Creating an LLC for Real Estate Transactions
It’s common to use a “limited liability company” (LLC) to buy and sell real estate, or conduct other real estate transactions, whether residential or commercial, and it can be a smart way to protect your personal assets when something goes wrong.
The purpose of a “limited liability company” is to separate the owners from the company’s legal liability. Under most circumstances, creditors cannot seek the owners’ assets and property to satisfy the company’s debts. Below we cover the basics of setting up an LLC and some exceptions to the liability protections offered under an LLC.
ARTICLES OF ORGANIZATION
In California, an LLC is formed by filing “articles of organization” with the Secretary of State. You can do this simply by filing Form LLC-1 online, by mail, or in-person for $70.
The articles of the organization have to include the unique name of the company (ending in “LLC” or some accepted derivation), its address, purpose, and its structure of management. The articles must also list an “agent for service of process” (also called a “registered agent”). The purpose of the agent is to receive any legal papers on behalf of the LLC. In other words, an LLC can shield owners from liability, but it can’t just be an empty mailbox—in the case of a lawsuit, there has to be someone to serve papers to. The agent can be another company, but it can’t be the LLC itself. The agent must reside in California, with their California address listed in the articles of the organization. You can pay a commercial service company (see the California Secretary of State’s list here), but for most small LLCs, it is easiest for a member or manager of the LLC to serve as the agent.
A small LLC is likely to be managed directly by its member(s), but the articles can also specify a manager or managers who will take care of the major duties of the LLC, so you don’t have to have a vote of all members for every action taken by the LLC. This could be useful, for example, if you plan to make most of the decisions about how to handle real estate transactions but want your spouse or children to have an ownership interest in the LLC or other “silent partner” investors.
Although the articles of organization include the purpose of the LLC and how it is to be managed, if the LLC has more than one member, the LLC should in addition have an operating agreement outlining member duties and ownership interest. It isn’t required by the Secretary of State, but the operating agreement ensures that the management of the corporation is unambiguous.
In the agreement, you make clear exactly how the LLC is set up. Typically, the articles will cover 1) how ownership is divided, 2) how the company will be managed, 3) the voting process, 4) what capital contributions have been made by specific members, 5) how profits (and losses) are distributed between members, 6) the process for adding or removing members, and 7) how the LLC can be dissolved.
If you are planning to set up an LLC with multiple members, even if those members are family, it is a very good idea to draft articles of organization with a qualified California attorney.
THE “LIMITED” PART OF LIMITED LIABILITY
Setting up an LLC protects you (the owner) from the company’s debts and from liability incurred due to the wrongdoing of company employees. However, an LLC will not protect you from personal wrongdoing, such as negligence or fraud. Even though you are surely not intending to use your LLC for any nefarious purpose, you should still have liability insurance to protect you against personal suits of this kind.
Take the current COVID-19 crisis: businesses are taking whatever precautions they can to protect their employees and attempt to follow recommendations from the CDC, OSHA, and state government agencies while continuing to conduct business. However, employees who contract COVID may still bring a suit for personal injury alleging a breach of duty of care (see our previous post “Torts: Personal Injury Tort Liability in the Wake of COVID-19”).
The case may be even more difficult in the case of rental properties: how does a landlord maintain his or her obligations to the tenants while also keeping themselves, the tenants, and employees or contractors safe from coronavirus? The LLC will probably protect you in this case, as long as you acted in good faith, but it doesn’t stop someone from potentially bringing suit, and there simply aren’t determinations by the courts at this point to know how this litigation will turn out. In other words, better safe than sorry.
Moreover, creditors in California do have recourse in the case of unpaid debts. While they can’t go after the owners’ assets directly, they can obtain a charging order forcing a member of the LLC to pay any income or profit distributions directly to the creditor. The creditor can also foreclose on an LLC member, essentially forcing the member to sell their financial stake in the company (to be bought either by the creditor or another member). This doesn’t give the buyer actual membership status and management control, but rather gives the buyer a right to any money that the member would have received through distributions or the dissolution of the company. Foreclosure in practice is an expensive and often unrewarding process for the creditor, but the threat does give creditors leverage when negotiating with an LLC member to settle a debt.
A final note on California law and single-member LLCs: In many states, single-member LLCs (SMLLCs) are not given some of the same protections as multi-member LLCs, because the purpose of those protections is to ensure that debt incurred or wrongdoing committed by one member does not harm the other innocent members. Obviously, this doesn’t apply when there is only one member. However, in California, SMLLCs are treated the same as all other LLCs. At the same time, there are a few situations where California protections may not apply. Adding another member to your LLC can help better protect your assets—but they must be a member in full standing, not just on paper.
When deciding whether and how to set up an LLC in California, for the purposes of real estate or for any other reason, it is always a good idea to consult with a knowledgeable California attorney today.