Create a Limited Liability Company
Real estate investors should consider forming a limited liability company (“LLC”) for their business. Forming an LLC has two benefits. It allows for simple tax reporting at the owner’s tax rate while limiting the owner’s legal exposure and financial risks.
Create an Operating Agreement
An LLC is meant to be a separate legal entity from the owner. To establish this “separateness of the business” the owner needs to create an Operating Agreement along with the LLC. Without an Agreement, it is more difficult to demonstrate to the public that your business is separate from your personal assets. This is critical if there is a lawsuit where a judge could find that personal assets are subject to a judgment creditor and collection. Unfortunately, the more property an investor owns, the more likely it is that they will be the subject of a lawsuit. Therefore, investors need to maintain a clear distinction between their company operations and their personal business by having an Operating Agreement in place.
Define Business Relationships
An Operating Agreement defines a business’ financial and management rules by which the company functions on a day-to-day basis. It regulates the business relationship between company members. Members of the company are bound by the duties and their defined responsibilities as provided in the Operating Agreement. It should be noted that without an Operating Agreement, less favorable state default provisions will be applied to a company. That’s why it is so important for company owners to dictate their own rules on how their business should operate.
Aside from the more obvious reasons for having an Operating Agreement—such as detailing ownership interests, rights to financial distributions, or voting rights. Listed below are the top three reasons a real estate investor needs a properly drafted Operating Agreement.
Define Member Authority
The Operating Agreement will define the duties and responsibilities of its members. When a company has more than one member, it is crucial to define which member has the authority to sign documents and legally bind their company. Regarding real estate, title agents and lending institutions will want to know who has the authority to endorse loan documentation or sign deeds. They’ll ask to see the Operating Agreement to ascertain the responsible party. Without the Agreement, they cannot proceed with an anticipated transaction.
Having an Operating Agreement also helps to prevent fraud and bad actors. Business “misconduct” happens more often than we would like to think. Where multiple members have defined duties, an Agreement can help a company protect against fraudulent or unauthorized acts of a rogue member by restricting their duties. For instance, a company will not be bound to a contract when a member without authority attempts to contract for the company.
Include Succession or Incapacity
Operating agreements should also include provisions detailing how the company will be managed in case of an owner’s incapacity or death. Failure to address these contingencies will often create legal havoc, leaving company members, family, or other heirs to fight over how the company should be managed or whether it should continue business at all. For real estate investors, the absence of succession provisions can prevent the disposition or sale of property or impact the company’s daily operations. Without a succession plan, state default provisions will be invoked. A once-healthy business can quickly find itself in a financial death spiral.
Protect From Creditors
A well-drafted Operating Agreement can protect a company against having its assets attached by an individual member’s creditors. For instance, if a creditor obtains a personal judgment against a member, the right contract provisions will prevent the creditor from attaching or liening the member’s corporate interest. If a member files for bankruptcy, the provisions in the Operating Agreement can automatically dissolve or terminate that member’s corporate interest, thereby protecting the company against further creditor actions—actions that should be directed against the individual bankrupt member’s personal assets instead.
Failure to draft proper provisions against creditors can result in a creditor’s lien attaching to a company’s assets or a member’s financial distributions. This will certainly affect a company’s daily business operations because the business now has to deal with third-party creditors.
Having a legal Operating Agreement is just one legal component that reduces a real estate investor’s financial risk and legal exposure. For the reasons set forth above, real estate investors who are serious about their business should consider having their Operating Agreement drafted or reviewed by a real estate or business attorney.