I Don't Like LLC's and Neither Should You

I am taking a break from the affordable housing information today.  I was out searching for information on converting a sole proprietorship to an S-Corporation, and everything I read was pushing the LLC structure.  It turns out that I have things to say about LLC's.

Limited Liability Company's, known as LLC's, are the hottest corporate entity out there.  They are easy to set up.  They are cheaper than a corporate structure and you can "check the box" for any type of tax treatment that you want.  You can be a single member or you can be many members.

LLC's are the most common entity I work with and they have certainly done their part to contribute to the full employment of tax accountants.  I have never liked them.

Let me break down some of the problems with LLC's.

LIABILITY
Let's get the issue of liability out of the way up front.  The name implies Limited Liability which offers corporate protection that you would not have with a sole proprietorship or even a partnership.  But let's get real - if you are just starting a business, no one is going to allow you to borrow funds, use credit or make major commitments with non-existent assets.  You will have to provide personal guarantees.  You will probably also have to list yourself as the Manager or Managing Member, which has less liability protection.   As a practical matter, you will be on the hook no matter what.

In addition to personal guarantees, there is a legal term called "piercing the corporate veil."  This is when the courts allow a plaintiff to disregard your company's liability status and come after the owners.  This is a hot topic right now, because we are seeing it happen more often in the case of LLC's than anyone ever imagined.  I think the reasons for this are partially because of the following discussion.

ORGANIZATION AND LEGAL STRUCTURE
LLC's are ridiculously easy to set up.  In many states, you don't even need an Operating Agreement.  In the cases where you do need an agreement, I have seen one as short as two pages long.  This simplicity may be appealing to you and I get that.  But if you plan on doing business in our world, you should be wary of the simple organizational structure.  If you have additional Members, a two page or no agreement will not tell you how profits will be shared, what will happen in the case of a Member's demise or unsuitability, and it will leave all things open to interpretation.  What if the other Member is your spouse and you get a divorce?  Not many people can maintain reasonability when going through a divorce.

I think it is important to be serious about the work that you are doing.  One level of that is mapping out the corporate structure and how profits, losses and yes, even cash, will be shared.  Laws regarding corporations are complicated, but they exist for a reason.  They help provide a framework for the governance of your new organization.  Mastering these complexities is one step to committing to your new venture.

Yes, as a CPA, I see the value of jumping through hoops in order to be successful.  Go figure.

When you don't have a good foundation for governance and things are handled on a half-baked basis, why would you assume that the courts and any future enemies would take you seriously as a separate corporate structure?  You are not taking yourself seriously.

TAXATION
Under current tax law, S-Corporations and LLC's are handled fairly similarly (with notable exceptions).  Earnings and losses of the business are passed through to the owners - Shareholders in the S-Corporation or Members in the LLC.  If you are a shareholder actively participating in an S-Corporation, the business needs to pay you a reasonable salary and you will need to withhold and pay payroll taxes.  If you are a member in an LLC, you will either get distributions or guaranteed payments.

If you have no operating agreement, you will have no idea which until you, or some accountant, checks a box on the tax return.

Your tax information will either be on a Schedule C or a K-1.  I like K-1's.  They are neat.  They tie back to another tax return.  They represent real numbers that have also been reported.  Schedule C's are messy.  Trust me.  If you run an actual business and are actively involved, there is a good chance that you may have muddled personal and business funds from time to time.  (No judgment.)  With a separate tax return, it is actually easier to keep this stuff clean when it comes to reporting.  Again, take your business seriously.  You don't want trouble with the IRS - they send letters every two weeks.  It is annoying.  And the envelopes are ominous.

Also, I should note that when you pay yourself a paycheck instead of whatever money is left, you are instilling a cash discipline that can only help when times are hard.  You are also continuing to have "earned income".  A W-2.  For many reasons, these are nice to have.  (Have you ever applied for a mortgage?)

I do need to disclose that there has been some discussion about taxing S-Corporations in a manner similar to C-Corporations, and if that happens, I may need to revise my loathing of LLC's, but until then...

EMPLOYEES
If you are planning on hiring employees, it is much easier to be a corporate structure.  You already have to pay yourself, so you can just add employees when the time comes.  When you interview and have to convince good people that you WILL be in business for a long time, it helps to be a corporation.  (People interviewing for jobs don't normally get that stability is a myth.  Even in this economy.  Especially in this economy.  They crave stability.)

I understand that everyone is afraid of doing payroll.  I understand that you don't want to deal with taxes and withholdings and how to track the things you need to track.  I am here to tell you that you can get help with payroll for a fairly reasonable cost - and if you don't know what you are doing, you should get help.  There is nothing that the IRS looks at with less humor than failing to pay payroll taxes properly.

Either way, don't be afraid of payroll.  Thousands of small businesses deal with it every year and so can you.

FUTURE PARTNERS
Are you hoping to have future partners?  Stock options?  Do you want to possibly sell out to a bigger company one day?  A corporate structure helps with this because, by law, they track the equity accounts of all the shareholders.  You can actually value and sell a part of your business if you wish.  You will know the amount of retained earnings if an owner wishes to exit.  You will have actual books, because you will be required to keep actual books.

Again, I understand that it is simpler to drop off the shoebox at your CPA, who I am sure is a wonderful person.  But, at the risk of sounding like a broken record, take yourself seriously.

INSURANCE
If you have no liability, why do you have to buy business liability insurance to rent office space?  To borrow money?

In addition to business liability insurance (and worker's compensation insurance), if you are offering professional services, you must have professional liability insurance.  I got mine about five minutes after I picked up the organizational documents from the attorney.  I pay that bill first every year.  Also, if you are offering professional services, there is a good chance that you have to register as either a Personal Services Corporation or a Professional Corporation - certain professionals can not opt out of liability.

In closing, let me say that I have seen Operating Agreements for LLC's that are in excess of 200 pages long.  These organizations are created for a specific purpose, such as holding one piece of real estate.  Many attorneys are involved and many precautions are taken.  These entities are not going to hire employees and they will cease on a certain date.  These types of entities are not the ones I am talking about.  I am talking about people owning a business and growing it with no foundation.  For those people, I say please, please, please reconsider your decision to be an LLC - or at least take a minute to think through the possible consequences of this decision.  Even the uncomfortable ones - divorce, death, the ending of a friendship - and put those items in your operating agreement.

Okay, there was some tax stuff in here, so I have to say:
Please be advised that, to the extent this communication contains any advice or opinions concerning federal tax matters, it is not intended to be, and may not be, used or relied upon by any taxpayer for the purpose of avoiding penalties under federal tax law.

Managing the Management Company: Cash

When you own a real estate project, affordable or not, you will have to determine how you are going to manage it.  The majority of owners look to third party management companies to assist in the collecting of rents, paying of expenses and dealing with tenant issues.  In addition, for affordable housing units, a third party management company can assist in meeting compliance requirements around income and rent limits and other items.

Selecting a management company is always a challenge.  An investor I work with has commented that every time there is a hot, new, really good management company, everyone will switch their projects, they will get too busy, and then they won't be as good anymore.  I always thought that observation could apply to a lot of small businesses.

Assuming that you are going to use a management company, there are a few things that you should know.

The management company is going to report to the budget.  In the management world, asset managers are held acountable to an operating budget.  In fact, they are often paid bonuses based on their portfolio's performance to budget.  And they are trained to move around expenses until they meet that budget.  I urge you to look closely at the budgets you approve, because that is a map of the results (assuming no unusual events).

I worked with one management company that put any items not on the budget in capital expenditures (balance sheet).  I once found a billing for marketing brochures in the fixed asset account.  Obviously, this is to meet their bonus guidelines, and is not really useful for your internal reporting and analyzation of financial benchmarks.

The management company can not be trusted with cash.  I am not saying that they will steal the cash (although fraud is always something that you should be on the look-out for); rather, I am saying that if a property is performing and there is a lot of cash sitting around, well, operations will eventually decline.

It's human nature to pay closer attention to expenses and make decisions based on cost/benefit when the cash situation is tighter.  If a project has a lot of cash in it, then the asset manager is saved from having to worry about it too much and may not watch expenses as closely.  This same attitude may affect the owner's side as well.

I generally recommend that owners sweep cash above a certain amount out of the management company trust account.  This ensures that current expenses are being paid from current operations.  If, for some reason, there is not enough cash to pay one month's expenses, you will know it immediately.  If you have a pile of cash, you may not realize there has been a change in operations for quite some time.

I work with one company that had a lot of developmental money locked into a project.  By locked, I mean, they forgot to take it.  One of the first things we showed them was the project's negative operating cash flow.  In fact, this project had been operating at a deficit for a few years.  This had not been closely monitored before, because the project had a $100,000 in the bank, so no one worried about it.

Had this owner swept the cash, they would have been able to implement some changes to the budget in a much more timely manner and been able to recover all of the development money that they forgot to take.  As it was, they left money on the table.

SWEEP THE CASH
In affordable housing, sweeping the cash does not mean that you have come into a windfall.  There are generally provisions in your Operating or Partnership agreement with the investor that stop you from taking cash until the annual audit is complete.  So, in this case, the owner should have a bank account in the entity's name where they keep the sweep of money from the management company.  That bank account would show on the project's books at the owner level (after recording activity from the management company).

The management company will reflect this sweep as one of two things:  an owner distribution (most common) or an other expense (I've seen this too).  In fact, it is merely a cash transfer, so you would record the cash received and credit whichever account the management company used to ensure that this sweep does not erroneously show up as revenue, expense, or a change in equity.