Limited Liability Companies May Have Some Liability Limitations
Jeff Newman, CPA, JD
During the last decade, limited liability companies (LLCs) have become one of the most preferred forms of business entities through which to hold title to investment real estate properties. Prior to LLCs, real estate investors seeking limited liability protection were largely limited to using either corporations or limited partnerships to acquire title, both of which have significant potential drawbacks.
All 50 states have enacted legislation creating some form of the LLC business structure, although the rules vary from state to state. The insulation from personal risk exposure for real estate investors provided by LLCs, coupled with the relative ease of administration and potential tax benefits, makes ownership of investment property through an LLC a desirable option in most instances. In general, an LLC member’s personal liability is limited to his or her equity investment. However, investors should be aware that there are some limits to the liability protections afforded by LLCs.
Environmental liability is a common concern when purchasing property, and use of an LLC to make the purchase does not eliminate that concern. The Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) imposes strict, joint and several liabilities — no showing of negligence or intent is required — for cleanup costs on past and present owners and operators of facilities where hazardous materials have been released. An LLC member who had the authority to control the operations or decisions involving the disposal of hazardous substances could be held liable for cleanup.
Loan Breaches and Defaults
LLC members who personally guarantee the company’s debts or obligations will be held liable for their non-payment or breach. This is a true risk when entering contracts or financing agreements before the LLC legally comes into existence because the other party insists on some guarantee.
To minimize the risk of personal liability, always act in the name of the LLC. When you sign contracts, for example, do so solely as an agent of the LLC, making sure to identify the LLC as the principal in the document. Similarly, make sure that the LLC’s other agents and employees act as representatives of the entity and not of you personally. For extra protection, members might consider adding a personal umbrella policy to the LLC’s traditional business insurance coverage.
Certain loan defaults may also create personal liability. Carefully review all loan documents to make sure you completely understand the consequences of all potential covenant violations.
An LLC will not protect a member from liability for his or her own negligent or otherwise wrongful acts that cause injury to another, such as assault or fraud. That could include negligent hiring or supervision of employees if an employee causes some type of injury and the member hired the employee in his or her own name, rather than in the name of the LLC.
Also note that, if an LLC member commits a wrongful act that causes injury while acting as an agent or employee of the LLC, it is not just the member’s personal assets that could be targeted by the injured victim. The victim could also go after the assets of the LLC, under a theory of vicarious liability (also known as “respondeat superior liability”) for its agent’s acts.
On rare occasions, a court will “pierce the corporate veil” to impose liability for an LLC’s debts and obligations on its members. This typically occurs when closely held and small businesses fail to observe corporate formalities such as holding regular board meetings, keeping minutes, adopting bylaws and ensuring company finances are separate from those of members. It could also happen if the LLC engaged in reckless conduct or fraud, or was inadequately capitalized from the beginning. In all of these circumstances, a court might conclude that the LLC is merely a sham to shield its members from liability.
Although LLCs seem to be regarded as the best vehicle for protecting you from potential personal liabilities, they, like other types of entities, are not perfect. Be sure to work with your tax and legal advisors to ensure you’re protected as much as possible.
IRC Section 1231: It’s the Best of Both Worlds
Tammy Partridge, CPA
Many people are aware that the sale of a business asset, including real estate, can have significant tax implications. The tax effects generally boil down to whether the sale results in a gain or a loss. Ideally, gains would be treated as long-term capital gains, subject to lower tax rates, and losses would be considered ordinary losses, which could be applied to offset ordinary income. Section 1231 of the Internal Revenue Code (IRC) permits just such advantageous treatment — the best of both worlds — for certain types of property in certain circumstances.
Sec. 1231 generally applies to depreciable property used in a trade or business that is held for more than one year. Sale of inventory or other property held mainly for sale to customers would not qualify. If you are able to recover all, or almost all, of your investment in the property by selling it, rather than by using it up in your business, it is property held mainly for sale to customers. On the other hand, property used to generate rents is considered to be used in a trade or business.
Notably, the IRS has taken the position that real property purchased or constructed for use in a trade or business qualifies for Sec. 1231 treatment even if it was never placed in service but instead was sold, as long as the property was held for more than a year, running from the purchase date to the sale date. In other words, property does not have to be placed in service to be considered property used in a trade or business.
Treatment of Sec. 1231 Gains and Losses
To determine the treatment of Sec. 1231 gains and losses, you combine all of your Sec. 1231 gains and losses for the year. If you have a net Sec. 1231 loss, it is an ordinary loss. Not only can such a loss be used to offset your ordinary income, but you are also not subject to the normal $3,000 capital loss per year limitation on how much of the loss can be used against ordinary income. Plus, the loss could generate a net operating loss that can be carried back or forward and reduce ordinary taxable income.
If you have a net gain, it is considered ordinary income up to the amount of your non-recaptured Sec. 1231 losses from previous years. The remainder, if any, is long-term capital gain that can offset other capital losses from sales of non-Sec. 1231 property.
The Recapture Issue
As suggested above, the benefits of long-term capital gains treatment might not be available if you had a non-recaptured Sec. 1231 loss in the prior five years. That means that for every year in the last five in which you have a net Sec.1231 gain, you must “look back” to determine whether you had an aggregate net Sec. 1231 loss. You have a non-recaptured loss if the total net Sec. 1231 losses exceed the total Sec. 1231 gains for the prior five years. Real property may also be subject to depreciation recapture under Sec. 1250.
A Complicated Matter
While the benefits of Sec. 1231 transactions are straightforward and clear, the applicable rules and their potential interaction with other provisions of the tax code are anything but. Your financial advisor can help you decipher the proper timing and planning to get the best of both worlds.