An Overview Of LLCs In Real Estate
At its core, a limited liability company (LLC) is a hybrid business ownership structure that combines the benefits of a corporation and a partnership. LLCs offer the liability protection of corporations, while providing operational and tax benefits akin to a partnership. For years, savvy real estate investors have embraced the investor-friendly LLC structure as a vehicle to accomplish their goals. One of the biggest advantages of an LLC is that a company’s owners are generally not responsible for the company’s debts and obligations. The exception is when a creditor can pierce your company’s "corporate veil," which will be covered below . Additionally, an LLC may allow its owners to pass through their company’s profits and losses for tax purposes. This can potentially minimize a company’s tax burden by offsetting profits with losses. The use of an LLC makes sense for virtually any type of real estate investment. However, it is particularly beneficial in the following situations: LLCs are a hybrid business ownership structure. As you can see, an LLC can be a powerful tool for real estate investors. But with all its potential, it’s critical that an LLC’s owners enter into an LLC operating agreement to set forth the rights and obligations of the company’s owners.
Key Elements To A Real Estate LLC Operating Agreement
When forming a limited liability company (LLC), particularly one that will own and co-own real estate, an operating agreement is essential to delineate how the business will run. Many of these aspects are also applicable to any type of LLC situation, but those investors purchasing real estate as an LLC with other members will want to particularly consider the following:
Naming the owners and their roles
Who is working the project? Listing the members of the LLC in the operating agreement along with their roles and how much of the LLC they "own" is very important. Who makes the final decisions? These items should be explained in detail to mitigate uncertainty when it comes to a crucial time for the LLC.
Managing money
How will the money be passed around? This brings up more questions. Will investors receive preferred returns? Are they receiving a return at all? Will they continue to receive returns after equity and principal, or just until their investment is paid in full? How will profits and losses be distributed? What happens to unused cash flows? Answers to all of these questions should be clearly laid out.
Making big decisions
How many votes does it take to make certain decisions, purchase new properties, make major repairs to old properties or invest in new ventures? How will you make a decision if there are no majority votes? Does the president have more votes, or can they cast tie-breaking votes? Importantly, what happens if a member wants to opt out of the LLC and how will the company buy them out?
Resolving disagreements
Typically, LLCs are organized as limited liability companies, meaning that long-term interests of the company would require most decisions to be made, backed and carried out by a small group or single person with little input from other members. However, things aren’t always that easy. How will inter-member disputes, deadlocks, personal bankruptcy or diminished mental capacity be handled? Including this information in the operating agreement is fundamental to resolving any issues before they arise.
Benefits Of A Real Estate LLC Operating Agreement
An LLC operating agreement, however, also provides benefit. These benefits include clarity in how the LLC will operate, protection against liability and business losses, and support in legal and accounting actions. The specifics of an LLC operating agreement offer additional clarity on how the business will run. In particular, the operating agreement provides a thorough explanation of business roles and responsibilities. The agreement outlines the structure of the LLC, such as whether it is member-management or manager-managed. Whatever the structure may be, an LLC operating agreement eliminates uncertainty by providing clear roles and responsibilities. Similarly, limited liability corporations can use an operating agreement to manage their business risks. As an LLC, the business becomes a separate entity from its owners. However, if it allows crossing, the LLC may not have limited liability. Therefore, an operating agreement clearly states the limited liability of the owners and what protections the LLC offers its owners. The LLC operating agreement can also protect owners from business losses. In the case of a financial discrepancy, the LLC may struggle to pay everyone involved. For investors, this could mean footing the bill out-of-pocket. However, the LLC operating agreement can set out how business profits will be divided, so that even if this money is lacking, each party can understand how payments will be divided and know who is responsible. Finally, an LLC operating agreement offers protection in the face of lawsuits or other legal matters. The operating agreement’s terms will dictate how the company must conduct itself in all situations. Additionally, document will limit the liability that members may assume under certain circumstances. This is particularly important because while the business may hold certain assets, its founders will also be held accountable for its actions. However, if an LLC operating agreement accurately conveys the relationship between the members and the LLC, the owners can separate themselves from personal liability. Whether you are new to real estate investing or have run multiple ventures, an LLC operating agreement can help you achieve success. It clearly and thoroughly states how your business will run, protects you against liability and other issues, and keeps your liabilities separate from your personal life.
Tips On Drafting A Real Estate LLC Operating Agreement
Drafting a comprehensive and effective LLC operating agreement for real estate investing requires a fine balance between specificity and flexibility. Without clear and unambiguous language in the operating agreement, management and decision-making issues can arise down the road, leading to disputes and potentially costly litigation. At the same time, while it is important to be thorough, it is also critical to avoid creating an inflexible and cumbersome document that, over time, fails to reflect the current reality of managing the investment property. The following tips should help guide you in drafting an LLC operating agreement:
Stick to Plain Language
All legal documents, including operating agreements, should be written in as straightforward and uncomplicated manner as possible. In real estate investing the stakes are high, so it is imperative that all members fully understand their rights, obligations, and restrictions. When drafting the operating agreement, avoid legal jargon as much as possible, remaining mindful that many may not have backgrounds in law.
Be Specific but Flexible
One of the most common complaints in real estate investing is the failure of contract parties to follow through with verbal promises or agreements – especially in a market as volatile as the present one. Typically it takes some time to purchase a property , get the funds in place, and then find the right tenant. Thus, when drafting an operating agreement, it is critical to spell out all important terms clearly and succinctly, in order to avoid confusion down the road among the members.
Customary Language
When drafting the members’ relationship, it is best to use customary language where possible, in order to avoid ambiguity. This is especially true when dealing with such things as: ownership shares, management and voting rights, distributions, capital contributions, and events that may trigger termination of the LLC. Generally speaking, some customary language for these terms might include:
At a minimum, the operating agreement should include the following:
Are there certain circumstances where members may only be entitled to receive distributions if the LLC’s finances permit? Does a member’s ownership percentage affect any other key terms of the operating agreement?
The bottom line is that clear terms in the LLC operating agreement can help minimize disputes among everyone involved, and can go a long way when it comes to ensuring that the real estate investment is a success.
What Not To Do
One way to examine the critical components of an LLC Operating Agreement is to look at some of the common mistakes made by real estate investors when drafting this important document.
Ambiguity and lack of specificity
Vague terms such as "majority of members" or provisions that do not set out a clear mechanism for decision-making can leave far too much discretion to managers or members. The result can often be chaos within an LLC. Without a clear procedure for making decisions, an LLC can be trapped by indecision at the same time as it is paralyzed by failed management. Members should spend the time to discuss how decisions will be made and adopt a specific method for doing so if the law does not provide the answer.
Incomplete provisions
An Operating Agreement can be an extremely handy tool for a member-managed or member-managed LLC. Standard rules about management and control are set out in Arizona law, but not all possible contingencies are addressed in the statute. Members are therefore free to address any issues they believe could arise in the future. Not addressing the issues in the first place is the biggest mistake we see LLCs make. An Operating Agreement is not a legal document you can create once and put away forever. It should evolve over the life of the LLC as the business matures and ownership goes through periods of transition.
Forgetting about state-specific regulations
Many new Arizona residents assume that their previous home state’s laws will apply in Arizona. This is not the case, and the biggest mistake we see owners make is assuming that they cannot customize the rules governing their LLC. The Arizona Limited Liability Company Act specifically permits a member to adopt an Operating Agreement. A member can draft one on their own, or they can have an attorney assist. Either way, it should be done.
The Legal Risks Of LLC Operating Agreements
The legal implications of LLC operating agreements are particularly significant for those who invest in real estate through a limited liability company. Disputes can occur in a variety of situations, including over the:
Those who have invested in an LLC are, in most cases, protected from legal action against the entity’s assets (this is one of the benefits of legally establishing an LLC). In the event of litigation, however, investors risk personal loss of assets if they had dispersions or distributions taken from the LLC at a time when the company is being sued or is indebted to creditors.
Hiring an attorney to draft an LLC operating agreement is a wise investment, as an attorney well-acquainted with the real estate industry knows what types of protections clients may need, and can provide guidance on how best to set the ratio of shares, manager responsibilities, and business plan.
Operating agreements are always considered in court-they are enforceable by law , and play a role in determining how profits are divided, financial responsibilities, and ownership when there are additions or dissolutions. State laws still apply to LLCs, and a good attorney will make sure your agreement meets legal requirements, leaving no room for error with improper terminology or missing clauses.
Although relying on state statutes seems easier, it may be more difficult to control your assets than with an operating agreement. The agreement does not usurp state law, but adds a layer of protection and control that makes it more difficult for a judge to rule outside the terms stated in your contract.
Operating agreements are recommended for all investors, even those who invest in just one piece of real estate. Legal issues can be complicated and usually do not have simple solutions. Having a qualified attorney available to answer questions before they become problems can save you money.