The use of limited liability companies remains prevalent among real estate professionals, who often use LLCs to hold title to investment properties.
But when the real estate market heats up, the speed of transactions can cause mistakes in setting up and operating LLCs.
The miscues can prompt legal challenges from creditors in an attempt to pierce the veil of a limited liability company so its members can be held personally liable, according to attorneys from Crosbie Gliner Schiffman Southard & Swanson LLP.
The San Diego-based commercial real estate law firm, known as CGS3, recently hosted an event in its “Building Innovation” series to highlight common errors in creating and operating LLCs.
Two of the firm's partners also suggested how to "bulletproof LLCs" to prevent mistakes and fend off lawsuits.
Greg Markow, chair of CGS3’s litigation practice team, said commingling funds and other assets is a significant mistake in operating LLCs.
“It means you have this beautiful structure of LLCs that you use, but instead of keeping them separate, you throw all the money in one big pot,” Markow said. “This alone will raise serious red flags."
A second error that courts frown on is the failure to adequately capitalize the corporate entity, he said.
Other common miscues include confusing records for separate entities, concealing and misrepresenting the identity of the ownership of an LLC and diverting assets to the detriment of creditors.
In order to prevent the types of mistakes that can prove costly in a court battle, Markow recommended that real estate professionals document everything, especially when they are managing multiple LLCs.
For example, he said records of loans between entities should be kept.
"If you can’t do a promissory note, at least do an accounting entry that shows a loan from one, and the other one receiving the loan," he said. "That's fine. It is when it just shows up as a payment of some sort from one to another that it turns into a problem."
Markow advised those operating multiple LLCs to have separate accounting for the entities, such as maintaining different accounting codes and bank accounts.
He also recommended that it be clear which company is communicating with another party, something that can be accomplished with separate email addresses.
If annual meetings are required, he said they should be held.
Even if operators of LLCs follow the guidance Markow offered, he said they still may face a legal challenge, but attorneys like him will be better equipped to defeat the claims.
“You will never not have people shooting at you, but the more you do these things, the easier and easier it is to defend,” Markow said.
He said his firm would prefer to keep the LLC-related business away from his end of the office and more on the side of his co-presenter at the event, partner Phil Jelsma, the chair of CGS3’s tax practice team.
Jelsma, co-author of the book "The Limited Liability Company," said he thinks members of the real estate industry have a lot of room for improvement in establishing and managing LLCs.
As result, he expects Markow will remain busy with litigation.
“I think the smart clients are asking good questions, but I think there are still a lot of problem LLCs out there,” Jelsma said. "Gradually, people will learn through hard knocks, but there are still a lot of difficult cases out there."
Besides sloppiness due to speed, another common cause of LLC issues is when real estate professionals turn to websites like LegalZoom that offer very inexpensive assistance in setting up limited liability entities, Jelsma said.
“You can jump on the Internet and get one form and there is nobody telling you, 'Well, make sure it is adequately capitalized. Make sure you are following the formalities,'” he said. “It’s just, 'Here are the keys. Have fun.’”
Both Jelsma and Markow recommended that people seeking to properly set up and operate LLCs in the commercial real estate sector turn to experienced legal counsel.