Form of entity ?

[Jeff Botheroyd]

Looking to get funding for our first deal.

We've heard about Lima Capitol at the beginning of podcast #167. What we want to do is get the pre-approval out of the way first so we can look at and make an offer on a rental.  Keep in mind that we haven't selected a property yet just want to get approved for the load.  Lima Capitol lends the hard money for the purchase as well as the monies for the rehab.

Now to my questions-

They require all loans to close in some form of entity. And need the following documents for the entity:

- Copy of the certificate of incorporation

- Articles of incorporation

- Resolutions of the board of directors

- Certificate of good standing

We are not incorporated so we don't have any of the first three and what exactly is a certificate of good standing?

Do all hard money lenders require all of the above?

Thanks,

-Jeff

[Jeff Copeland]

@Jeff Botheroyd - Disclaimer: I am not an attorney or an accountant; Talk to someone who is for specific advice on your specific situation. 

And also, that's a loaded question with a multifaceted answer!

First of all, there are two reasons to consider using an entity: liability protection, and tax benefits.

With regards to liability, let's say a beam falls off the ceiling of your investment property and breaks Joe Schmuckatelli's collar bone.  Joe's a good guy and has no intention of suing you, so he just goes to the hospital emergency room and uses his own health insurance. While he's there doing his check-in, he explains what happened and where/how it happened.

Guess what? Even though Joe doesn't want to sue you, his insurance company will (in a heartbeat) if they feel the liability belongs to you (this is called subrogation, when the insurance carrier sues or brings a claim against a third party on behalf of their client), and if the accident happened on your property, and it was your roof beam that fell on Joe - they have a very strong case.

Now...if you own the home in your personal name, all of your assets are in play. Your homeowners insurance steps up to bat first. But let's say for argument's sake Joe's collar bone got infected and he lost the use of his arm and can no longer work. His claim for injuries and loss of income is $2.5 million. Your general liability limit on your insurance policy is probably only $1 million...where does the other $1.5 million come from? YOUR personal ASSets!

Now if you own the home in the name of ACME LLC, it's a completely different story. The only thing ACME LLC owns is an $80k rental/rehab property and a $5k cash reserve sitting in the bank. Worst case scenario, you liquidate these assets, declare ACME LLC bankrupt, and everyone goes on their merry way.

It doesn't matter if you (personally) have $10 million in the bank, or have 12 other properties in other LLCs or corporations ...ACME LLC doesn't, and it is a separate and distinct entity from you and your other LLCs or corporations.

That's why Donald Trump has declared bankruptcy several times, but is still relatively well-off.

That being said, there are two schools of thought, generally:

1. Own all properties in an entity (be it an LLC or Corporation*) to limit your personal liability, or

2. Hold properties in your own name, and use insurance to limit your personal liability.

(*The general consensus seems to be that an LLC gives you about the same liability protection as a corporation, but with less cost and red tape, and more tax options.)

There are pros and cons of each, and everybody has their own opinion. Personally, it is so easy to form an LLC (and and LLC gives you so many tax options...see next paragraph), I see very few reasons not to form an LLC. However, I would never presume to know what is best for you.

Tax considerations are secondary to the 1 vs 2 decision above. 

As an LLC, you can structure your entity (for tax purposes) as a pass through (where all of the profits pass through to your personal tax return), an S-Corp (where it is taxed like a corporation), or a Partnership (where profits pass through to any number of partners according to your business model). So an LLC gives you maximum flexibility, tax-wise.

As you can see, this all depends on your personal situation, risk tolerance, income, tax bracket, net worth, and a myriad of other factors. An hour or two with a CPA and/or an attorney is worth every penny on the front end ... it's easier to set things up correctly in the beginning than to change things mid-stream in a year or two.

Finally, if you choose to go the "entity" route, it is imperative that you keep separate accounts, separate books, etc and not commingle your business and personal funds. Otherwise you risk a plaintiff/claimant "piercing the corporate veil" and challenging the validity (and thus protection) your entity provides.

Sorry for the rambling answer, but I warned you at the beginning!