What an LLC does – and doesn’t – protect
LLCs shield their members from legal claims, but the company itself still carries liability risks.
Angela J. Thomas, ATM Investments, Baton Rouge, Louisiana
I am just starting out in the investment world and am still a bit green in understanding certain things. I purchased two investment properties in 2004 and am renting them out. This year, I created an investment LLC for them. My questions is, although I have the LLC with its “limited liability,” do I still have to put insurance on the company?
By Shara Rutberg, Fortune Small Business contributor
Dear Angela: You don’t have to, but it would definitely be wise.
Forming an LLC shields the owners, called “members,” from liability, but the firm itself is still liable, explains David Sokolow a senior lecturer at the University of Texas at Austin School of Law whose areas of expertise include corporations. In this respect, an LLC is similar to a corporation, in that shareholders aren’t liable but the firm itself is.
“You should purchase the same kind and amount of insurance you would if you were operating the business as a corporation. Although you may not be personally liable, third parties may not want to deal with your LLC if it doesn’t have insurance,” he says.
Peter Bennett, chairman of the American Bar Association section of tort trial and insurance practice, agrees.
“The selection of a form of a business is not a replacement for insurance,” says Bennett, who is also president of The Bennett Law Firm, PA in Portland, Maine. “You need coverage to protect against liability.”
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DiggYou MAY have violated the Mortgage Co’s loan agreement by flipping the DEED from your personal name into an LLC which could trigger a “Due On Clause” from the Mtg Co. Simply put, they COULD demand payment in full at that point. But as long as I’ve been doing RE investing, I’ve NEVER once heard of any Mtg Co actually doing this. The problem you MAY encounter is if something should happen to this investment property such as , Flood, Wind Damage, Fire, etc. If the property were damaged or destroyed, the Insurance Co COULD, and probably would, refuse to pay out any claim if you purchased in your personal name and flipped into an LLC and left the Ins in your name. You must make sure that the Ins follows the name on the Recorded Deed.
You also violated your loan agreement as I assume you QUick Claimed the property out of your personal name and into an LLC.
Insurance can be a vital tool in preserving the “limited liability” aspect of your LLC. Failing to have enough cash in the coffers, or insurance coverage on-hand, to satisfy any claims against the LLC could lead a court to disregard the protections of the LLC and view the entity simply as an extension of its members. The LLC’s members would be on the hook for any liabilities just as if you ran the business as a sole proprietership or partnership.
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You may not be able to deduct any mortgage interest as a regular business expense. Assuming you have a mortgage on the properties; did you transfer the note into the LLC. You probably did not; therefore, since the LLC does not have any legal liability to pay the mortgage; you cannot deduct any interest expense against the rental income. The interest would be classified as investment interest and put on Schedule A, subject to investment interest limitations. In short, your income tax bill just went way up. Generally, I find that most people do not understand corporations or LLC’s at all. In Arizona, just about anybody can set up the LLC, corporation, etc; what they don’t do is ensure that the LLC’s title to assets is valid and receives the LLC liability protection and they don’t evaluate all the taxation ramifications. Pay the money – get a lawyer to draft up the LLC or corporation and ensure the assets and liabilities are properly titled; engage a CPA for your taxes. By the way, most people estalish a corporate entity for tax purposes; when in reality it’s for legal reasons. Do all this before starting the business. As part of the process – what is your exit strategy from the business.