Do I need a business entity in any state I do business in?

Question

Is it true that I need a business entity set-up in any state that I do real estate investing in?

Jonathan Twombly · Answer

@Ralph E. Ralph, @Chris Martin is correct.

Liability insurance and limited liability are two different things, and if you're in business you need them both.  Let's say you have your property owned by an LLC.  The property is worth $200K and you have $500k of liability and umbrella coverage on the property.  What happens if someone slips and falls on the property, suffers a horrible injury, sues for $1 million, and wins?

In that case, they recover $500K from your insurance, and they take your property and that's it.  Even though the award is more than the insurance and property value combined, they are limited to that recovery.  That's what "limited liability" means - your liability is limited to the asset.

Now, what happens if you have $500K of insurance, and no LLC - you own the property in your own name.  In that case, they get the insurance money, the property, and they still have a judgment against you personally for $300K.  In many states the statute of limitations on judgments is 10 years.  So, for the next ten years, they can garnish wages, come after other property you own, etc., until the judgment is fulfilled.  Unless you have the assets to pay them, you're probably looking at personal bankruptcy.

What happens if you have no insurance and an LLC?  The plaintiff gets the property and that's it.  Your liability is limited to the value of the property.  They will probably sue you and try to pierce the corporate veil, which requires them to prove that you didn't really operate the LLC as a separate entity, so to avoid that, you must keep really good books and observe all corporate formalities.

Before you go and say that you don't need insurance if you have an LLC, stop right there.  Most claims are going to be for less than he value of the property.  Without insurance, you will pay any claims out of pocket - or rather, the entity will.  You might have to sell the property to raise cash to pay the claim.  And, in any case, if you have a mortgage the lender will require you to have insurance to stop this possibility from happening.  So you can only get away with having no insurance if you own the property outright.  And, sometimes, if you have no insurance, the court will cite that as a factor for piercing the corporate veil.  So it's best to be insured too.

Of course, you also need a casualty policy because your liability policy and limited liability entity don't protect you from damage that happens to the property from storms, accidents, fires, etc.

And insurance does not protect you from claims by creditors, such as workmen who are not paid for work on the property.   Only a limited liability entity protects your personal assets from them.  Of course, if you give personal guarantees, they can go around the entity to get paid.  But assuming you don't, their only recourse is against the entity that hired them: your LLC.

SO, in sum, insurance and limited liability serve two very different, but complementary purposes.  The confusion comes from the fact that the word "liability" is in both.  Liability insurance pays a plaintiff on your behalf - up to the policy limit - if you are found liable.  Limits liability entities (Inc., LLP or LLC) protect you by limiting what you must pay a plaintiff to the value of the assets inside the LLC, shielding all your other assets unless it can be proven that you played fast and loose with the LLC.

And just one last word on this subject.  Gurus create this misunderstanding because they encourage people to get LLCs for TAX AVOIDANCE reasons.  They tell you to avoid taxes by running personal expenses through the LLC.

This is EXACTLY the sort of conduct that will convince a court that you disregarded the legal separateness of the LLC so that the corporate protection should be waived and your personal assets exposed to recovery by the plaintiff!!!!

Don't do it.

David Dachtera · Answer

@Ralph E.,

To clarify, any business your entity does in a specific state will governed by the laws of that state, regardless where the entity was founded.

You will need to register your entity as "foreign" doing business in that state, which increases your entity maintenance costs. So, best just to have an entity in each state where to do business to minimize costs.

Not legal or financial advice. Consult qualified professionals.

Ralph E. · Answer

@Jonathan Twombly,

Thank you for this very helpful information.

David Dachtera · Answer

@Jonathan Twombly,

That may be your understanding of what some "gurus" teach about business entities. It is, however, inaccurate and, more disturbingly, incomplete.

The tax benefits of business entities are not TAX AVOIDANCE, they are tax liability reduction. The tax code was written by rich people for rich people. So, the way to be more like them and obtain tax code benefits is to use the tax code the way it was intended.

Also, if you're using LLCs outside of a business entity structure, you're doing it wrong and you will leave yourself open to being considered as having disregarded "the corporate veil" which will leave you open to attack from shysters and thieves ... er, prosecuting attorneys and plaintiffs.

Your tax accountant and tax attorney can provide guidance on this, @Ralph E. Yes, all entities need full insurance coverage. Entities are NOT a replacement for proper insurance!

That said, remember: if you have full insurance but hold properties in your own name and become the target of litigation your ENTIRE ESTATE will now be exposed and at risk.

Chris Martin · Answer

Then get liability insurance. Your entity isn't going to help you with a liability claim.

Ralph E. · Answer

@Jonathan Twombly,

Thanks for the info Jonathan. I feel that I'd rather have liability protection, since I couldn't afford to lose what little assets I do have.

Ralph E. · Answer

@David Dachtera,

Thank you for the reply!

Jonathan Twombly · Answer

No, not from a legal point of view.  It's a good idea to have a legal entity for liability limitation.  But you can always do business in a personal capacity.  It's called a sole proprietorship.  But you have unlimited liability if you do it that way.

Most states will allow you to do business as a foreign (i.e., foreign to that state) business, but many if not most require you to register your out-of-state entity in the state in order to get limited liability protection in that state.

Do I need a business entity in any state I do business in?

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