Do I Need a Legal Entity?

Part 1 of a 12-part series on Legal Considerations for Your Missouri Leasing Business: What You Should Consider Now, Later, and Throughout the Process

A common statement we’ve heard from folks considering getting into real estate leasing (or investing for that matter) is that they need or want “a LLC,” but far fewer seem to know exactly why. While there are certainly other valid reasons for choosing to operate your business through a legal entity, the primary basis for using one is asset protection.

Consider this: If you buy stock and the price plummets to zero, you’re typically out only the cost of your investment. Real estate investment, on the other hand, operates differently and may not necessarily end at zero or the cost of your investment, but can extend beyond to reach your personal home, bank account, and day-to-day finances. Proper use of a legal entity can help insulate you from that risk and ensure a bad investment does not turn into your financial ruin. The following scenarios help exemplify the importance of using a legal entity:

Scenario 1: Direct or Individual Ownership and Operation

John takes $50,000 from his savings and buys a condo in his personal name. He then enters into a lease with Bob, as landlord and tenant respectively, in his personal name. Within the first month of the tenancy, Bob falls down the stairs and is injured (ideally John would have insurance in place to cover such an incident, but let’s assume he doesn’t in this example). Bob racks up $75,000 in medical bills. Bob believes his injuries resulted from a defective condition at the condo and sues John, his landlord and owner of the condo, personally. Bob wins and obtains a judgment against John, personally, in the amount of $75,000. John refuses to pay the judgment and Bob begins collection efforts against John.

The law permits Bob to have a sheriff seize the condo and sell it at auction; however, the law also permits Bob to target other assets owned by John, individually. Thus, after collecting the auction proceeds of the condo, Bob can then target John’s personal checking account, seize John’s car, place a lien on John’s home, and finally begin garnishing John’s paychecks. When the dust settles, John’s attempt to create an additional source of income has cost him not only his entire condo investment, but also drained his bank account, left him without a car, and the full amount of his paychecks.

Scenario 2: Legal Entity Ownership and Operations

Same facts above, except that, before buying the condo, John consulted an attorney who advised John to set up John’s LLC, which the attorney did for John. John then contributed his $50,000 investment to John’s LLC, which then purchased the condo in its name. John then entered into the same lease with Bob as manager of John’s LLC rather than his personal name. The same injury and medical bills occur except this time Bob sues John’s LLC rather than John because John’s LLC is the owner and landlord of the condo. Bob obtains the same judgment and again seizes the condo, except this time, assuming John properly set up and managed John’s LLC (discussed in later sections) that may very well be it for John and Bob. Bob would not be permitted to collect from John’s personal assets.

The general rule is that a judgment creditor of a legal entity (like Bob) can collect from the assets of the legal entity, but not the personal assets of the members or shareholders. In the scenarios above, John’s LLC protects John, individually, from collection. His contribution to John’s LLC is still gone, but his personal residence, car, bank account, and wages are safe.

Asset Protection Actually Goes Both Ways

The above scenarios address asset protection from the member/shareholder’s individual perspective; however, in many states, including Missouri, proper use of a legal entity also helps to protect the assets of the legal entity from a member/shareholder’s personal affairs.

Going back to scenario above, imagine for a moment there is no injury and John’s LLC has two members, John and Tom. Tom overspends his credit card and his credit card company obtains a judgment against Tom. Many states have statutes limiting the credit card company to collecting only from Tom’s interest in John’s LLC through what is known as a “charging order” – the ability to receive only Tom’s share of the profits of John’s LLC. The condominium, owned by John’s LLC, cannot be seized by Tom’s personal creditors and John’s LLC continues to operate as usual except that it distributes Tom’s share of the rent payments to Tom’s credit card company, not Tom. If, on the other hand, John and Tom bought the condominium in their own names, they would not enjoy such protection, and Tom’s credit card company would be able to seize Tom’s ownership interest in the condominium itself. Since most credit card companies are not in the business of holding real estate, Tom’s creditor would likely force a sale of the condominium to liquidate Tom’s interest, thus ending the real estate venture.

The scenarios above are simple and straightforward and designed to emphasize how use of a legal entity can help minimize the risks of real estate leasing (and real estate investing in that regard – simply switch out the tenant for a stranger who slips and falls at the property). The examples are not intended, nor should they be construed to be exhaustive or any sort of guarantee that the facts above will always result in the endings above.

There are many factors which can alter the analyses and outcomes above and, as explained in later sections, threaten member/shareholder’s personal assets even when a legal entity is used. The takeaway should be that use of a legal entity can have a significant impact your financial exposure. Appropriate use of a legal entity can significantly reduce the risk that your real estate investment ends up leading to not simply an investment loss, but potentially personal financial hardships and/or even bankruptcy.

***

This post is part of a series designed to help folks understand and navigate the various pitfalls and legal considerations of real estate leasing. If you would like to learn more about forming and operating your business through a legal entity, one of our experienced real estate attorneys would be happy to meet with you.

Introduction
Part 1: Do I Need a Legal Entity?
Part 2: What Type of Legal Entities are Available?
Part 3: Tax Treatment Considerations When Selecting Your Entity
Part 4: Your Entity’s Governing Documents
Part 5: Operational Considerations – Purchasing Real Estate – Title Insurance
Part 6: Operational Considerations – Purchasing Real Estate – Indenture Review
Part 7: Operational Considerations – Purchasing Real Estate – Loan Documentation
Part 8: Observing Corporate Formalities
Part 9: Insurance Considerations
Part 10: Drafting the Right Lease Agreement
Part 11: Litigation Considerations
Part 12: Should I Employ an Attorney to Assist my Real Estate Business?