Posts in: February

Real Estate Investor Escapes Criminal Charges: Legal Factors When Raising Money from Others with Promissory Notes

February 28, 2017 Business planning, Real Estate Comments Off on Real Estate Investor Escapes Criminal Charges: Legal Factors When Raising Money from Others with Promissory Notes

Thousands of real estate deals/projects involve the use of promissory notes as a way to raise money to fund the project.  If you are raising capital for a real estate project using promissory notes and you assume incorrectly that securities laws do not apply to your deal/project, you could be fined or possibly end up in an orange jump-suit.

In a recent California case called People v. Black, the California Court of Appeals was asked to whether a promissory note in the real estate deal (an investment in land in Idaho) was a security.  Needless to say the project/deal did not go as planned.  Once the lender felt that he was getting the “run-around” from the borrower, he hired a private investigator which eventually led to a criminal investigation of the borrower.  Please note that this was a criminal case, which is important to mention because it highlights the fact that certain actions when raising capital can result in criminal charges, i.e., fraud, etc.  Also, although this case is from California, it is instructive for many real estate venturers and investors even outside of California because the court used many securities law cases from the United States Supreme Court to reach its conclusion.

The court in Black concluded that the promissory note at issue was not a security.  It used the “Howey Test”, to reach its conclusion, which derived from the famous securities case, SEC v. Howey Co., 328 U.S. 293 (1948).  The Howey Test is this:  If the funds were invested with the promoter/manager with the expectation of receiving a profit from a business enterprise, which profit wholly depends on the managerial efforts of the promoter/manager, then the promoter/manager has issued a security.   The analysis of WHY the court reached this conclusion with respect to promissory notes and securities law is very instructive.  Here are the “take-aways” from the case:

  1. Avoid Profits Sharing in Notes, Split of Profits v. Straight Interest / Promise to Pay. The promissory note in the Black case stated that the amount of interest paid to the lender would be either a percentage of profits from the sale of the underlying real estate, or two lots from the property if it is held for development.  There was also a provision that whether the property is sold or developed, the principal amount plus 10% interest would be due one year from the date of the note.  This last provision was a very important fact that the court seemed to place a lot of emphasis.  However, it also conceded that “the promise of a fixed return does not in itself remove the transaction from securities laws” because as the United States Supreme Court stated in a case called Edwards, (SEC v. Edwards, 540 U.S. 389 (2004)), “unscrupulous marketers of investments could evade securities laws by picking a rate of return to promise.” In other words, the court in Black was careful to not “hang its hat” on just this one factor.
  1. Give Investor Control or Protections, Control of the Investment / Split of Profits. If the note is a profit-sharing note where the borrower has total control of the investment and there are not protections to the lender, the investment will look more like a security.  The court relied on a United States Supreme Court case called Marine Bank, involving a profit-sharing arrangement involving loans between the parties.  The U.S. Supreme Court held that the loan in that case was not a security because the lender in that case has a measure of control over borrower regarding the investment/project despite the fact that the borrower’s obligation to repay was based in part on the success of the venture/project.
  1. Avoid Bringing in Multiple Parties Without Proper Legal Documents, Negotiated One-on-one v. Offered as a Uniform Instrument to the Masses. The lender and borrower in this case knew each other for six years.  They had appeared to individually negotiate this promissory note with each other as opposed to the lender simply taking the same promissory note and offering it to multiple investors especially in a public manner through public advertising.  The court also used the Marine Bank case mentioned above in this context.  As opposed to many deals/projects that involve promissory notes that are issued to many investors, another reason the U.S. Supreme Court held in the Marine Bank  case that the profit-sharing loan arrangement was not a security was because of the one-on-one nature of the investment.  The court in Black was careful to state that this is not the only factor but is simply one of a number of factors.
  1. Give Security for the Loan, Is the Promissory Note Adequately Secured. The lender in this case had secured the promissory note with his separate / personal property.  This was a factor in the court’s conclusion but it is important to note that the security must be adequate.  The court was careful to make this point and it did so by mentioning a case called Shock, (People v. Schock, 152 Cal.App.3d. 379 (1984)), in which the California court of appeals found that the public sale of fractional interests in secured promissory notes were securities, in part, because of the inadequacy of the collateral together with the investors’ dependency on the promoter’s success for a return on the investment subjected the superficial loan transaction to security regulation.   Similarly, In a California case called Miller, (People v. Miller, 192 Cal.App.3d. 1505 (1987)), the promoter issued notes to multiple investors in connection with a luxury home purchase “scheme”.  The court determined the notes and trust deeds were securities because the loans, i.e., the funds obtained by Miller were so far in excess of the value of the secured interest that no resale or foreclosure could recoup more than a few cents on the dollar to the individual lenders.  Also, it should be noted that investors were solicited from the general public and had no control over the success of the venture.  Likewise, in a 9th Circuit case called Wallenbrock, (SEC v. Wallenbrock, 313 F.3d 532, 9th 2002), the court found that promissory notes sold to the public which were secured by the accounts receivable of Malaysian latex glove manufacturers were securities.  The court determined that if the receivables existed at all, the investors had no way of reaching the assets. If you are planning to invest and your investment is secured by the receivables of Malaysian latex glove manufacturers, it’s probably not a good investment.  Nothing against the Malaysian latex glove industry, I’m just saying.

In summary, some promissory notes are securities and some are not.  Each deal/project must be analyzed by looking at the substance rather than just its form. The details matter as does careful legal planning. In this case, the promissory note (a) was an actual promise to repay regardless of the success of the underlying venture/project, (b) was adequately secured, and (c) was negotiated one-on-one i.e., individualized versus a uniform document to be used by the mass investors.  These facts were persuasive enough for the court to conclude the promissory note in this case was not a security.  If you’re using promissory notes to raise money in real estate deals, please carefully consider the points in this article and call our office to discuss your situation.

Just “Having” an S-Corp May Not be Enough

February 21, 2017 Business planning, Law, Real Estate, Tax Planning Comments Off on Just “Having” an S-Corp May Not be Enough

Just “having” an S-Corporation may not be enough. It’s important you make sure to reap the tax and legal benefits of your S-Corp if you’re going to set one up.

If you routinely read articles in this space or have heard any of our attorneys speak around the country, you are probably aware that we are big fans of the S-Corporation structure as a way for folks who own and operate small operational businesses (i.e. ones where they are selling goods or services and are not someone else’s W-2 employee) to get some limited liability protection and (probably more importantly) to save on self-employment taxes.

When self-employed folks don’t incorporate and instead operate as a sole proprietorship, their entire net profit from the business is subject to self-employment taxes. If you don’t do anything about them, self-employment taxes will eat up about 15.3% of your income – before we even talk about income taxes. So, on a net profit of $100,000, a self-employed person will pay about $15,300 in self-employment taxes

If instead, a self-employed person operates as an S-Corporation, they can do a “salary/dividend split” on the net income from the business. In a salary/dividend split, the business owner will pay himself a “reasonable” salary from the S-Corporation’s profits. A general rule of thumb is that roughly 1/3 of the company’s net profit is considered a reasonable salary. Self-employment taxes are paid on the amount of the salary, and the rest of the income flows through to the business owner as a type of “dividend” from the S-Corporation. That dividend is not subject to self-employment taxes.

So, if a small business owner has the same $100,000 of net profit and operates as an S-Corporation, he will pay himself a “reasonable” salary of about $33,000 and pay self-employment taxes of about $5,000 (instead of $15,300). The remaining $67,000 flows through to the owner free of self-employment taxes. We love the S-Corporation structure for self-employed doctors, dentists, engineers, realtors, commissioned salespeople, certain types of real estate investors, and others whose income would otherwise be subject to the 15.3% tax.

Right now, you’re probably either thinking: “Yep, Jarom, you’re preaching to the choir. I already have my s-corp and I’m saving a bunch on my self-employment taxes!” OR “Man, I need to look into an s-corp right away!” Either way, please keep reading because establishing an s-corp and doing the correct tax filings is only part of the equation.

The recent U.S. Tax Court Case of Fleischer v. Commissioner (2016 T.C. Memo. 238, filed 12/29/16) demonstrates that just having an S-Corporation may not be enough to save on self-employment taxes. Mr. Fleischer is a financial consultant who signed on as an independent contractor representative for a couple different brokerage houses. He also established an S-Corporation, and funneled his income through that entity to save on self-employment taxes in roughly the same way I described above.

So, why was Mr. Fleischer in Tax Court? Well, the IRS sent him something called a Notice of Deficiency. The Notice basically said that his use of the S-Corporation to save on self-employment taxes was invalid, and that he owed roughly $42,000 in back taxes, plus penalties and interest. Mr. Fleischer disputed the Notice, and the case went before a Tax Court judge.

The IRS argued that the Notice they sent was proper because the income at issue belonged to Mr. Fleischer, personally, and not to his S-Corporation. In support of this argument, the IRS presented evidence (which was unrefuted by Mr. Fleischer) showing: 1) Mr. Fleischer signed both independent contractor representative agreements in his personal capacity, not on behalf of his S-Corporation; and 2) Payment for Mr. Fleischer’s work went to Mr. Fleischer personally, not to his S-Corporation’s bank account.

Mr. Fleischer’s primary argument in response was that he had to sign the agreements and receive payment in his own name because he, not his S-Corporation, is licensed and registered as a financial advisor, and it would cost him millions of dollars to get the same required licenses for his company.

The Tax Court wasn’t impressed with Mr. Fleischer’s arguments, and ruled that he was indeed on the hook for all the taxes, penalties and interest the IRS asked for in the Notice. While the Tax Court’s decision in Fleischer isn’t necessarily binding on other cases, it is instructive for those hoping to use the S-Corporation to save on self-employment taxes – and have that use stand up under IRS scrutiny. Namely, it drives home two important points:

1)   To the extent possible, all of your S-Corporation’s contracts – especially those where it will be receiving income – should be in the name of your S-Corporation. This is crucial. One of the huge factors the IRS looks at when determining whether income belongs to a corporation is the existence “between the corporation and the person or entity using the services [of] a contract or other similar indicium recognizing the corporation’s controlling position.” A contract between your S-Corporation and the person or entity paying it will satisfy this factor. Besides, entering into contracts in the name of the S-Corporation also helps from a limited liability standpoint if the other party wants to sue for breach of that contract.

2)   Again, to the extent possible, all payments for goods or services provided should be made to the S-Corporation directly. Such direct payments may serve as “other similar indicium recognizing the corporation’s controlling position.” At the very least, these direct payments will save you from being in a position where you have to explain to the IRS why income being reported through you S-Corporation went first to you personally.

The S-Corporation is a wonderful and legitimate tool to save on taxes. Please just take the time to make sure you are using and operating it correctly. Doing so will save you time, money and headaches if you are ever audited by the IRS (or sued in your business).

Who’s Liable- The Landlord or the Tenant?

February 14, 2017 Asset Protection, Business planning, Litigation, Real Estate, Small Business Comments Off on Who’s Liable- The Landlord or the Tenant?

We have many clients that own residential rental and commercial properties and lawsuits involving landlords continue to happen throughout the country, and will continue so long as someone is willing to ‘rent a room’ and someone is likely not to pay or damage something.

However, the question then becomes…who’s liable when something goes wrong.  As you can imagine a lot of finger pointing takes place and it can oftentimes be difficult to see who is in the right.

Thus, history has taught one of the most important lessons of all- “learn from the past”.  As such, I have compiled a brief snapshot of a few recent court cases throughout the country that have dealt with landlord liability.  Hopefully learning from one of these difficult situations will help you avoid the some of the same mistakes.

In a case called Lipp v. Ginger C., LLC (W.D. Mo., 2016), the tenant threw a party. Surprise…Surprise!!! And as you would expect, one of the guests, who had been drinking at the party, went onto a second floor deck to urinate. While on the deck, the wooden balcony broke, causing the guest to fall 18 feet onto the driveway. He then died a few days later. The landlord knew that the balcony had been temporarily repaired by a prior owner, but the landlord had not permanently repaired the balcony as of the date of the party. The family of the deceased guest sued the landlord.

In a case called Ortega v. Murrah (Tex. App., 2016), the tenant broke her leg after slipping on water that had leaked from a broken pipe under the rental property’s kitchen sink. The tenant sued the landlord for personal injuries.

In a case called Moore v. Parham (Ariz. App. 2016), the landlord owned a residential property in Lake Havasu that he leased to a tenant. A satellite dish installer came to the property to install a satellite dish for the tenant. The installer was injured when he attempted to access the roof by climbing on a shade structure attached to the house. The installer sued the landlord for personal injuries.

Lastly, in a case out of California last year called Ramos v. Breeze, 2016, the tenant tripped and fell in the parking lot of the apartment complex in which she was living.   The tenant sued the landlord for personal injuries.  The landlord was held substantially liable for the injuries.

These are just a few of many recent cases involving landlord liability and a landlord being sued. Most of the cases above are still working themselves through the court system in terms of being resolved on the merits, but the point is that if you’re a landlord, you need to consider your exposure to liability and consider what steps you can take as a preventative measure, including the following:

  1. Have your landlord-tenant agreement reviewed. Whether you’re a landlord of commercial real estate, or investment residential real estate, you need to make sure you have a strong “landlord-friendly” agreement. Have you had it prepared or at least reviewed by an attorney?
  1. Review your rental property insurance policies and applicable limits. If a landlord is subject to a legitimate claim, hopefully it never ripens into a lawsuit because the claim is a covered event under the appropriate insurance policy. But make sure you know exactly what claims are covered and what claims are not covered under your insurance policy(ies) so that you know what is and what is not covered under the policy(ies). Do you know what policies you have and what events are covered and what events are not covered?
  1. Consider how you’re managing your rental(s). You want to make sure you utilize best practices and procedures for managing your rental(s), whether you can and are managing them yourself or you have someone else manage them for you.
  1. Consider how you’re vetting your tenant(s). Are you being careful to properly vet/screen your tenants? A little extra time on the front-end to make sure the tenant is properly qualified will save you a lot of time later on.
  1. Consider an entity(ies) for your rental(s). Certainly having an LLC own your rentals is not the end-all, be-all, and it won’t in of itself prevent a lawsuit. However, it can, unless abused, prevent you from personally being named in the lawsuit, and thus exposing your personal assets in the event the plaintiff obtains the judgment against you.

Even in cases in which the landlord “wins”, the time spent and the costs involved to defend the lawsuit can be enormous. An ounce of prevention is worth a pound of medicine, particularly when it comes to landlord liability. This type of liability can arise in a number of ways, including failure to comply with statutory requirements, a breach of contract, premises liability, or negligence.

Each one of these liabilities requires a state-specific analysis based on statutes and cases in the particular state in which the property is located. Please contact our office at 888-801-0010 if you would like to schedule a consult regarding these matters.

Which State’s Law Applies in a Lawsuit?

February 14, 2017 Asset Protection, Business planning, Corporations, Law, Litigation, Real Estate, Small Business Comments Off on Which State’s Law Applies in a Lawsuit?

We frequently hear from clients who have been told by others that they should incorporate in Nevada (or other states outside of their home state) in order to take advantage of their favorable laws.   We have seen many individuals persuaded into incorporating in a state outside of their home, only to complain about the cost and complexity of the structure which ultimately had to be unwound.

This is not to say that incorporating an entity in Nevada or Wyoming should never be considered as part of an asset protection strategy. One primary reason for incorporating a Nevada or Wyoming entity is arguably due to their strong “charging order” protection.   The charging order is a concept protecting an LLC owner who is sued and held liable for something unrelated to and “outside” from the LLC from then being able go and take that LLC interest or the asset held by the LLC.   For example, if you’re cruising on the highway over the weekend and get into a major accident causing serious injuries, the charging order could prevent or hinder the injured plaintiff from seizing your assets held in your LLC.

However, the myth that we often hear from clients is that because states like Wyoming or Nevada have strong asset protection laws, they should take advantage by incorporating these entities into their structure even if they don’t own assets or do business there. What is often omitted from the conversation is whether Nevada or Wyoming law will actually be applied if there is no connection between the lawsuit and Nevada or Wyoming.

Since we are a union comprised of fifty states with different laws, there is an incentive to try and take advantage of states that have more favorable laws. Courts generally discourage this type of “forum shopping” where people try to use the favorable laws of one state even if they have no actual connection with that state.

One of the ways courts deal with these types of cases is by applying a set of rules called Conflicts of Laws. It is an area of the law that allows a state to determine which laws will apply to a case when the laws of multiple states could potentially apply.

For example, lets say a California resident is driving in Nevada on his way to Vegas and collides with a Colorado resident causing catastrophic injuries. Where should this type of lawsuit be filed and which of these three state’s laws should we apply? Because these types of circumstances can be so varied depending on the residency of the parties and the location where the events resulting in a lawsuit occur, it is sometimes difficult to predict where a lawsuit should be and what state’s laws should apply. This is further complicated by the fact that states have different Conflicts of Law rules.

Here are some general rules that courts will usually apply depending on the type of case. Examples include the following:

  1. Personal Injury or Fraud: Generally the law of the state where the wrongful act causing the injury or fraud occurred will be the law that should be applied. For example, if the accident or fraudulent conduct occurred in Nevada, that is an indicator that Nevada law should be applied;
  2. Personal Property (damage or theft): Where the personal property was located when the act causing the theft or damage occurred may determine which state’s laws should apply;
  3. Real estate: The state where the real estate is located will often determine which state’s laws will apply in a dispute relating to real estate;
  4. Contracts: Where the contract was entered or where the principal events necessary to form the contract occurs. Keep in mind that many contracts have provisions governing which state’s laws or courts will be used in the event of a dispute. These types of “forum selection” or “choice of law” clauses are often enforced by courts, unless there is no substantial or reasonable relationship with the chosen state. For example, if you are in California and you enter into a contract with someone else in California and all the activities relating to the contract occur in California, it is unlikely that a California court would enforce a provision that says Delaware law should apply even if you included such a provision in your contract.

These are just some very general guidelines as courts may consider additional factors in any given case. Hence, the outcome in any particular case is often difficult to predict with any consistency.

Therefore, before you decide to set up a structure that includes incorporating in a state which you have little or no connection with, make sure you understand not only the purposes for choosing that particular state, but perhaps even more importantly, its limitations.     Don’t assume that if you incorporate your entity in Nevada, that you will necessarily get the benefit of Nevada’s laws, especially if you do not live in Nevada.

What Is a “Holding Company” and When Could It Make Sense to Have One?

February 7, 2017 Asset Protection, Business planning, Real Estate, Small Business Comments Off on What Is a “Holding Company” and When Could It Make Sense to Have One?

We have lots of clients who come to us after dealing with promoters and would-be practitioners who have recommended elaborate (and usually expensive) entity structures for their businesses. This “up-sell” approach tends to happen whether the business sells cheeseburgers or invests in buy-and-hold rental properties.

One of the structures that is almost always included in these intricate structures (especially when real estate is involved) is something called a “holding company.” Simply put, a holding company is a business entity that exists solely to own other business entities. In our practice, we see this most often in the form of a holding company LLC, which owns one or more additional LLC’s, each of which, in turn, owns a single rental property.

At first glance, this structure may seem like overkill, and in many situations it is. Owning a rental property in the name of a single properly established, maintained, and operated LLC will provide the LLC owner with limited liability for the potential debts and obligations associated with that property.

In several states (but certainly still less than half), this simple structure also does a great deal to protect the rental property from the debts and obligations of the LLC owner. In these states, if an LLC owner has some sort of judgment against him or her, the sole remedy available that judgment creditor has to get at the LLC owner’s interest in the LLC that owns the rental (and the rental itself) is something called a “Charging Order.” Let’s call these states “Charging Order States.”

The Charging Order lets the judgment creditor step into the LLC owner’s shoes if and when the LLC makes a distribution of profit – but it doesn’t let that judgment creditor do much else. For that, and several other reasons, the Charging Order is a particularly weak remedy that many judgment creditors will simply decide not to pursue (or that they may be willing to walk away from for pennies on the dollar).

So, given the protections offered by a single LLC, when can a holding company, set up in a Charging Order State, actually make sense in the context of rental real estate? Here are a few:

1)         You work in a profession that tends to get sued a lot (think doctors and engineers), and your rentals (and their associated LLC(s)) are located in a non-Charging Order State. In this situation, the holding company can be an effective barrier between the people who might sue you for malpractice and your rental property assets.

2)         Even though you don’t work in a “high risk” profession, you are a bit of an asset protection junkie, so for you, because your rentals (and their associated LLC(s)) are located in a non-Charging Order State, the additional cost and paperwork of having another entity is worth the additional protection from personal creditors. Here, the holding company may have less practical effect than in number one above, but it will serve as that same barrier if you get tied up in a lawsuit you end up losing.

3)         You are a bit of an asset protection junkie, and you like the idea having two layers of limited liability protection between the liabilities associated with your rental property and your personal assets. In this situation, if a plaintiff in a lawsuit is for some reason able to pierce the corporate veil of the entity that owns the rental and get at the owner, they will find yet another corporate entity whose veil will also have to be pierced before they can access your personal assets to satisfy a judgment.

You’ve worked hard to accumulate the assets you have, and it makes sense to take steps to protect them. Don’t be fooled by those who say “you have to” do X, Y or Z. There is no one-size-fits-all-approach. The art and science of asset protection involves one cost/benefit analysis after another. Make sure you are seeking and following the advice of a knowledgeable professional who has your best interests at heart.