​Living in CA, investing out of state. Where to form LLC?

[Kelly Byrd]

I think I have a simple enough situation that I won't require advice from a asset protection lawyer, I'm hoping some of you are in a similar situation and can pass on what you have done.

My wife and I live in California. We are under contract for our first investment deal, a multifamily in South Dakota. We have assets outside of this property that we would like to protect, so my plan is to form an LLC for this property and then get umbrella insurance on top of that. The property is over four units, so we're looking at a commercial loan regardless. The lender has no issue with an LLC holding the property.

I know California is going to consider us "doing business in California" and therefore subject to the $800 minimum franchise tax in California. It seems my options are to either form a South Dakota LLC and register it as a foreign company or form a California LLC and register it as foreign company in South Dakota.

My questions:

• The LLC operating agreement can be simple, my wife and I will be the only members. Can someone share a sample simple operating agreement for this "married couple holding a single property" LLC?
• What are the pros and cons of forming the LLC in CA vs where the property is? The typical advice for RE investors is to form in the state where the property is because it avoids the overhead of having to register a foreign corporation where you are doing business. But since we are CA residents, we have that overhead regardless.
• California is a community property state, South Dakota is not. If we form a South Dakota LLC, can we still treat it as a disregarded entity because we live in California?

Thanks in advance!

[Katie L.]

@Kelly Byrd

Sounds like you may have already set up your LLC so maybe this is too late, but in case you haven't or for any other readers, there are brand new partnership audit regulations which drastically change the course of audits of partnerships (including LLCs if treated as partnerships). Such changes will likely require amendments to your LLC agreement or partnership operating agreement or else there can be significant downsides, depending on your situation. These are changes that you are NOT likely to see in a standard operating agreement you get from a legal zoom or nolo type service. The rules are effective January 1, 2018 and since they're federal rules, they will affect your LLC whether it's in California or South Dakota. I am working with clients here in San Diego to update their documents to protect them from some of the rules - which include the IRS appointing a "Partnership Representative" if one is not named, and their appointment is final! Might be something to look into for your document and agreement, or for past LLCs if you have an older operating agreement.

Also, have you considered a C-corp? Generally not recommended for real estate because of the rental income, which is usually used by owners to pay rental expenses, which could result in double taxation at corp level and shareholder level. But, if you have enough assets that you can use to pay for the rental and leave it as a long-term growth vehicle, the corporate rate is now 21% with the newest tax laws, which may be lower than your individual rate that you will pay on LLC pass-through earnings on your individual return (highest rate is 37%).

The newest tax laws also implemented a new section 199A which gives a benefit for certain pass-through shareholders if you meet certain tests.  But the rules are complex for what income qualifies and what taxpayers qualify, but is something you may want to consider in how you structure your company.  Might make sense for some taxpayers to have separate LLCs for the same piece of real estate depending on the type of income so that some of it qualifies for the new 20% deduction/rate which could have significant tax savings.  2018 brought a flurry of new rules and opportunities!

In regards to your question about community property vs separate property, there's a lot that goes into that analysis and since I do not know all the facts, I will refrain from comment or advice.  It may be that your property is "quasi-community" property.  Depends on several factors including where you and your wife live, where you were married, if you used community funds for the down payment, if you use community funds to pay the debt, etc.  You may want to consider a transmutation agreement if it is necessary.  Also not sure if you had a pre-nup or post-nup.  

Last comment for right now, if you don't have an estate plan in place you will likely want to get one ASAP. Sounds like you have a lot going on and you just never know what life can bring. It sounds as though you're trying to save costs, but good legal advice is worth paying for. Let me know if you need referrals in San Diego or Southern California. Going through probate in CA can be a very expensive process and a huge hassle and if you drafted your LLC agreement yourself, you may be headed that way eventually.

*None of this post is intended to be legal or professional advice or relied upon in anyway.  It does not create an attorney-client relationship or CPA-client relationship.  Readers are advised to seek professional advice.