Creating a sole proprietorship is simple. Filing taxes for a self-owned small business is pretty easy as well.
But it also means your business is in YOUR name.
That might be fine today. It might be fine tomorrow. But down the line?
Take real estate investors, for example. If a renter sues you, all of your personal assets are at risk. Your bank account, car, and home are all on the line if you lose a lawsuit.
The wealthiest real estate investors in America know better than to use a sole proprietorship because it simply doesn’t offer the level of protection they desire. Other corporate structures are safer. Other corporate structures give them advanced asset protection—and they're just as inexpensive and easy.
Here are some things you should watch out for when you’re thinking about forming a sole proprietorship for your real estate business (or any other small business).
A sole proprietorship isn’t really an incorporation; whoever makes money through it pays income tax on that money themselves—and that’s that. You might have to file some paperwork, but that’s just so the state can keep tabs on what you’re up to. It's simple. You might want to form a husband-and-wife business as a sole proprietor or partnership, for example.
So what’s the legal implication of operating your real estate business this way?
To answer that, let’s review how income should flow:
The key words in the above bullet points are “separate entity.” When you form an LLC or business trust, you separate the business (your rental property) from you (your car, your home, your savings). In the grand scheme of things, it seems like an incredibly small distinction. In the legal world, it’s incredibly important.
When you’re a sole proprietor, you’re the only entity. You’re taking full responsibility for everything that occurs at your rental properties while keeping in mind that there are certain disasters that are simply outside of your control.
When you’re a business owner, the business takes the brunt of the liability. After all, that’s why it’s called a “limited liability” company.
There isn’t anything wrong with this form of incorporation, they just aren’t as safe as other options.
What options are available if you decide to go a different route? What are the best asset protection structures? And are they affordable?
One of the best ways to protect your assets is with the Series LLC, the Delaware Statutory Trust for real estate investors in California, and a traditional LLC network for investors in states without the Series LLC.
Using these structures to organize your business allows you to protect it from lawsuits by separating your personal assets from your business assets. That means, in the event of a lawsuit, the assets at stake are the property itself, not everything you own. If you’re found liable for some sort of issue at any of your rental properties, the worst thing that can happen is the loss of that specific rental property.
Finally, it isn’t even that costly. In many states, it only costs a few hundred dollars to open an LLC, and even less to maintain it year-to-year. Compared to other forms of asset protection, it’s very inexpensive.
Instead of going through all of the trouble of setting up separate LLCs for each of your rental properties, why not just purchase an umbrella insurance policy?
There’s nothing inherently wrong with an umbrella insurance policy, but you should understand that, if you’re found liable for an issue at your rental property, as soon as you make a claim, an agent is assigned to find a way to deny coverage. After all, that’s how real estate insurance companies make money and stay profitable: by collecting more money on premiums than they hand out for claims. If you’re denied coverage, everything is at stake. There isn’t a safety net.
Again, that doesn’t mean an asset protection insurance policy is a bad idea—you should always be protected against events like floods and fires, but some methods offer more protection than others.
Want to make sure your real estate investing business is protected? Start with our investor quiz and we'll help you find ways to protect your assets.
Furthermore, LLCs offer a degree of anonymity that dissuades potential lawsuits. If the potential plaintiff’s lawyers can’t find the name of the person who is supposedly at fault for whatever occurred at their property, they can’t find a way to file a lawsuit against that person. When you’re a sole proprietor, your ownership of real estate is public record. It’s easily accessible to anyone with a computer and an internet connection.
When you use LLCs to organize your real estate assets, the names of those LLCs can be whatever you like, making it much harder (and in some cases, nearly impossible) for lawyers to track down the owner of the property.
That means proprietorships don’t protect your anonymity while LLCs and other forms of incorporation do.
Doing business as a sole proprietor is easy. In fact, it’s so easy that as soon as you sign the dotted line on your first rental property, you’re a sole proprietor whether you know it or not.
However, there are better ways to protect your assets. If you’re found liable for an issue at your property, everything from your primary residence to your children’s college funds is on the line in.
If you lose, you could lose everything. It’s better to structure your companies in a way that makes this scenario impossible. You can do this by forming a Series LLC or whatever is appropriate in your state, and we highlight some of the advantages of doing this above, including asset protection, low costs, and anonymity.
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Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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