Are you growing your business? Adding new products or services? New locations? Adding partners or owners? If so, these are all instances when you should consider setting up a subsidiary or other new entity for your existing company. While you can run multiple streams of business through one entity, there are tax, asset protection, and partnership reasons why you may want to open up a new subsidiary entity for your new activity.
Let’s run through a few common situations when it makes sense to open up a subsidiary entity. And by subsidiary, I mean “a new entity which is owned wholly or partly by your primary business entity or by a common holding company.” Your new subsidiary could result in a parent and child relationship where your primary entity (parent) owns the new subsidiary entity (child), or it could be a brother and sister type structure where the primary business is a separate entity (brother) to the new entity (sister) and the two are only connected by you or your holding company that owns each separately and distinctly. (See the diagrams below to view the differences.)
I. Adding a New Product or Service
You may want a new entity to separate and differentiate services or products for liability purposes. For example, let’s say you are a real estate broker providing services of buying and selling properties and you decide to start providing property management services. Because the property management service entails more liability risk, a new entity owned wholly by your existing business could be utilized. The benefit of the new subsidiary is that if anything occurs in the new property management business, then that liability is contained in the new subsidiary and does not go down and affect your existing purchase and sale business. On the other hand, if you ran the property management services directly from the existing company without a new subsidiary and a liability arose, then your purchase and sale business that is running through the same entity would be effected and subject to the liability.
For tax purposes, in this instance, the income from the new subsidiary entity (child) will flow down to the parent entity without a federal tax return, and as a result, there is no benefit or disadvantage from a tax planning standpoint.
II. Opening a New Location
What if you’re establishing a new retail or office location for your business? Let’s say you are a restaurant opening up your second location. For asset protection purposes, you should consider setting up a second entity for the new location. This can limit your risk on the lease (don’t sign a personal guarantee) for the new location or for any liability that may occur at the new location. In this instance, if one location fails or has liability, it won’t affect the other location as they are held in separate entities. The saying goes, “don’t put all your eggs in one basket.” In this case, the basket is the same entity and the locations are your eggs. In the multiple location scenario, you should consider the brother-sister subsidiary structure such that each location is owned in a brother-sister relationship (e.g. neither owns the other) and their common connection is simply the underlying company (or person) who owns each entity for each location. Because both locations have risk it is useful for each to have their own entity and not to own each other (as can occur in the parent-child subsidiary). When structured in a brother-sister relationship, the liability for each location is contained in each subsidiary entity and cannot run over into the other subsidiary entity (the sibling entity) or down to the owner (which may be you personally or your operational holding company).
For tax purposes, the brother and sister subsidiary income (usually single member LLCs) flows down to the parent or primary entity where a tax return is filed (usually an S-Corp). (See the diagram below for an illustration.)
III. Adding a New Partner
Maybe you’re starting a new business or operation where you have a new partner involved. If this partner isn’t involved in your other business activities or your existing company, it is critical that a new entity be established to operate the new partnership business. If you have an existing entity where you run business operational income (e.g., an S-Corporation), then this entity may own your share of the new partnership entity (e.g., an LLC) with your new partner. Your share of the new partnership income flows through the partnership to your existing business entity where you will recognize the income and pay yourself. In this instance, your existing entity is the parent and the new partnership is a partial-child subsidiary. The new partnership entity will typically file a partnership tax return.
IV. California Caveat
Because of gross receipts taxes in California, you may use a Q-Sub entity model where the subsidiary entity is actually another S-Corporation and is called a Q-Sub. This is available only when the parent entity is an S-Corporation and can avoid double gross receipts tax at the subsidiary and parent entity level.
Make sure you speak to your tax attorney for specific planning considerations as there are asset protection and tax considerations unique to each business and subsidiary structure.
keys to house with home ownership documents
Real estate may be owned in your personal name, in a business name, or in a trust. You may have heard of revocable living trusts, corporations, LLCs, series LLCs, or limited partnerships. Here’s a quick guide to where you should own different types of properties.
1. Personal Residence
Your home should be owned in your revocable living trust. A living trust is an excellent choice to own your personal residence as the property can pass under the terms of your trust upon your death and your heirs won’t need to go to probate court to transfer ownership. If your residence is owned in your personal name it can only pass to your children/heirs after you’ve gone to probate court which requires far more legal fees and time than setting up a trust now. For homes with significant equity you may want to consider a domestic asset protection trust which can protect the equity in the home from personal creditors.
2. Rental Property
Your rental property should be owned in an LLC. Rental properties generate income and wealth but they can also create liabilities. If a rental property is owned in your personal name everything that happens on the home creates personal liability to you and a plaintiff can go after all of your personal assets, income, and wages. On the other hand, if a rental property is owned in an LLC the plaintiff will be required to sue the LLC and can’t go after the LLC owner personally. In certain states where you have lots of properties you may want to consider a series LLC which provides liability protection in the LLC between multiple properties such that if something happens to one property in the series LLC it doesn’t effect the other properties in the series LLC. An LLC owned by one person or a married couple isn’t too difficult to manage and generally doesn’t require a separate LLC tax return. Instead, you report the property and its profit/loss on your personal return in the same way you ‘d report the profit/loss if you owned it in your personal name. In most instances, limited partnerships should not be used to hold rental properties as your tax losses and write offs are restricted when you own them in a limited partnerships.
3. Land or Second Home
Your land or second home should be owned in your revocable living trust. Again, this helps keep your assets coordinated with your estate plans and outside of probate court. For land or second homes with significant equity you may want to consider a limited partnership or domestic asset protection trust which can protect the property from the owner’s personal liabilities. Generally, an LLC is not used unless the property itself creates liability. For example, if you rent your second home or cabin you may want an LLC for liability protection but most second homes or parcels of land do not create liability and therefore do not need an LLC.
4. Where Should Properties Never Be Held
Except for short short term real estate holds (under one year) properties should not be owned in a s-corporation and should never be held in a c-corporation. Additionally, we rarely recommend clients use land trusts to own property for asset protection purposes as land trusts provide little actual asset protection beyond making the owner of the property difficult to determine at the county records.
There are lots of options and many nuances to how you should own your real estate. For a more detailed and specific analysis for your properties please contact the law firm for an estate and asset protection plan that fits your needs. We can also assist with deed transfers to get your properties into the right place.
Your IRA can buy real estate using its own cash and a loan/mortgage to acquire the property. Whenever you leverage your IRA with debt, however, you must be aware of two things. First, the loan your IRA obtains must be a non-recourse loan. And second, your IRA may be subject to a tax known as unrelated debt financed income tax (UDFI/UBIT). This comprehensive webinar explains the non-recourse loan requirements, as well as the non-recourse loan options and goes into detail on how UDFI tax may be applied and how it is calculated. Below are the slides from the presentation as well as the recorded video presentation of the webinar. Note that page 27 in the pdf slides below was up-dated from the webinar as I made a calculation mistake on the debt owed. The final tax numbers were still correct though. Thanks to Roger St.Pierre, Sr. VP at First Western Federal Savings Bank for co-presenting the topic with me.
Comprehensive Webinar: Buying Real Estate with Your IRA and a Non-Recourse Loan Mat Sorensen from Mathew Sorensen on Vimeo.
When IRA-owned property is held for rent, the management of the rental property must be structured such that rental income is received by the IRA and expenses are paid by the IRA. The IRA owner and other disqualified persons (e.g. IRA owner, spouse, etc.) cannot personally be the “middle man” by paying expenses personally or by collecting the rent in their personal account and then forwarding the funds to the IRA. There are essentially three different methods whereby the IRA may be structured to properly collect rent and pay expenses.
Three Methods to Manage the Property
|1. Manage directly through the IRA. Money goes to the IRA custodian and expenses are paid by the custodian at the direction of the IRA owner.|
|2. Property Manager. The IRA hires a property manager who manages the property and receives the income and pays property expenses. Cash flow is returned to the IRA.|
|3. IRA/LLC. Under the IRA/LLC, the IRA owner is the manager of the IRA/LLC and receives income and pays expenses from an IRA/LLC checking account. The IRA/LLC structure is very common in IRA owned real estate investments.|
First, the IRA may be receiving the income directly and paying the expenses. This method involves a lease between the IRA and the tenant directly. Under this method, the tenant pays rental income to the IRA (e.g. ABC Trust Company FBO Sally Jones IRA) and sends the actual payment to the IRA custodian and the custodian then deposits that income into the respective IRA. If expenses are due, the IRA owner will need to direct the custodian to pay them by completing a written form (e.g. payment authorization letter) and instructing the IRA custodian as to the expenses to be paid from the IRA. There is usually a fee each time an instruction letter is issued to a self directed IRA custodian. This method can be tedious and can be fee intensive and as a result is not the most common way of managing a rental property held by an IRA.
Second, the IRA hires a property manager who receives the rental income to the property and pays the expenses to the property. The property manager cannot be a disqualified person to the IRA owner and the property manager will typically take a percent of the rental income collected as payment for their services. Under this method the IRA enters into an agreement with the property manager and the property manager then enters into leases with respective tenants. The IRA receives rental income minus property expenses and fees charged by the property manager.
Third, many IRA owners with rental property decide to use a structure known as an IRA/LLC. Under the IRA/LLC structure, the IRA invests into a newly created LLC and the IRA’s investment is then the ownership of the LLC. The IRA will invest an amount designated by the IRA owner into the LLC, and then funds are typically deposited into an LLC checking account at a bank selected by the IRA owner.
IRA/LLC Structure for Real Estate
The IRA owner then, as manager of the LLC, signs the contract for the LLC to purchase the real estate. The property should close in the LLC name with funds from the LLC bank account and the LLC then in turn rents the property, receives the income and pays the expenses all from the LLC checking account. The LLC is entirely owned by the IRA and all funds in the LLC checking account must eventually be returned to the IRA when the IRA owner desires to take a distribution.
Regardless of the method used to own and manage the IRA owned rental property, the property cannot be leased to a disqualified person. So, for example, the IRA cannot purchase a property and allow the IRA owner’s son to lease the property as that lease would be a transaction with a disqualified person which results in a prohibited transaction.
In addition to prohibited transactions that are involved in leasing the property to family members, the IRA owner should closely analyze any leasing arrangement to a company where the IRA owner or other disqualified persons are owners of the IRA or company. For example, any lease to a company that is owned 50% or more by the IRA owner or other disqualified persons would constitute a prohibited transaction. IRC § 4975(e)(2)G).
In summary, there are many different ways to manage a rental property owned by your IRA. Make sure you are implementing one of these methods and that you are managing the IRA’s income, expenses, and properties properly.
This article is an excerpt from Mat Sorensen’s book, The Self Directed IRA Handbook.
When analyzing asset protection for self directed IRAs we must consider two types of potential threats. First, we must analyze how a creditor can collect against an IRA when the creditor has a judgment or claim against the IRA owner personally. Secondly, and most importantly for self directed IRA owners, we must analyze how a creditor can collect against an IRA or its owner when the IRAs investment incurs a claim or judgment.
There has been much written on the protections to retirement plans that prevents a creditor of the IRA owner from collecting against the IRA to satisfy their judgment. Various federal and state laws provide this protection which prohibits a creditor of an IRA owner from collecting or seizing the assets of an IRA or other retirement plan. For example, if an individual personally defaults on a loan in his or her personal name and then gets a judgment against them the creditor may collect against the individual’s personal bank accounts, non retirement plan investment accounts, wages, and other non-exempt assets but is prohibited from collecting against the IRA or other retirement plans of the individual. Even in the case of bankruptcy a retirement plan is considered an exempt asset from the reaches of the creditors being wiped out. U.S. Bankruptcy Code, 11 U.S.C. §522. Because of these asset protection benefits retirement plans are excellent places to hold assets outside the reach or creditors.
The second asset protection issue and the focus of this article is to consider how an is IRA protected from claims arising from the IRA’s investments and activities? This issue is one that is particularly important to self directed IRA accounts since some self directed IRA investments are made into assets that can create liability to the IRA and the protections preventing a creditor of the IRA owner against the IRA assets does not apply to liabilities arising from the IRAs investments. In other words, if the IRA has a liability the IRA is subject to the claims of creditors. For example, if a self directed IRA owns a rental property and the tenant in that property slips and falls the tenant can sue the self directed IRA who owned and leased the property to the tenant. Consequently, the IRAs assets are subject to the collection of the creditor including the property the IRA owned and leased to the tenant as well as the other assets of the IRA. But what about the IRA owner and their personal assets, are their personal assets also at risk?
Let’s analyze this issue further and look at whether a creditor/plaintiff against the IRA can also sue the IRA owner personally if the IRA’s assets are not sufficient to satisfy the judgment against the IRA. IRC § 408 states that an IRA is a trust created when an individual establishes an IRA by signing IRS form 5305 (this form is completed, with some variations, with every IRA) with a bank or qualified custodian. Courts have analyzed what an IRA is under law and have stated that they are a trust or special deposit of the individual for the benefit of the IRA owner. First Nat’l Bank v. Estate of Thomas Philip, 436 N.E. 2d 15 (1992). In other words, the IRA is not a separate entity or trust which would be exempt from creditor protection of its underlying owner. Since the IRA is a trust that is revocable and terminated at the discretion of the IRA owner, each investment in fact is truly controlled by the IRA owner as her or she could terminate the IRA at any time and take ownership in their personal name. As a result, the IRA is akin to a revocable living trust used for estate planning which trust is commonly understood by lawyers and courts to provide no asset protection and prevention of creditors from pursuing the trust creator and owner from liabilities and judgments that arise in the trust. Following this same rationale, a self directed IRA would likely be subjected to a similar downfall in the event of a large liability which is not satisfied by the assets of the IRA. As a consequence, the personal assets of the IRA owner may be at risk.
As a result of the asset protection liabilities for self directed IRAs, we recommend that self directed IRA owners consider an IRA/LLC for the asset protection reasons that many individuals use LLC’s in their personal investment and business activities. Simply put, an LLC prevents the creditor of the LLC from being able pursue the owner of the LLC (in this case the IRA). An IRA/LLC is an LLC owned typically 100% by the IRA and the LLC would operate and take ownership of the investments and the liabilities similar to an LLC used by an individual. For example, instead of the IRA taking ownership of a rental property directly and leasing it to a tenant the IRA/LLC would instead take title to the property and would lease the property to the tenant. When the IRA/LLC owns and leases the property any claims or liabilities that arise are contained in the LLC and as a result of the LLC laws a creditor is prevented from going after the LLC owner (in this case the IRA, or the IRA owner).
There are certain types of self directed IRA investments that benefit greatly from the asset protection offered by an IRA/LLC. Rental real estate owned by an IRA achieves significant asset protection benefits from an IRA/LLC since rental real estate can create liabilities to their owner. Other self directed IRA investments such as promissory note loans, precious metals, or land investments do not have the same asset protection issues and potential to create liability for the IRA and as a result an IRA/LLC isn’t as beneficial from an asset protection perspective for these types of investments.