UMBRELLA INSURANCE POLICY OR LLC

by Mat Sorensen | Jul 12, 2015 | IRA/LLCs

Many real estate investors and landlords often ask whether they should use an umbrella insurance policy or an LLC to protect them from liabilities that may arise on their rental property. An LLC protects the owner of the LLC from liabilities that arise on any property in the LLC and prevents a plaintiff from being able to go after the LLC owner personally. As a result, we often say that an LLC protects a business owner’s personal assets from the risks and liabilities of the LLC business. An umbrella policy is coverage above and beyond the typical property insurance but it only adds additional coverage to insurance the property owner already has in place.

There are many issues and factors to consider in making this decision and there is no one-sized fits all recommendation. In many instances we recommend that you have both an LLC and an umbrella policy and in other instances we may recommend just an LLC or just an umbrella policy. The first factor to consider is the cost. The cost of an LLC in our office is $800 and on average you can expect about $200 in fees a year to keep that LLC active with the State (about $900 annually in California, each state is different). As a result, the major cost of an LLC is in the first year but you can plan on having about $200 in fees each year to keep your LLC active. If you have a partnership LLC then you also have the cost of a LLC partnership tax return but the LLC also provides a significant amount of partnership advantages and protections and we would almost always recommend an LLC for property owned between two or more parties.

An umbrella policy on the other hand is typically paid for monthly and there isn’t an un-front cost. Let’s say you are able to get a $1M umbrella policy at a cost of $50 a month. That would run you about $600 a year. Insurance policies have benefits which include attorneys whom the insurance company will appoint and pay to defend you (and protect themselves from having to pay) but also contain certain exclusions to coverage that may leave you with no coverage for the liability you incur.

One very common misunderstanding about umbrella policies is that they ONLY provide additional insurance coverage on top of insurance coverage you already have. So, for example, let’s say you have a property insurance policy with landlord liability protection of $100,000 and an accident occurs on the property that is covered by the policy. If that liability is covered by existing insurance and once that insurance has been exceeded, then the umbrella insurance provides coverage. Umbrella insurance does not, however, provide coverage in areas where you don’t already have coverage. This is a major limitation to and misunderstanding about umbrella insurance. I’ve talked to a few clients over the years who’ve needed to make claims on their umbrella insurance policy and who were surprised to find out and learn that the umbrella insurance didn’t cover any new liabilities or gaps in their existing insurance. As a result, just make sure you understand what the umbrella insurance actually covers.

An additional factor to consider is the type of property you own. If you own a multi-unit property or commercial property we would recommend having both an LLC and an umbrella policy because you have more liability exposure when you have more tenants. On the other hand, if you have a single family rental in an otherwise good neighborhood where you feel less likely to be sued then we may only recommend an LLC or an umbrella policy on its own. Bottom line, consider both an LLC and an umbrella policy in your analysis and get quotes and advice upon which to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.

And finally, consider the equity that is in the property and your overall net worth. The more equity you have in the property and the more personal assets you have in general then the more reason to have both an LLC and an umbrella policy.

FEDERAL CIRCUIT COURT SAYS NO SALARY FROM IRA/LLC TO IRA OWNER

by Mat Sorensen | Jun 16, 2015 | IRA/LLCs

In Ellis v. Commissioner, a Federal Appeals Court recently held that an IRA owner engaged in a prohibited transaction when he paid himself compensation from his IRA/LLC. An IRA/LLC (aka, “checkbook control IRA”), is an LLC owned by an IRA and is used primarily by real estate investors who choose to have their self directed IRAs own an interest in an LLC (usually 100%) and then this IRA/LLC in turn owns the real estate asset. The LLC will typically have a bank checking account and will receive income from the property and will be used to pay property expenses.  The most common IRA/LLC structure is one where the IRA owner serves as the Manager of the IRA/LLC. Most self directed IRA companies and legal professionals will require that the IRA/LLC documents restrict the IRA owner from receiving any compensation from the IRA/LLC for serving as the Manager of the LLC. This restriction is a result of the prohibited transaction rules for IRAs which effectively state that certain persons called “disqualified persons” (e.g. IRA owner, their spouse, parents, kids) cannot transact with or personally benefit from an IRA’s investments or assets. IRC § 4975 (c)(1)(D), (E). For reference to the underlying Tax Court case and additional case facts and issues, please refer to my 2013 blog article on the Tax Court case here.

As a result of the Ellis case, Self-directed IRA owners should note the following key points from the 8th Circuit Court of Appeals decisions when investing their IRA funds into LLCs or other closely held companies.

1. No Compensation or Benefit. The company documents must restrict the company from paying any compensation to a disqualified person. In essence, the Tax Code restricts an IRA from transacting with so called disqualified persons and these disqualified persons include the IRA owner (as a fiduciary), their spouse, kids, and parents. For more details on who is a disqualified person, please refer to my disqualified person article and diagram here.
2. Don’t Rely on the Reasonable Compensation Exemption for Payments from an IRA/LLC to a Disqualified Person. In the Ellis case, the IRA owner made an argument that the compensation paid from the LLC to the IRA owner was “reasonable compensation” exempt from the prohibited transaction rules. This argument was based on the “reasonable compensation” exemption found in IRC § 4975 (d)(10), which exempts “reasonable compensation” paid from an IRA to a disqualified person in the performance of plan duties. The Court held that the reasonable compensation exemption did not apply to Ellis as his compensation was for managing the LLC’s business activities and not in the performance of plan duties. Further, the Court noted the “in-direct” self dealing prohibited transaction restriction and also relied on DOL Opinion 2006-01A, which restricts an IRA from investing into a company if that company is supposed to then transact with or compensate a disqualified person. In the Ellis case, as would be in the case in all IRA/LLC arrangements, compensation paid to an IRA owner would follow this rationale and an in-direct prohibited transaction would a rise. Consequently, compensation should never be paid to a disqualified person in an IRA/LLC or other closely held IRA owned company structure.
3. IRA/LLCs Are an Excellent Tool for Many Self Directed IRA Investors When Established and Operated Properly. The Ellis case is an excellent example of someone taking a good idea too far. The IRA/LLC is an excellent tool that provides many benefits to self directed IRA owners and the same structure has been used by pension and profits sharing plans for owning  real estate or other alternative assets for years. That being said, the tax rules applicable to self-directed IRAs can be tricky to understand and investors self directing these accounts for the first time can find themselves in the middle of a prohibited transaction if they don’t seek competent advice before they invest their account. Before investing tens or hundreds of thousands of dollars into an IRA/LLC or checkbook control IRA, make sure that the documents are established properly by a competent lawyer and that the IRA owner properly understands how to operate the LLC following set-up. Self-directed IRA owners should not rely on advice from their IRA custodian or administrator as they make you sign waivers saying you aren’t relying on their advice. Also, don’t rely on someone selling you an investment as the may have mixed motives in completing the transaction. Instead, seek the guidance of a competent attorney in this area and avoid structures where an IRA owner or other disqualified person would be compensated personally as part of the IRA/LLC structure.

Our office has been establishing LLCs for IRAs and other retirement accounts for over ten years and our basic IRA/LLC set-up fee is $800 plus state filing fees. This fee includes an attorney consult, an operating memo and guidelines, and all of the IRA specific LLC documents your self-directed IRA custodian will require. For additional information on IRA/LLCs, please refer to my book The Self Directed IRA Handbook or my website at www.poetic-floor.flywheelstaging.com.

LLC OR CORPORATION VERSUS UMBRELLA POLICY

by Mat Sorensen | Feb 24, 2015 | IRA/LLCs

Many real estate investors and business owners often ask whether they should use an umbrella insurance policy or an LLC/Corporation to protect them from liabilities that may arise on their rental property or business. To understand which you should use you first must understand how they protect you. Unfortunately, I have found that most people who have an umbrella policy misunderstand what it actually protects. An umbrella policy is a policy of insurance that goes on top of and that adds additional liability coverage amounts to insurance coverage you already have. So, if you have auto insurance with $200K of liability coverage and business general liability insurance of $500K, then a $1M umbrella policy is going to give you $1.2M of auto liability coverage and $1.5M of general business liability coverage. The umbrella policy does not cover any additional areas of liability or risk, instead, it solely adds more coverage to coverage you already have.  Because an umbrella policy does not cover additional areas of risk, but rather adds more coverage to areas you already have coverage, it isn’t as great of an asset protection tool that many people think it is.

Consider an example of a recent client of mine who was an LLC and who provided home appliance services to residential and business customers. There was a claim made by a customer against the client’s LLC for damages from an expensive failed appliance. The customer brought a lawsuit against the client’s LLC. The client had general liability insurance and an umbrella insurance policy and made claims on both. Both claims were denied by the insurance company as the general liability policy did not provide coverage for product defects. Since the general liability policy was useless and didn’t provide coverage the umbrella policy was also useless. The client did have an LLC, so their personal assets were not at risk but the business could still end up getting a large judgement against it. The case was settled by the parties but the client was really frustrated with an “umbrella policy” that he thoughts was covering gaps or areas of liability that he didn’t have coverage for. So, if you’re considering an umbrella policy, keep in mind that it only gives you more coverage in areas where you already have existing insurance coverage. The use of the word “umbrella” is a great marketing tool but anyone buying an “umbrella” policy hoping to take cover from liability may be surprised that the umbrella is full of holes and is only going on top of whatever umbrella you already have over your head.

An LLC (as well as a corporation) , on the other hand, protects the owner of the LLC from liabilities that arise in the LLC and prevents a plaintiff from being able to go after the LLC owner personally. As a result, we often say that an LLC protects a business owner’s personal assets from the risks and liabilities of the LLC business. What is at risk though in a lawsuit against the business entity (LLC or corporation) is the assets of that business itself as a creditor could collect against the assets of that business. So, for example, if you have an LLC with multiple rental properties with equity then those properties and their equity would be at risk in a lawsuit.

There are many issues and factors to consider in making this decision and there is no one-sized fits all recommendation. In many instances we recommend that you have both an LLC and an umbrella policy and in other instances we may recommend just an LLC or just an umbrella policy. The first factor to consider is the cost. The cost of an LLC in our office is $800 and on average you can expect about $$50-200 in fees a year to keep that LLC active with the State (about $900 annually in California, each state is different, AZ is zero). As a result, the major cost of an LLC is in the first year but you can plan on having about $50-200 in fees each year (each state is different) to keep your LLC active. If you have a partnership LLC or a corporation then you also have the cost of a LLC partnership tax return or a corporation partnership tax return.

An umbrella policy is typically paid for monthly. Let’s say you are able to get $1M in umbrella protection at a cost of $50 a month. That would run you about $600 a year. Insurance policies have benefits which include attorneys whom the insurance company will appoint and pay to defend you (and protect themselves from having to pay) but also contain certain exclusions to coverage that may leave you with no coverage for the liability you incur. Another important factor to consider is the type of property you own. If you own a multi-unit property or commercial property we would recommend having both an LLC and an umbrella policy because you have more liability exposure when you have more tenants. On the other hand, if you have a single family rental in an otherwise good neighborhood where you feel less likely to be sued then we may only recommend an LLC or an umbrella policy on its own. Bottom line, consider both an LLC and an umbrella policy in your analysis and get quotes and advice upon which to make an informed decision so that you are protecting your assets in the most efficient and effective way as possible.

And lastly, I did hear an insurance joke today that relates to deciding on what insurance to buy so I might as well share it here. If you’re a transformer, do you buy auto-insurance or life insurance?

SEC FINALLY RELEASES NEW CROWDFUNDING REGULATIONS

by Mat Sorensen | Oct 29, 2013 | IRA/LLCs

The SEC finally issued their proposed regulations for Crowdfunding last week in a 538 page proposed set of regulations. These regulations are open for comment for 90 days and will then go into effect in their present or modified form shortly thereafter.

Crowdfunding is the newest form of raising capital for small business or investments and it will eventually dominate as a primary method of raising capital in amounts under $1,000,000. Crowdfunding relaxes the current securities law restrictions, which make it nearly impossible for a small business or budding entrepreneur to raise capital from others. The basic premise of the Crowdfunding exemption to the securities laws is that the laws are loosened so long as the total amounts being raised are capped ($1M) and so long as each investor is only allowed to invest only a small portion of their income or net worth.

Here’s a summary of what we already knew.

1. Total amount that may be raised in a Crowdfunding offering is $1,000,000.
2. The company raising funds under the Crowdfunding rules must prepare disclosure and legal documents which comply with the rules.
3. An investor may invest an amount between $2,000 and $100,000 depending on their annual income or net worth. This is a total for all Crowdfunding projects from that person annually.
4. Crowdfunding deals must be processed through a Corwdfunding portal that acts like the title or escrow company in the transaction. Crowdfunding portals will be on-line companies registered with the SEC.

Here’s what is new in the regulations.

1. Crowdfunding offerings up to $500,000 do not need to have audited financial records. Offerings over $500,000 must complete audited financials.
2. Crowdfunding portals must be registered with the SEC and must also register with FINRA.
3. Annual reports need to be filed with the SEC by any company that conducted a Crowdfunding offering.
4. The income or net worth of an investor, which determines how much they can invest, does not have to be verified by the portal.

If you’re looking to raise capital from others in amounts under $1,000,000 you should consider a Crowdfunding offering. While the implementation process has taken nearly 2 years the end of the tunnel is in sight and Crowdfunding will be available soon.