California Limited Liability Companies And Real Estate Investors

In the brutal California economy of the last few years, real estate investors need every trick available to reduce financial risk. And an LLC is one such trick. But unfortunately California's limited liability company laws complicate the use of a LLC for real estate. Accordingly, California real estate investors and their advisors need to consider three California issues.

Issue #1: Long Processing Lead Times

Many states process the articles of formation that create a limited liability company almost immediately. Often, for example, these states use an online website to collect the LLC information (name, address, owners and so forth) and the formation fee. And then the acceptance of the documents occurs almost instantaneously.

For real estate investors, however, here's where things get more complicated with California. The California Secretary of State takes several weeks to process the formation paperwork. In the fall of 2011, for example, mailed in LLC filings take three weeks to process. And if you want to hand-deliver the LLC filing, the turn-around time accelerates to roughly two weeks.

You can also pay fees for expediting the processing of your formation documents. You can, for example, get "same day" filing by paying an extra $750. With "same day" filing, the Secretary of State will process your paperwork by 4pm as long as you turn the paperwork in by 9:30am. And you can get "24-hour" filing by paying an extra $350. With "24-hour" filing, your paperwork gets processed within a twenty-four hour window: If you turn in the paper at noon on Tuesday, your application will be processed by noon on Wednesday.

What all of the forgoing means, however, is that if you want to use a California LLC for a particular property, you either need to think ahead and get the limited liability company set up several weeks early or you need to budget for and then pay expediting fees in order to get your LLC setup almost as part of the closing process.

Issue #2: The $800 Gorilla (aka Franchise Tax)

Another LLC issue unique to California is the state's $800 a year franchise tax.

Setting up an LLC in the state doesn't cost you much. In 2011, for example, the filing fee is a modest $70. That's a great deal, in a sense, for the limited liability protection you get from the llc.

But the state also tags you with an $800 annual franchise tax. So even if you've got a very modest real estate investment such as an inexpensive building lot way out in the desert or a small condo, you've still got to pay the annual $800 fee to hold the property inside an llc.

The rather extreme annual franchise tax means that investors purchasing small properties need to think carefully about the trade-off between the increased legal protection an LLC offers and the extra cost the franchise fee creates. In many cases, unfortunately, the investor probably won't be able to justify the ongoing extra cost of a California LLC simply because of the franchise fee.

Two quick notes about the California LLC franchise tax before I move on to the next issue: While you must pay the California LLC franchise tax if you own an LLC that owns property in California, you should be able to avoid the tax if you own property outside the state with a non-Californian LLC. Say you want to hold a Washington state rental property through an LLC. As long as you set up a Washington state LLC for this and the only activity of the LLC is holding property outside the state of California, California shouldn't be able to levy the $800 tax. (Washington State charges a $69 annual fee for LLCs, an amount which is pretty much in line with what other states charge annually.)

Issue #: Consider the S Election for Flipping LLCs

A final quick point related to using LLCs for real estate investments: If your LLC will flip properties, your real estate income may not be passive. The "real estate flipping" income may be considered active self-employment earnings and subject to self-employment taxes. So here's why this is important to consider: The extra taxes that self-employment-earnings status creates can add up. Self-employment taxes (which are the small business's equivalent of Social Security and Medicare tax) equal roughly 15% of the first $100,000 a person makes and roughly 3% of any other income a person makes.

Using a long-established accounting trick, however, an LLC may make an election to be treated for tax accounting purposes as an S corporation. Note that the California LLC is still, for state law purposes, an LLC. But for federal and state tax purposes, the LLC reports its income and deductions as an S corporation.

The benefit of using the S corporation tax accounting rules is that the real estate investor flipping properties gets to split the real estate profits into an "employee wages" share and an "owner" share. Only the employee wages share gets hit with the self-employment taxes.

Note: Commonly real estate flippers using S corporations pay themselves modest salaries. A real estate flipper who makes $100,000 but pays himself a $40,000 wage saves roughly $9,000 a year in self-employment taxes by using the S corporation accounting rules for his California LLC.