory is that a Colorado court would then interpret and enforce the other state’s law in your lawsuit. Good luck with that.

Repeated Sidebar: It is common to have domestic LLCs that are owned by another LLC domiciled in Wyoming or some other LLC friendly state. We expanded on this rental property tiered structure earlier, but to repeat ourselves in a succinct way, you basically have a Texas rental owned by a Texas LLC which is wholly owned by a Wyoming LLC which is then wholly owned by you, or you and your spouse. The Wyoming LLC would generally not be considered doing business in Texas and therefore would not have to register as a foreign entity (foreign qualify). This does not change the location of your lawsuit, however.

Please don’t believe the hype. Do your homework! Do you know of anyone in all your walks of life and circles that fought a lawsuit based on some other state’s law? Perhaps, but sleeping at night solely based on this layer of protection might not be that comforting. Moreover, people who have won those lawsuits had a floor of attorneys working on their case- most real estate investors reading this book likely don’t have millions of dollars to defend a lawsuit.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Nothing lasts forever, even the Cubs eventually won a pennant. If your partner is not your spouse, understand that you could suddenly find yourself in business with his or her spouse or children. Imagine you and your partner. Happy as a clam. Successful. Cement truck. Dead. She left everything she owned to her whacked out children including her portion of the real estate business. Now you and her kids are partners. Wonderful. Do scenes from Horrible Bosses come to mind?

But valuation and funding are the biggest hurdles. For example, the real estate entity might be worth a zillion dollars, but has no cash. Or the value is all tied up in assets, such as houses, buildings or machinery. In other words, the assets are not easily liquid which is common in real estate investments including rental properties. Exit plans or Buy-Sell Agreements really make sense only when the entity has value (which is not always the same as equity).

By Jason Watson, CPA
Posted Saturday, August 3, 2024

If you are a single-member LLC or if your business partner is your spouse, this information might not apply. But if you are in business or own a rental property with another person, even a brother or sister-in-law, then a beefy Operating Agreement is a must have, at least eventually.

Operating Agreements are like Bylaws for an LLC, and they protect the rights of the members and define the parameters in which the members can operate. In general, attorneys do an adequate job drafting this critical document, but there are some holes that WCG CPAs & Advisors feels compelled to mention.

Death, Divorce, Incapacitation

Death and divorce are easy, and attorneys have this in their templates all the time however incapacitation is often left out, or only briefly mentioned. Look at Donald Sterling who was found mentally unsound and could not run his business. If your business partner is Donald Sterling who is not dead nor divorced much to Clipper fans’ chagrin, you might want a contractually obligated and legally enforceable plan to get rid of his member interest.

Do you need one doctor? Two doctors? What is the triggering threshold? Traumatic brain injuries are more common than you think and therefore you need to protect yourself if they occur. It is not just incapacity from a mental perspective either; your business might suffer if a member cannot physically perform the role either.

Accounting, Corporate Waste

Most attorneys draft language allowing any member to request a formal accounting of the expenditures and financial records, and this is commonly afforded in most state statutes that govern corporations and LLCs. However, they often neglect to build thresholds where all members must sign off on an expense. For example, let’s say you are a minority member at 25%, and the other three members are also 25% each. Interestingly, the other three members are also a voting block since they are all family members as well. What’s to prevent them from buying a business car for someone other than you?

In Colorado we have seen a flood of marijuana investors. This is a cash business of course and all these minority investors are pouring their savings into new pot farms. It is not a bad investment; first to market, stake your claim, build mega farms, control the pricing, etc. However, and this is a big however, it is still a cash business. Don’t you want a little assurance that the majority owner is not skimming the till?

Did you know the IRS can determine your sales volume as a bar owner? They look at your purchases which is why most bars must buy from a distributor. Determine the cost of goods purchased slap on a regional markup, and boom, you have sales regardless of what the cash deposits say. Same with divorces; we often look at lifestyle and spending to “back into” the income figures.

There are several other examples that fall under the accounting and corporate waste provisions but we need to move along.

Distributions

Oftentimes the entity will have income, but no cash since it is re-investing back into the venture. However, as a shareholder of an S corporation or a member of a multi-member garden variety LLC, you will pay taxes on business income (profits) and not distributions. Theoretically you could have a big tax bill based on income but never see the cash. How does this work?

The entity has net income of $100,000 after expenses and everyone decides to put the money back into the venture such as paring down debt or renovating the kitchen. Cool, since everyone agrees but all the owners will have a tax obligation based on the $100,000. This means that if you are a 25% owner at a 22% marginal tax rate, you will have a cash out-of-pocket tax bill of $25,000 x 22% or $5,500.

WCG CPAs & Advisors recommends two things when it comes to distributions. First, define and calculate working capital for your business. If the entity needs working capital to operate or for future purchases or initiatives (what we call capital expenditures or capex for short), how is that calculated? Second, once working capital is defined, what portion is distributed and what is kept in the business?

From there, the Operating Agreement could dictate that a minimum of 40% is distributed to the owners unless all owners agree to a different figure. This helps reduce some of the tax sting of net ordinary business income or net rental real estate income being allocated to you without the same amount in cash.

What WCG recommends is-

• Determine working capital (time-based operating expenses + capex + buffer).
• Determine a budget.
• Use math to then determine how much you can safely distribute to the owners.
• True up each quarter or semi-annually to align reality with budget. In other words, if your interim profit is higher than budgeted, perhaps another off-cycle distribution can safely occur.

Dispute Resolution

Templated Operating Agreements usually have language about dispute resolution, and specifically mediation. Mediation is fine, and some courts have a standing order that parties will attend mediation prior to trial. However, mediation is not binding and parties don’t necessarily have to enter into mediation with good faith. Trials take a long time- anywhere from 12 to 24 months, just to get to opening statements.

Arbitration is like mini-court and the rules of discovery and evidence are usually more relaxed including procedure. They can be expensive since you are paying for your attorney plus the arbiter who is usually a retired judge or attorney. However, they can also be efficient.

Regardless of mediation, arbitration or trial, make sure your Operating Agreement has expeditious dispute resolution provisions, and incentives for all parties to be efficient and bargain in good faith.

Business Valuation

If a member wants out, no problem, but what is the value of the business? Should you use a formula to determine the value? Perhaps something based on revenue? A full-blown business valuation? What if you and your business partners cannot agree on the selection of the business valuation expert?

Keep in mind that while real estate entities can easily be valued with an asset approach, the income approach is often used in commercial and other investment settings. Make sure there are provisions in your Operating Agreement.

As a side note, if the value cannot easily be derived from a formula, we often see language where the exiting member and the remaining members each pick a business valuation expert. Then those two experts pick a third as a neutral, or some other seemingly detached and disinterested selection mechanism.

As we’ve said in the past, just because you are working with an attorney or an accountant doesn’t mean you are working with a smart person. WCG CPAs & Advisors can act as a consultant with your attorney when drafting these documents.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

While discussion with a qualified estate planning attorney is essential when using a Trust, here are some basics about Trusts to better understand how they mesh with your business world.

Trusts do two things very well. First, they usually help bypass probate. If you own property in three different states, then probate must be opened and closed in all states. The process is long. It is expensive. It is public.

Second, they help you, the dead guy, dictate policy from the grave. If you want to ruin a 30-year old’s life, give Junior a million dollars. A Trust can dole out money according to a schedule. Special needs kid? Drug addict? Nut-job son-in-law? A Trust can protect your interests long after you’re cold.

Trusts might also protect your children. Here’s an example. You die. Your wife wears a short dress and heels to the funeral (naturally), and waits the obligatory 4-6 weeks before dating again. She gets married because your dying words were, “I want you to be happy.” She lives another decade and then dies suddenly. Now this dude whom you never met has all the money and doesn’t care about your kids. Wonderful.

The only difference for women is that men would only wait 2-3 weeks to start dating, but the rest remains unchanged.

Revocable Trusts are also called Living Trusts. This is where the grantor and the trustee can be the same person. If a revocable trust owns real estate, the grantor can burn the place down, paint it purple or sell it. Since the grantor has ultimate authority over the trust asset, there is no creditor or asset protection afforded. Zippo. None. Don’t believe the asset protection hype. If you want protection, you must usually give up control.

Irrevocable Trusts are the roach motel- assets can check in, but they can’t check out. The grantor does not have any authority over the trust; only the trustee does. The trustee cannot be you, the grantor. The trustee could be your best friend but cannot be influenced by you. The trustee must make decisions with the Trust’s interests in mind as a fiduciary.

Some people try to install poison pills in an Irrevocable Trust where if certain events happen, the assets revert back to the grantor. Be careful on this. The IRS ruled in Private Letter Ruling 201426014 that the,

provision in trust that provides that, in the event that both the children are no longer serving as members of the Distribution Committee or if there are fewer than two serving members, the trust property will be distributed to the grantor, and the trust shall terminate, constitutes a reversionary interest under Code Sec. 673.

This is one example of a poison pill that backfired. This was a Revocable / Living Trust disguised as Irrevocable.

Those items that have built in beneficiaries such as life insurance and investment accounts might be placed in a Trust, but they do not have to be since these assets bypass probate automagically. However, if you want these proceeds metered out according to a schedule, then the Trust needs to be the beneficiary. Get some planning!

Litigious assets are usually encapsulated in an LLC prior to being placed in a Trust. Automobiles are an example of litigious assets, but they are usually directly owned by an individual. Real property such as rental real estate is another great example. But what if you wanted to have your rentals pass through to your estate and skip probate?

Having said all this, many business and corporate law attorneys will suggest only using an LLC with an Operating Agreement, and not rely on a Trust. The new generation of estate planning attorneys are also abandoning the use of Trusts. Some believe that Trusts are being oversold, and while they are necessary, the ideal situations are fewer and farther between.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

Let’s say you have rental properties in Montana, Colorado and Texas. For all the benefits of using an LLC to own your rental property that we discussed previously, you decide to put each property into a separate LLC. However, you also want a holding company to own or “hold” all these LLCs under one entity.

As such, an LLC is created in Wyoming given their low annual costs plus anonymity (other states work too, but Wyoming is nice). Next, LLCs are created in Montana, Colorado and Texas. Keep in mind the order here. The parent, the Wyoming LLC, needs to exist first since the child LLCs will be wholly owned by the parent LLC. In other words, each rental property will be owned by an LLC that has a single-member, and that single-member is the parent LLC.

Should you have some LLCs now, and want to create a holding company later, that is perfectly fine. You simply need to assign your interest in each LLC to the holding company LLC. If possible, creating the parent or holding company first is more elegant and helps with employer identification number (EIN) assignment.

Sidebar: When you are obtaining an EIN for your child or subsidiary LLC where the sole member is another entity, the application process is a bit more clunky and generally cannot be submitted online with the IRS website.

The Wyoming LLC is now a holding company, and with an attorney’s assistance, the Operating Agreement can be crafted as part of your estate planning and orderly transfer of wealth for all your rental properties. There are some other advantages as well if the Wyoming LLC is taxed as a partnership. See our section on using partnerships for rental properties.

You own the Wyoming LLC. It owns the gaggle of LLCs. Each LLC owns its respective rental property.

The Wyoming LLC would generally not be considered doing business in Montana, Colorado or Texas and therefore would not have to register in each of those states (what we call foreign qualification). However, we would recommend that each child or subsidiary LLC be manager-managed. Huh?

An LLC needs a manager. The manager can either be a member or another named person or entity. As such we have member-managed or manager-managed. An LLC that is member-managed as the name suggests is managed by the member, and in this example, the Wyoming LLC.

In working with other attorneys, WCG CPAs & Advisors recommends manager-managed with the manager being you, the human. This helps preserve that the Wyoming LLC is simply a holding company and is not considered doing business in Montana, Colorado and Texas. In other words, you, the human, are directing each child LLC.

However, income tax returns will still be filed in each state (while Texas does not have an income tax, it does require LLCs to file certain annual filings). If your Wyoming LLC is taxed as a partnership (Form 1065), then the entity files these tax returns at the entity level. You, the human, might also have a tax return obligation depending on ultimate taxable income from each rental property.

If your Wyoming LLC is a single-member LLC, and therefore disregarded for tax purposes, you, the human, will file income tax returns in each state even if the rental property ultimately has a loss (each state has the right to inspect your books and records to confirm your tax loss).

A multi-entity tiered structure for your rental property kingdom is a great way to add some layers to your onion including anonymity plus the estate planning benefits.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We broached this from an investor perspective earlier and is largely repetitive. This tiny section expands on the notion of your cash going into the entity, and how that might be problematic.

The question comes up from time to time about how to fund the new venture. If you are the only owner, then any money going into the business, real estate investment or rental property entity should be deemed a capital injection and not a loan. For some reason small business owners and real estate investors want their entity to owe them money; this typically does not make sense and can set you up for problems down the road.

For example, if you lend your entity money and it goes bankrupt, your bad debt deduction might be limited as a short-term capital loss. According to IRS Publication 535 Business Expenses, a business loan is comprised of-

• Loans to clients, suppliers, distributors, and employees

• Credit sales to customers, or

• Business loan guarantees

As such the loan to your entity might be deemed a non-business loan and limited as a short-term capital loss.

Let’s not forget that you must also impute interest expense to the entity, and then subsequently pick up interest income on your individual tax return (Form 1040). Issuing a 1099-INT from the business to yourself seems silly, but true!

However, another situation might arise where you are partnering with someone else, and let’s assume you have all the money for startup funding. Recall the golden rule where the person with the gold makes the rules. As such, you might want to consider your funding as a loan to the business or real estate venture. This allows you to do two things; you can take money out of the venture ahead of others as a loan payment (return of capital) and you can execute a personal guarantee from your other partner collateralizing the loan.

You can also convert your loan into additional equity. For example, you are a 50% owner and lend the business $100,000. Things are going great; however, the entity does not have the cash to pay you back since all the cash is being re-invested back into the venture. You might have a provision within the loan agreements that allows you to convert the debt into equity.

We talked more about this myriad of possibilities when partnering with others, including adding partners in a previous section. Check it out!

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We are only going to scratch the surface on the types of deals and arrangements that you might see out there. Our intent with this section is to illustrate some of the considerations. One of the common statements we get from clients at WCG CPAs & Advisors is, “I have a guy who is giving me $100,000 to help me start my real estate venture.” Our next response is, “Will the guy be an investor, lender or both?” Then your response is stunned silence… which is certainly re-assuring. Not!

There are many ways to handle this, and no one way is always the best. It depends on humans, emotions and personal objectives. Don’t forget the golden rule where the person with the gold makes the rules (you hear this often in our book, but it is so true).

Here are some ideas and various considerations-

Investor is Truly a Lender

If the investor wants to get paid back first with interest then make him or her a bank, and pay or accrue interest accordingly. Done. This is also finite, right? After the loan is paid back, the cord is cut, and everyone lives on like perfect strangers.

Investor is a Lender with Economic Interest

Same as above, but once the loan is paid back the investor continues in an economic interest capacity and has claim to some of the business or rental property profits. Perhaps this claim expires at a predetermined time such as five years following loan re-payment. This is tricky since the investor is both a lender and an owner of sorts which could be conflicted.

This is commonly called a profits interest where you receive a share of the future profits (revenue less expenses) and the appreciation of the assets of the business. There are some rules, with the most common one being “the service partner must receive only a profits interest in the partnership in exchange for the contribution of services.” In turn, the profits interest partner cannot be given a share of current capital in exchange for the contribution of services. This makes sense since you usually have tax basis in your capital, and to have tax basis you needed to have paid taxes on that capital at some point in the past. Yeah, we geeked out there. Sorry.

Investor is a Lender with an Interest Upon Sale

Similar to above, but the lender gets a piece of the action upon sale of the business or real estate investment. Perhaps the loan is paid back as necessary, with the sale option enduring into perpetuity. The thought process is, “hey I helped you get off the ground and now you owe me beyond the 8% interest I charged.” Surely these are your inside words and they are presented in a softer way to others.

Some caution is in order too. You might not have any control regarding the sale such as terms, timing, etc. For example, you have an agreement that upon sale you get 10% of the proceeds. Great! What constitutes a sale? What if a 100% owner sells 60% of the business but retains the remaining 40%? Hmmm. In these cases, you could draft the agreement to read that upon sale, partial sale or change in control, there is a payout.

That change in control is a big deal since you probably have a personal connection with the owner, and now you are tethered to someone else. People are pro-marriage, but they generally do not want to be told who to marry.

Back to the original idea. The investor is initially the lender but has a contractual interest should an event occur regardless of the current loan status (paid off or not). These particular arrangements need to be stress tested with various scenarios and contingencies.

Investor is an Owner

Rather than recording a loan on the books, the injected cash is credited to the investor’s capital account. The investor may get a return of capital prior to other owners per an agreement. In other words, distributable cash goes to the investor first as a return of his or her original investment. The splits can vary; for example, the investor contributed $90,000 and you contributed $10,000. You could still own 90% of the entity while the investor only owns 10% (an exact flip-flop). We call this special allocation.

Loans Versus Capital

Most lenders want some sort of guarantee from the owners. As such, the angel investor might demand that you guarantee the loan personally which can make a failed business or real estate venture scenario a messy one causing ruined friendships, awkward Thanksgivings and all that fun stuff. Conversely, an investor who wants to be an owner (versus a lender) and injects capital now has a seat at the table so-to-speak and might not fully let you run the venture the way you see fit.

Your Capital as a Loan

While there might be some good reasons, typically you do not personally lend money to your single-owner business or real estate venture. We hear it all the time, “my business owes me money.” Unlikely. Rather, what is meant is that you’ve invested money into the venture and / or perhaps you’ve paid for things with personal funds (since the venture was broke as… well, it didn’t have the necessary funds). This is invested capital and not a loan. When there is distributable cash, you can take that capital out of your venture generally tax-free.

Keep in mind that a loan requires a loan document, amortization, interest expense (which becomes income to you) among other things. Therefore, while the venture might have your money, it doesn’t technically owe it to you. However, you are allowed to take it back when it’s sitting on a pile of cash.

S Corp Rigidity

While not super pertinent to rental property investments, S corporations can be super rigid with the splitting of distributable cash. At times you also want to get a rip of the action ahead of others. In partnerships, not taxed as an S Corp, these “payments ahead of others” are usually in the form of guaranteed payments. You do not have this option in an S Corp unless it is in the form of increased shareholder salaries which largely defeats the purpose of an S corporation election.

What about varying capital accounts in an S Corp situation? Let’s say you and another person are consultants and you ban together to form a 50-50 partnership, and you also want to use the S Corp election to save on self-employment taxes. Furthermore, you have $100,000 to invest while your partner has $1,000 and some average looks. A consideration (not a rule or a must-have) would be to have each of you inject $1,000 in cash as capital, and then you provide the remaining $99,000 to the shiny new S corporation as a loan. This allows for an elegant way for you to get your cash out.

For ways around the S Corp rigidity conundrum, please see our book, Taxpayer’s Comprehensive Guide to LLCs and S Corps.

Ineffective S Corp Elections

Again, this is not usually super relevant in a rental property environment. However, in that brokerage commissions, management fees, and fix and flip world ineffective S corporation elections can be problematic. As you know by now, limited liability companies are amazingly flexible in structuring a deal. You can build an LLC with all kinds of deal structures such as-

• Special allocation of income and losses (including qualified income offsets to maintain compliance),

• Liquidating distributions made in accordance with positive capital account balances,

• Employment agreements,

• Buy-sell and redemption agreements, and

• Options and warrants, including convertible debt.

This list isn’t exhaustive, but what this is telling us is that certain agreements inside and outside the Operating Agreement might make the S Corp election ineffective. Why? Special allocations are simply not allowed in an S Corp. That’s easy. However, the outside agreements such as employment, buy-sell, redemption, options, warrants, debt instruments, etc. (all the fun stuff in this section), can create a second class of stock. As you might recall, an S corporation can only have one class of stock (voting and non-voting is allowed, however) according to IRC Section 1.1361-1. Recall? Of course you do!

Front-End Back-End

There are two things to consider when bringing in another owner or becoming that new owner yourself. Do you want to make money on the front-end, or the back-end, or both? In other words, do you want to make money along the way as an investor owner getting a return on investment from operations? Or… do you want to forego some money from operations, and put more emphasis on an eventual sale?

Sidebar: You might hear the term liquidity event. According to Investopedia, a liquidity event is an acquisition, merger, initial public offering (IPO), or other action that allows founders and early investors in a business to cash out some or all of their ownership shares or interest.

Of course, your risk aversion and the risk versus reward thing are going to drive this decision including your current lifestyle and income needs. Are you the person who works hard trusting you’ll get paid in the end? Or are you the person who wants money today and is willing to sacrifice the big payday at the end? Everyone is different. Every deal is different. You just need to find one that fits everyone involved.

Venture Capital

As we’ve mentioned here and there, and at the risk of over stating it, the one with the gold makes the rules. This is the Golden Rule. Some venture capitalists and other “professional“ investors have specifications before they will entertain an investment. For example, an investor might require a C corporation domiciled in Delaware. Period. Take it or leave it. Why?

Who knows? Perhaps that is what they have always done, and why change now? Or… perhaps that is how the investor was able to raise capital and the prospectus outlined this detail such as “all equity investments will be made into C corporations domiciled in Delaware only.”

By now you should have a good handle on the fact that a C corporation is a lousy tax vehicle and that Delaware only adds to your tax filing headache if you operate in a state other than Delaware. But! If that is what it takes to receive seed money for your big idea, then that is what you do.

Nuts and Bolts of Adding Another Owner

Let’s assume you have a single-member LLC, and you want to add a 20% member for $50,000. What are the accounting mechanics behind this transaction? It depends. If you are personally receiving the $50,000 then you are selling a part of your interest directly to the new owner which might create a capital gain to you, as a seller.

Conversely, if the LLC is receiving the $50,000 as a capital injection and carving out a 20% interest to this new member, this is not a taxable event. This also does not mean the business is worth $250,000 (1/5 = $50,000 so 4/5 = $200,000). When a business valuation is performed, the enterprise is valued as a whole, and then discounts are taken for lack of control (minority interest) and then lack of marketability (difficulty in converting ownership into cash).

Therefore, this $50,000 is just a number the two of you came up with based on some data. When that $50,000 is received by the LLC it becomes a part of the capital account of the new owner. This is a tax-less transaction for the existing or original owner(s).

Let’s recap this a bit. When adding an owner, you can-

• Sell or gift a portion of your interest or shares to them, or

• The entity can sell shares or “create” an interest in exchange for consideration (usually money but it could easily be another asset like property).

In the case of an LLC (versus a corporation), the second scenario is preferred. There is an election under Section 754 which allows a new member (partner) to receive a step-up in basis of the entity’s assets which might lead to additional depreciation and amortization benefits. The “754 election” as it is commonly tossed around at parties and accounting back alleys aligns the new member’s portion of inside basis (the assets inside the entity) with the outside basis (the investment by the new member). This can also occur when you buy out another member (partner). We discuss the 754 election and its power later.

Sorry for throwing you into the weeds on this little tax code issue.

Injecting Different Property

This is one of those Pet Shop Boys “I’ve got the brains, You’ve got the looks, Let’s make lots of money” sort of things. The best way of describing this deal arrangement is with a real-life example.

WCG has a client who helped a business (let’s call them ABC Co) develop a product. However, he wasn’t fully paid for his services (about $836,000) and was willing to get paid on the backend. The product cost about $7.5 million dollars to develop and ABC fronted all the costs.

They wanted to create another entity where our client was going to be a 25% owner and ABC was going to be the remaining 75%. Initial capitalization was low since our client did not want to realize any income until later. In other words, if the injected product was valued at $10 million, our client might have to realize the $836,000 deferred income as part of the $2.5 million capital account. There were a bunch of other basis issues that are not worth going into with this approach.

So, it was abandoned for a different arrangement.

The plan was to keep developing the product and eventually sell out to another business who would take it to market (a liquidity event). If this new entity sold for $12 million, then it would be easy to pay out $7.5 million to ABC and $826,000 to our client, and then split the remainder 75% – 25%. But what if it sold for $5 million? Who gets what and when?

We agreed on various tranches. Tranche 1, ABC received $2,500,000. Tranche 2, our client received $278,000. Then Tranche 3 was 90% ABC and 10% our client for the remainder of what was available. Finally, there was a Tranche 4 should the business be sold for more than $8.4 million or so that was split 75-25 (or along party lines of the member interests).

This was a shared risk approach. Certainly, ABC was the 800lb gorilla and wanted to recoup a big chunk first, but it was also willing to reduce our client’s risk as each tranche was satisfied.

These things are unique since they involve humans and emotions, and various risk horizons. But as they say, there are a thousand ways to skin a cat, and as such, only limited imaginations get in the way of a good deal.

Recap of Angel Investors

Are we suggesting avoiding these situations entirely? No. At times they are the only options available. We just want to let you know of the concerns and considerations. Marriage is all about love, and divorce is all about money. Business, including real estate investment and rental properties, is no different, and in some respects can be worse.

The cool thing is that you have several options, and you can certainly rip off best practices or other ideas, smash them up, and create your own plan.

By Jason Watson, CPA
Posted Saturday, August 3, 2024

You can own different interests in an LLC entity, and the most common are economic and equity. Generally, as an equity owner you are an owner of the business’s equity which includes its assets (tangible, and intangible such as goodwill) minus the liabilities and debts. This also typically means that your equity interest entitles you to a share of the proceeds upon sale (unless contracts and agreement state otherwise).

An economic interest is generally a share of the profits but does not necessarily entitle you to the equity or value of the entity itself. Many businesses will have a profit-sharing plan which is similar to an economic interest, however these are usually reserved for certain employees or groups of employees, and not necessarily memorialized in a business’s Operating Agreement. Here are some examples-

• You work for Google and they have a profit-sharing plan where you receive a prorated amount of the allocated profit sharing based on a formula (such as salary and years of service). This is generally not viewed as owning an economic interest in Google, however Google probably has at least a contractual obligation to you.

• You work for an accounting firm. You are paid 30% of the gross revenues less direct labor attributed to your efforts. This payment is made directly to you and bypasses payroll (i.e., not reported on your W-2). The Operating Agreement of the accounting firm reflects all this, and you are named a non-voting member. This is commonly regarded as an economic interest, and as such you are technically a partner in the accounting firm and will receive annual K-1s reflecting your earnings.

Subtle difference.

What’s the big deal? In a true business environment, at times you might not want to immediately give away or sell the net worth of a business to a partner. Rather, you want to split the difference; you want them to feel like an owner, think like an owner and get compensated like an owner, without actually owning the sticks and bricks. Later, down the road and upon reflection, an economic interest can be piggybacked with or wholly converted to an equity interest.

In a real estate investment environment, it is common to not view the operation like a business, but it truly is. Aside from maximizing rent and minimizing expenses like any business, you might also have a maintenance person or a listing agent who is very much valuable to the overall success. As such, you might envision them becoming owners in some capacity.

In a pure rental property environment, you might want to report your activities on a partnership tax return (Form 1065) as mentioned previously on page xx. To do so, you could add another member to your LLC in an economic interest capacity only. They would receive a K-1 with their portion of the rental income or loss, but they would not own equity in the LLC or the rental real estate directly. You could make their economic portion super tiny as well, such as 0.1% (you would be allocated 99.9% of the net rental real estate income or loss accordingly).

Expanding ownership is tricky and it requires legal documents to be safe; but it is also unlimited in terms of buy-in arrangements, splits, vesting schedules, exit strategies, etc. WCG CPAs & Advisors can help with the imagination! You’ll freak out because casting future unknowns in stone can keep you awake at night; we can also help make things malleable without being locked into a once-was-good-but-now-is-bad deal.