The term ‘LLC’ is doing the rounds, quite a lot, these days in the Vacation Rental space. There are pros and cons of everything and LLC is no exception. But to start, let’s first understand what exactly is an LLC. LLC is a ‘Limited Liability Company’. That raises more questions than it answers. So let’s explore the LLC from the perspective of a Vacation Rental Owner. This will bring out the nature, benefits & complexities of an LLC.
If you want to decide quickly, check out the below slides to find out the main pros and cons of an LLC:
You and the Property are not the same…
Let’s say Mr. Smith owns Smith’s Vacation Rentals (SVR). Till now, he has been treated the same as the Property. He is personally responsible for any losses that SVR faces. However, Mr. Smith wants to reduce this burden. He doesn’t want to become bankrupt if SVR is in losses. This is where an LLC can come to the rescue.
Incorporating the SVR as an LLC would give it a separate identity, different from its owner Mr. Smith. In principle, this is known as a ‘Separate Legal Entity’ but let’s not go too much into the jargon and legalese. What it means is that SVR LLC will have its own losses and profits and Mr. Smith will only bear the amount of losses in the proportion of his investment into the SVR LLC. So for example, suppose times are tough and people are not going on too many vacations, causing SVR LLC to incur losses. The maximum amount that Mr. Smith will lose is the amount he has invested in it.
The people who have financed the SVR LLC can sell off only those properties which the LLC owns in its own name. Not those assets which belong to the owner Mr. Smith. So if SVR LLC goes bankrupt, it doesn’t mean Mr. Smith will go bankrupt too. His home, his car, and all such personal assets still remain with him and can’t be used to pay off the debts of the SVR LLC.
But this doesn’t mean that Mr. Smith has the best of both worlds. He will profit only in the proportion of his investment too. If there are multiple investors, each will get a share in the profits in the proportion of their investment. However, if Mr. Smith is the only investor, then it does mean the best of both worlds.
LLC will bring you tax benefits…
If the LLC is a separate entity, then it should pay its own taxes too. However, there are several tax benefits of an LLC. If Your property is an LLC, then you can take advantage of pass-through taxation.
What this means is that the owner’s income tax returns and the LLC’s tax returns can be clubbed the same way as they could be when the business was not an LLC. You may wonder how this is an advantage? It is an advantage because even with the separation of liabilities, you don’t have to face double taxation.
Going back to the example of Mr. Smith, and SVR LLC. Now he bears the losses of the LLC only to the proportion of his investment. Had it been any other form of a corporation, the SVR LLC would have paid a separate tax and only from the after-tax profits, would Mr. Smith receive his share. For example, if the SVR LLC had a profit of $10,000 and the tax rate was 20%, The after-tax profit would be $8,000. If Mr. Smith owned 100% of the SVR LLC, then he would get only $8,000 in profits.
But what LLC does is, it doesn’t charge tax at its own level. Mr. Smith will get 100% of $10,000 i.e. $10,000 as his income. Then in his individual tax return, he will pay tax on this income. It totally depends whether he pays more or less tax on the level of his other personal income. Suppose he faces a loss personally, it may lower his income to a level where he has to pay no tax at all. So in simple terms, LLC avoids double taxation.
LLC has several forms, one form is an S corporation. In this, the owner is eligible to get a salary too and not just the share in the profit. This salary lowers the taxable income of the LLC and therefore reduces tax paid by the owner. S corporation also allows pass-through features.
LLC makes inter-generational transfers easier…
As in most families, the heirs of the owners might not live in the same state as the vacation rental property. This makes the transfer of the property very difficult in case of the death of the owner. The heirs might have to go into the lengthy process of probate to prove their claim over the property. This can be avoided if the property is incorporated as an LLC.
At the time of transfer, the cost basis of the property is reevaluated and adjusted for inflation. This increases the cost price of the property. So in case, the heirs want to sell the property, the profit from the sale is calculated over this reevaluated price. This reduces the profits and in turn the tax payable on the same.
LLC is not as easy as it sounds & it comes at a cost…
In the US, LLC is governed by the laws of the state and therefore may vary from one state to another. You need professional help to guide you through the process and at times even help you with the registration, filing, and all the required paper-work. Therefore, it is always advisable to consult a professional before deciding upon creating an LLC.
Coming to the part everyone is curious about. Such professional consultation and assistance cost you money. Further, it is not a one-time endeavor. You have to maintain separate books of accounts and furnish a few periodical disclosures. For all such work, you might need periodic help from these consultants and also hire accounting staff. Which means additional costs. So bear in mind, that LLC is only a good option if these costs are within your budget.
Further, if there are several investors, it becomes mandatory to have an operating agreement. Like in Partnerships, this agreement defines the investments and reward-sharing ratio. To initiate the business, you will need all clearances from the authorities and the certificate for commencement of business.
The one time expenses of registration and incorporation can cost you up to $900 while the periodic consultation might cost you close to $500. Some states may impose additional charges such as the Franchise tax.
So all in all, having a consultant who can take care of legal, tax, and accounting matters will be of great help if you plan to go into an LLC. Bear in mind that these will cost you a little but it is an essential expense.
Authorities know the framework too…
The benefits of an LLC can backfire too. Lending institutions such as banks are aware of the separate legal entity concept. They perceive lending to an LLC riskier than lending to an individual. As the personal assets can’t come in the radar of the lenders, they either refuse to lend to LLCs or require substantial collateral against the loans.
Collateral is the asset against which the loan is secured i.e. the asset which can be forfeited by the institutions in case of a default of loan payments. Most of the time, the rental property itself serves as the collateral. However, it should be commensurate to the amount of money borrowed, in the eyes of the lender.
Lenders might even charge a higher rate of interest perceiving the loan to be riskier. Therefore this might again cost you more than it would have without an LLC.
At times you want to convert an existing property into an LLC. You may have to look at your loan documents again. Most documents would have restrictions imposed over such conversions and might require full repayment of the existing mortgage before you can go about it.
What could be the alternative…
One of the biggest advantages of the LLC is that your personal assets are protected. But you may get it otherwise too. You may want to look into insurance policies. Having a policy in place reduces the risk of losing your personal assets.
For example, if the property faces unforeseen losses, a claim can be made against the policy. This will generate funds needed to pay off the losses. However, if these funds are not sufficient, then your personal property might have to be involved. So even though it reduces the risk, it does not completely eliminate the same.
Now coming to the big question again, should you go for an LLC? The answer is, you have to conduct a cost-benefit analysis to take your decision. It need not be a sophisticated one, however, your estimates should be realistic.
LLC is suitable for those property owners, who are sure of generating sufficient revenues to meet all expenses and generate sufficient profits. Therefore, once your property is established enough, you may think about an LLC. Don’t jump into it while you are just starting off on a small scale. It has its benefits, and it costs so give it a good enough thought, consult professionals, don’t go by hearsay and make the wrong decision.
LLC in isolation is a great concept but you need to know whether it is appropriate for you or not…