Watson CPA Group
Email Phone Fee Info Consult Portal Chat
  • Email
  • 719-387-9800
  • Phone
  • Text Us
Watson CPA Group
  • Fee Info
  • Consult
  • ShareFile
You are here: Home > I Just Got a Rental, What Do I Do? > Chap 1 - Ownership Arrangements > Liability Protection Fallacy Of An LLC

  • I Just Got a Rental, What Do I Do?

    • Introduction

      • About the Author
      • Progressive Updates
      • Introduction Disclaimer
      • Shameless Self-Promotion
      • Book Introduction
      • Quick Reference 2023
      • Quick Reference 2024
      • Glossary
    • Chap 1 - Ownership Arrangements

      • Real Estate and Rental Properties as a Business
      • Basic Business Entities For Real Estate Investment
      • Sole Proprietorship
      • Single-Member Limited Liability Company (SMLLC)
      • Multi-Member Limited Liability Company (MMLLC)
      • Limited Liability Partnerships (LLP) and General Partnerships (GP)
      • Rental Property In Partnership Entities
      • C Corporations
      • Rental Property In C Corporations
      • S Corporations
      • Pass-Through Versus Disregarded Entity Taxation
      • Your Spouse As A Business Partner (Happy Happy Joy Joy)
      • Owning A Rental Property With Others
      • Real Estate Investing With Family Partners
      • Real Estate Holding Company and Operating Company
      • Pure LLC Holding Company
      • Economic versus Equity Interests
      • Structuring Real Estate Deals with Angel Investors
      • Loans or Capital Injections
      • LLC Benefits For Rental Properties
      • Multi-Entity Rental Property Tiered Structure
      • Using a Trust In Your Real Estate Holding Company
      • Operating Agreements For Real Estate Partnerships
      • Real Estate Succession Planning
      • Fallacy Of A Nevada LLC (or Delaware, or Wyoming, or wherever!)
      • Liability Protection Fallacy Of An LLC
      • Charging Orders
      • Using A Self-Directed IRA Or 401k To Buy A Rental Property
      • Trapped Rental Assets In An S Corporation
    • Chap 2 - Initial Asset Management

      • Getting The Rental Business Launched
      • Rental Property Acquisition Costs
      • Real Estate Asset Setup On Your Tax Returns
      • Cost Segregation Study
      • Retroactive Look-Back Cost Segregation Study
      • Converting Primary Residence To A Rental
      • Moving Your Rental Property Into An LLC
    • Chap 3 - Rental Property Tax Considerations

      • Three Types of Income
      • Passive Activity Loss Limits
      • Passive Income Generators (PIG)
      • Your Small Business As A Passive Income Activity
      • Material Participation Rules
      • What Time Counts For Material Participation
      • Real Estate Professional Status (REPS)
      • Short-Term Rental (STR) Loophole
      • Vacation Home Rules
      • State Problems With Your Rental Property
    • Chap 4 - Rental Property Tax Deductions

      • Chapter Introduction
      • Five Basics to Warm Up To
      • Value of a Rental Property Tax Deduction
      • Rental Property Tax Deductions Themes
      • Section 199A Rental Property Deduction
      • Common Rental Property Tax Deductions
      • Allocation of General Rental Expenses
      • Rental Property Travel Deductions
      • Rental Property Meals
      • Mortgage Interest Tracing
      • Acquisition Costs (revisited)
      • Rental Property Repairs Safe Harbor (revisited)
      • Repairs Versus Improvements (revisited)
      • Rental Property Depreciation (revisited)
      • Automobile Deductions with Rentals
      • Automobile Decision Tree
      • Home Office Deduction
      • Real Estate Education Expenses
      • 185 Rental Property Tax Deductions You Cannot Take
      • Deductions the IRS Cannot Stand
      • Cohan Rule For Rental Property Owners
      • Reducing Taxes
    • Chap 5 - Operational Asset Management

      • Rental Property Repairs Safe Harbors
      • Improvement Versus Repairs
      • Rental Property Renovations (Rehab)
      • Accelerated Depreciation and Section 179 Deduction
      • Allowed Versus Allowable Depreciation
      • Qualified Improvement Property (QIP)
      • Partial Asset Disposition (PAD)
      • 1031 Like-Kind Exchange
      • Selling Your Rental Property
      • Buying Out Your Real Estate Partner
      • Taking The Rental Out of Service
      • Changing Depreciation Between 27.5 and 39.0 Years
    • Chap 6 - Retirement Planning

      • Retirement Planning Within Your Rental Property
      • Basic Retirement Planning
      • Tax Savings and Tax Deferrals
      • The Owners-Only 401k Plan
      • Roth 401k Plans
      • Roth 401k Versus Traditional 401k Considerations
      • Two 401k Plans
      • Rolling Old 401k Plans or IRAs into Your Small Business 401k Plan
    • Epilogue

      • Rental Property Tax Return Preparation
      • Rental Property Accounting
      • Real Estate CPAs
Home
  • WCG
  • I Just Got a Rental, What Do I Do?
  • Chap 1 - Ownership Arrangements
  • Liability Protection Fallacy Of An LLC
Print

Liability Protection Fallacy Of An LLC

llc fallacyBy Jason Watson, CPA
Posted Saturday, August 3, 2024

Can you be sued personally if you operate an LLC? Yes. And you can easily lose on both a business and personal level. There are several myths out there regarding the use of an LLC as a shelter from potential lawsuits and litigation. Some of the hype has been created by attorneys who used to charge upwards of $1,000 to form an LLC. Need to pay for condos in Maui, presumably. We accountants tease attorneys that LLC really means Lawyer’s Likely Choice.

Sidebar: LLCs are quite powerful. As we’ve already discussed, the deal structures within the entity are endless and the flexibility is strong within multi-entity arrangements. Let’s not forget solid estate planning can be achieved with an LLC as well.

Back to picking on attorneys. Remember, attorneys are not necessarily smart because they went to law school. People are smart, and smart attorneys are people who were already smart and then chose law as a profession. To be fair, the same is true for accountants and doctors.

While consultation with an experienced attorney is strongly recommended for your unique situation, as business owners ourselves we feel the excitement of the LLC has overshadowed the reality of our litigious society. In other words, if your acts, errors or omissions injure someone even though it was under the auspice of your LLC, there is a good chance you will be personally named in the lawsuit and held liable as the owner of the LLC.

The word liability in the LLC truly refers to financial liability. Please read on.

For the matter of this liability discussion, LLCs, S Corps, C Corps and limited partnerships are considered the same. No liability protection is asserted for sole proprietorships, general partnerships and general partners in limited liability partnerships (don’t forget the old timer LLLP which limits everyone’s liability even the general partner). Sure, this is a huge generality, and exceptions always exist depending on agreements and state law.

Types of Liability

There are three areas where you can be held personally responsible- criminal, contractual and torts. Torts is probably most people’s concern, and torts can either be-

  • negligence where you have a general duty to act in a reasonable way and you didn’t (like drive your car safely), or
  • intentional torts where there was a purposeful act to harm.

There are other tort buzzwords like gross negligence, careless disregard, defamation, etc. Remember, negligence is the opposite of diligence.

Piercing the Corporate Veil

Officers and directors of corporations are routinely held liable for the actions of the corporation. This is called piercing the corporate veil. Can you say Enron?

Piercing the corporate veil typically is most effective with smaller privately held business entities (close corporations) in which the corporation has-

  • a small number of shareholders (owners),
  • limited assets, and
  • separating the corporation from its shareholders would promote fraud or an inequitable result.

While this refers to a corporation, the same philosophy is applicable to a limited liability company. Does that sound like your LLC? Yes. Could it happen to you? Yes. Is there a small chance of this happening? Who knows? We say risk it, put it all on red and let it ride. Just kidding. No one bets on red.

Even a two-member LLC would easily be considered a closely held entity. If those members were grossly negligent in the way they managed the entity, separating the corporation from its shareholders (or LLC from its members) would certainly promote unfairness from a liability perspective. This is our opinion of course, but we want to share with you some of the behind-the-scenes perspectives from the courts and law that might not be readily considered when forming an LLC.

Another perspective- if you owned shares of Ford Motor Company, you were not personally responsible for the damage caused by the Ford Pinto even if you were a shareholder. However, if you were a corporate officer who ignored (gross negligence) the potential for harm, you could be held responsible, even criminally. In other words, fix that loose railing before your tenant hurts himself (using an LLC owning a rental as an example).

The general rule across the country is that individuals acting on behalf of a business are personally liable for their tortious conduct even if they did so on behalf of the business. So, to protect your personal assets you need to fund the LLC with enough resources to pay for a lawsuit. This defeats the purpose of not having to pay personally since you are personally doing the funding.

There might be situations where a real estate investor has a lot to lose personally as compared to his or her smaller co-investors. Therefore, perhaps funding the LLC on an equal basis to hedge against potential lawsuits or to have similar language in an Operating Agreement or Partnership Agreement can mitigate some exposures.

Furthermore, if you own multiple investments and LLCs, and you think you can protect the other assets in the event of a lawsuit on one, think again. In our non-legal opinion and observation of surrounding events, if you face a credible lawsuit arising out of your acts or omissions there is a chance everything you have is going to be pursued by the injured party’s attorney including your personal residence, cars, college funds, LLC’s assets, Snuggie collection, etc. Yes, even the leopard one.

Other Things to Think About

You are a reasonable person. Does it seem reasonable for someone to hide behind the auspice of an LLC or a corporation when they do bad things? Of course not. Public policy shouldn’t allow this. Therefore, it follows that if you maintain an unsafe rental property or if you are reckless while driving the business car, you should be sued, and you should lose.

Some attorneys will argue that if you mix personal and business funds together, even accidentally, you might erode the separation of you, an individual, and the entity. For example, an owner will pay for car insurance through the entity. The car is owned personally by the entity’s owner, and the owner is getting reimbursed for mileage. On the books, the car insurance is not a deductible expense, and is coded as an owner draw or shareholder distribution. In this scenario, a court might determine that the “veil” between you and the entity is getting thin, and might be determined to be too thin.

Same with minutes and other business governance. Some argue that if you do not keep up with the housekeeping of your entity, you can chip away at the corporate or LLC protection. There is a natural human response to pile on once a defect is discovered. “In closing your honor, on top of Exhibits A through AJ, this LLC failed to record basic business governance.” While we doubt how much weight this would be given, it certainly helps buttress a level of carelessness or disregard. As mentioned elsewhere, LLCs generally do not document meetings or minutes unless the state requires it.

Protecting Yourself

After all the gloom and doom, there are some small elements of protection. If your employee’s conduct creates a liability for himself and one for the LLC, the owner of the LLC may be absolved. This can get tricky depending on the conduct, and any instructions the LLC provided to the employee. This is attorney type stuff.

So, what do you do? In addition to your general business liability insurance, you should secure a decent umbrella policy both at the personal and commercial level. This is our strong recommendation for liability arising from your acts, errors and omissions. General umbrella policies are $1,200 to $2,000 per year depending on the limits. Something to note is that your liability limits on the underlying assets such as buildings, rental properties and cars might have to increase to reach the floor (starting point) of the umbrella policy. This prevents gaps in insurance.

It appears that many credible lawsuits will sue to the limit of coverage to avoid lengthy and expensive trial litigation. Again, please consult your attorney and insurance agent for your unique situation.

LLC Protection in Borrowing

In addition to the above, there is also a small element of financial protection. LLCs and corporations protect the owners from being personally responsible for the business’s debts and obligations unless the owners or officers personally sign for the loan (called a recourse loan).

However, in today’s lending climate it will be very difficult to get a business loan in the name of the LLC without having to sign a personal guarantee on the note. In other words, you will more than likely need to sign twice- first, as the person directing the entity to borrow and second as an individual promising to pay should the entity fail to do so.

Business debt without a personal guarantee is called a non-recourse loan since the bank or lender does not have recourse against the individual. Tough to get, expensive at times and requires significant equity (60% loan-to-value is the general rule of thumb using real estate as an example).

Quick Recap: In personal worlds including small businesses and rental investments, loans are typically collateralized twice. First, real property is attached with a lien so you cannot sell it without paying the lender. Second, your promise to pay. Lenders can sue to foreclose on the real property, and they can also sue based on your now-broken promise to pay.

How this works is straightforward. Let’s say you own three businesses, one is an LLC operating a pizza joint, another LLC owns a rental with a ton of equity, and another LLC is used to trade stocks, bonds and options. The rental property was purchased with a non-recourse loan. The rental house has extensive mold, is un-insured for mold, and eventually is foreclosed leaving some creditors holding the bag. Picture the poor guy in Monopoly. Those creditors cannot attach or seize your pizza joint or your portfolio since they are held in other LLCs. This is an overly simplified example, and there are probably some rare and narrow instances where you could still be in trouble, but generally this strategy affords some protection according to most attorneys.

A common arrangement is the self-rental which is discussed in more detail later, but here’s a glimmer. You operate an LLC as a business and you also buy the office building with another LLC, of course with a non-recourse loan (the only collateral is the building itself and not your personal promise to pay). The business also has a line of credit. Depending how all the debt is structured, each of these assets (the business and the building) has a Chinese Wall between them. Don’t laugh; that wall served well for nearly 3,000 years.

Again, banks are smart. You are not the first Tom, Dick or Harry to come around. We should probably update the names to reflect the current smattering- how about you’re not the first Parker, Logan or Dakota to come around with your androgynous name and lofty schemes. Most lenders require personal guarantees on every loan.

Asset Protection in Equity Stripping

Another asset protection strategy that is older than dirt is equity stripping (it does not necessarily need an LLC either). It is a process of encumbering your assets to the point where there is no value for lack of equity. In the simplest of forms, you pull cash out against your assets, and separate your cash from the assets. Be very careful. There are “bogus friendly lien” triggers where a person will use a Nevada corporation to file a lien against the asset, however the asset and corporation are owned by the same person (or some related party). This lien is subsequently pierced or tossed as self-serving or deemed to lack commercial merit.

Equity stripping can be a good asset protection strategy, but it requires careful planning with a skilled attorney. And No, it is not older than dirt but it has been around for quite some time.

LLC Protection in Contracts

There is some wiggle room on financial shielding using a limited liability company. If you sign a contract for internet service, or for a copier lease, or some other commitment, you might be able to get away with executing the agreement under the LLC. So, if your business or real estate investment fails, the LLC might be liable for the remaining contract obligation but not you personally. Keep in mind, however, the judgement and foreclosure process could still get you- if someone gets a judgement against the LLC, they can later attempt to foreclose on the distributions or future income of the LLC, and they can also later foreclose on the equity (ownership) of the LLC. On top of all that, your business bank account might be seized to the amount of the lien.

How about we just keep our promises and pay our bills, huh? See Charging Orders for expanded information.

Liability and State Nexus

We chatted about nexus from an income tax perspective earlier- this little tidbit is about nexus from a liability perspective. Several business entities are created in what some people perceive as business friendly states, such as Delaware or Nevada. But when it comes to liability especially tort liability, you will generally be sued in a jurisdiction where you have an economic and / or physical presence.

Yes, an attorney will show up and attempt to fight jurisdiction. But he or she might lose. Now you must hire an out-of-state attorney to fight your out of state lawsuit. Sounds like a grand plan.

So, if you file Articles of Formation, Organization or Incorporation in another state such as Delaware, maintain a presence in Kansas and cause damages in Kansas, you will probably be sued in Kansas. Yes, you can write contracts that clearly dictate the forum of law, but now you are asking a Kansas court to possibly understand and enforce Delaware law. According to several attorneys that we work with, if you march into court pinning your hopes on Delaware law being enforced by a Kansas court, you have already lost. Mediate, settle and move on down the line.

Also, most parties will want the jurisdiction to be in their backyard. You trip and fall in a Wal-Mart and sue Wal-Mart, you are not having to fly to Bentonville, Arkansas to file the lawsuit. Although Table Rock Lake to the north of Bentonville is amazing, you want to sue in your local town, using local courts and jurors. After your big fat judgement, fly to Table Rock Lake in your private jet. Good stuff!

Yet another example. A lot of real estate investors will incorporate or form an entity in Nevada (for example) because of the seemingly friendly business laws, and then buy rental properties in Colorado. This requires a foreign entity registration in Colorado. It is a near guarantee that if you are grossly negligent in the maintenance of your rental property, you will be sued in Colorado. So why the heck are we forming in Nevada? Or Wyoming? Or Delaware? The theory is that a Colorado court would then interpret and enforce the other state’s law in your lawsuit. Good luck with that.

Repeated Sidebar: It is common to have domestic LLCs that are owned by another LLC domiciled in Wyoming or some other LLC friendly state. We expanded on this rental property tiered structure earlier, but to repeat ourselves in a succinct way, you basically have a Texas rental owned by a Texas LLC which is wholly owned by a Wyoming LLC which is then wholly owned by you, or you and your spouse. The Wyoming LLC would generally not be considered doing business in Texas and therefore would not have to register as a foreign entity (foreign qualify). This does not change the location of your lawsuit, however.

Please don’t believe the hype. Do your homework! Do you know of anyone in all your walks of life and circles that fought a lawsuit based on some other state’s law? Perhaps, but sleeping at night solely based on this layer of protection might not be that comforting. Moreover, people who have won those lawsuits had a floor of attorneys working on their case- most real estate investors reading this book likely don’t have millions of dollars to defend a lawsuit.

Jason Watson, CPA, is a Senior Partner of WCG CPAs & Advisors, a boutique yet progressive tax,
accounting and business consultation firm located in Colorado serving real estate investors worldwide.


Jason Watson CPA LinkedIn     Jason Watson CPA Email

real estate cpa

I Just Got A Rental, What Do I Do? 2024-2025 Edition

This KB article is an excerpt from our 320+ page book (some picture pages, but no scatch and sniff) which was released September 30, 2024, and is available in paperback from Amazon, as an eBook for Kindle and as a PDF from ClickBank. We used to publish with iTunes and Nook, but keeping up with two different formats was brutal. You can cruise through these KB articles online, click on the fancy buttons below or visit our webpage which provides more information.

s corp book amazon s corp book kindle s corp book pdf
$19.95 $15.95 $12.95

Talk to a Real Estate CPA About Your Rental Property

Please use the form below to tell us a little about yourself, and what you have going on with your investments and wealth-building objectives. WCG CPAs & Advisors are real estate CPAs, tax strategists and rental property consultants, and we look forward to talking to you!

We typically schedule a 20-minute complimentary quick chat with one of our Partners or Senior Tax Professionals to determine if we are a good fit for each other, and how an engagement with our team looks. Tax returns only? Business advisory? Tax prep, and more importantly tax strategy and planning?

Should we need to schedule an additional consultation, our fee is $250 for 40 minutes. Fun! If we decide to press forward with a Business Advisory or Tax Patrol Services engagement, we will credit the consultation fee towards those services.

Appointments are typically held through Microsoft Teams and are scheduled on weekdays during the work day. Yes, we can easily accommodate nights and weekends, but those are reluctantly agreed to after some eye-rolling and complaining. Additionally, our schedules are more compressed during tax season (who would have thought, right?).

Shockingly we will return all appointment requests via email with 24-36 hours weather-permitting, or perhaps a phone call (if the moment strikes us). No black holes here! In a hurry, please call us at 719-387-9800 or use our chat service in the lower right corner or the button below.

Text WCG Offices
Call Our Amazing Team
Chat With A Tax Pro
Previous Fallacy Of A Nevada LLC (or Delaware, or Wyoming, or wherever!)
Next Charging Orders
watsoncpabackground-01
Taxpayers Comprehensive Guide to LLCs and S Corps
2023-2024 Edition
DOWNLOAD OUR BOOK
watsoncpabackground_sep2019-01
LIKE US ON FACEBOOK
SUBSCRIBE TO YOUTUBE CHANNEL
CONNECT WITH US ON LINKEDIN
FOLLOW US ON TWITTER
taxes_2
Next deadline is April 15, 2024
for Q1 estimated tax payments!
watsoncpabackground_sep2019-01 - copy
LIKE US ON FACEBOOK
SUBSCRIBE TO YOUTUBE CHANNEL
CONNECT WITH US ON LINKEDIN
FOLLOW US ON TWITTER
businessman_2
Our firm will take you through the financial
cycles of your personal and business lives.
Call Today
watsoncpabackground_sep2019-01 - copy - copy
LIKE US ON FACEBOOK
SUBSCRIBE TO YOUTUBE CHANNEL
CONNECT WITH US ON LINKEDIN
FOLLOW US ON TWITTER
previous arrow
next arrow

Resources

  • Beyond Sole Proprietorship
  • S Corp Election
  • Late S Corp Election
  • Reasonable Shareholder Salary
  • Section 199A Deduction
  • Business Tax Deductions
  • Business Retirement Plans
  • LLC (Sched C) Tax Prep
  • Business Tax Prep
  • Business Services Proposal
  • Periodic Business Review
  • Aug and Nov Tune-Ups

Quick Links

  • Client Portal (secure)
  • Send A File (secure)
  • Engagement Agreement
  • Tax Checklists
  • Send Us a Payment
  • eFile Authorization
  • Tax Return Extension
  • Fee Info (transparency)
  • Tax Consultation
  • History of WCG
  • Privacy Policy

Portals

  • Business Formation Services
  • Small Business Consulting Services
  • Getting Started (tax prep)
  • Tax Preparation Center
  • Tax Support
  • Knowledge Base
  • WCG Blog
  • Contact Us
  • Fee Structure
WCG Inc. | 2393 Flying Horse Club Drive, Colorado Springs, CO 80921 (formerly Watson CPA Group PLLC) | 719-387-9800 tel, 855-345-9700 fax, 719-345-2100 txt | WCG Inc. (License FRM.5000080) is supervised by Tina Denise Watson, CPA (License CPA.0022434) | XML Sitemap | Services Sitemap | Knowledge Base Sitemap

Information provided on this web site “Site” by WCG Inc. is intended for reference only. The information contained herein is designed solely to provide guidance to the user, and is not intended to be a substitute for the user seeking personalized professional advice based on specific factual situations. This Site may contain references to certain laws and regulations which may change over time and should be interpreted only in light of particular circumstances. As such, information on this Site does NOT constitute professional accounting, tax or legal advice and should not be interpreted as such.

Although WCG Inc. has made every reasonable effort to ensure that the information provided is accurate, WCG Inc., and its partners, managers and staff, make no warranties, expressed or implied, on the information provided on this Site, or about any other website which you may access through this Site. The user accepts the information as is and assumes all responsibility for the use of such information. WCG Inc. also does not warrant that this Site, various services provided through this Site, and any information, software or other material downloaded from this Site, will be uninterrupted, error-free, omission-free or free of viruses or other harmful components.