By Mike Heayn

How do you protect yourself from a lawsuit if you own real estate?

A limited liability company, also known as an LLC, is a legal entity that can conduct business. An LLC is divided into managers and members. Both managers and members can own an interest in an LLC. Normally, the managers run the LLC, while the members own an interest. The benefits to an LLC are that members and managers are personally protected from legal action.

For example, if an LLC holds a piece of property and the company loses the asset due to a lawsuit, the members and managers are only able to lose what they placed into the LLC. If the LLC files for bankruptcy, the creditors cannot go after the members’ or managers’ personal assets. For this reason, many owners will form multiple LLCs for each property, so they can’t lose an entire portfolio due to legal action. Another benefit to an LLC is what is known as a “pass through entity,” meaning that the members and managers are not subject to double taxation. With double taxation, an entity, such as a corporation, pays tax on net income and then the shareholders or owners of the corporation pay tax on dividends or income on a personal level.

Corporations can be broken down into different types. Two types are the C-corporation and the S-corporation. The technical definition is that a C-corporation elects not to make the subchapter S election to be taxed as a partnership. So what in the world does that mean? Per the previous paragraph, this means that a C-corporation is subject to two levels of taxation — the first on the corporate level for net profits, the second on the shareholder or personal level for dividends.

An S-corporation makes an election to be taxed like a partnership, meaning it is a pass-through entity for taxes. One of the big differences between an S and C corporation are that an S-corporation can only have a limited number of shareholders and classes of stock. A corporation shares the benefits of an LLC, in that it can do business under its own name because it has its own tax ID, which is like a social security number for entities.

The other type of entity is called a trust. Trusts are entities, which offer protection from liability, but are set up differently then LLCs or corporations. A trust on its most basic level involves three parties, all of which can be the same person — they are the trustor, trustee and beneficiary. The trustor forms the trust, for a beneficiary, however, a trustee manages and controls the assets in the trust. For example, let’s say John and Jane Doe want to set up a trust for their children. John and Jane want to have control over the trust, and therefore, the assets it holds for the rest of their lives. They decide they will be the trustors, but they also want to manage the trust, so they make themselves the trustees. However, they also want to make sure if one of them dies before the other that the survivor gets the benefits of the trust till they pass away, so they make themselves the beneficiaries as well. For the children, they have each of them as successor beneficiaries and possibly as successor trustees since they are all over 18. This example is a simple one. Trusts can be set up multiple ways with multiple individuals and different types of trusts receive different types of tax benefits.

Other types of entities exist which can help protect a real estate asset. With time, some entities become more popular than others due to the tax benefits they provide. The three entities — LLC, corporation and trust — all have benefits that may help an investor. The best advice is to consult an attorney, C.P.A. and/or financial planner to see which entity benefits you the best.

Mike Heayn is a Washington Mutual multi-family loan consultant. He can be reached at (310) 428-1342 or michael.heayn@wamu.net.