California real estate investors are faced with a unique problem – the State of California. If you are considering investing in this State, or if you live in California and are considering investing anywhere in the Solar System, pre-planning is necessary to avoid unnecessary delays and costs when creating your asset protection plan.
The first problem lies in creating your plan of action in California. If you need asset protection or tax savings immediately, California is not the place to create your plan. On average it is taking 4 to 5 months to create an entity in the sunshine state. From the time you submit your business filing, it will appear as if it is a race between the Secretary of State to recognize it or the last judgment to arrive. This is why it is beneficial to look at other States when deciding where to form your business.
The second and more vexing problem is the Franchise Tax Board, also known as the FTB. Most rational people could agree that if a LLC is formed in California to transact business, it should fall under the FTB’s taxing authority. (Whether or not a minimum tax of $800 a year, regardless of revenue, is reasonable is a matter of debate.) However, common sense begins to wane when the FTB takes the position that any LLC, regardless of the State the entity is formed in, will be considered “doing business” in California if the LLC owner resides in California.
Consider the situation of my clients Charlie and Sidney Chaplin. The Chaplin’s are brothers and California residents who created Moon Cheese, LLC, a Lunar limited liability company taxed as a partnership, to own Copernicus crater on the moon. (I think they negotiated the purchase through Governor Jerry “Moonbeam” Brown.) After the creation of Moon Cheese, LLC, Charlie contracted with Marvin Martian to administer a new colony built on this location. Three years after the formation of Moon Cheese, LLC, the FTB contacted Charlie and Sidney and requested they file California Form 568 for their Lunar limited liability company. According to this form, the FTB views Moon Cheese, LLC as conducting business in California via Charlie and Sidney’s ownership. Thus, the FTB subjected the Lunar limited liability company to the $800 annual franchise fee.
After speaking with both Charlie and Sidney, I can attest that they were not happy. Neither could comprehend how the moon colony was connected to California. Unfortunately, neither could I, but for some inexplicable stretch of logic (see FTB Instructions for Form 568) the FTB thinks it’s obvious.
You may be asking, what is a person to do who needs a business set up immediately? How about the real estate investor that does not have the funds or desire to pay the FTB $800 per LLC? Again, you may need to look outside of California.
Setting Up a New California Business
If you need an entity set up quickly, consider establishing a Nevada entity (these can be filed within 24 hours), then registering it to conduct business in California. Although this approach will be slightly more expensive, it will give you the asset protection and tax benefits you are seeking much sooner than starting the formation process in California.
If you are a California resident setting up an out of state LLC, it is best to create it as a disregarded entity. If you choose partnership taxation, it will result in a K-1 that will be reported on your California State return. Charlie and Sidney discovered this to their detriment. The filing of a partnership return is a direct invitation for the FTB camel to come into your tent and take a look around. Unfortunately, once he is in the tent, there is no getting him out and you will be forced to pay $800 per year for your out of state LLC. Alternatively, a disregarded LLC is ignored for tax purposes; thus nothing is attached to your individual return that will invite scrutiny or questions.
Land Trusts for California Real Estate
Typically, a land trust is used as a tool to avoid the “due on sale clause” issue surrounding the transfer of real estate. If an investor purchases property in Georgia, his first step in protecting the property would be the creation of a land trust, followed by a Georgia LLC to hold the beneficial interest of the trust. In most situations, we create the land trust and the LLC in the State where the property is located. However, no legal requirement exists that dictates the LLC must be created in the State where the trust is created. This is typically done for ease of administration. However, some may be willing to embrace added complexity if it results in an $800 per year savings. Here is how:
Step 1 – Create a Nevada LLC
Rather than create the LLC in the State where the property is located i.e., California, the real estate investor holding property in California should consider creating a Nevada LLC treated as a disregarded entity for tax purposes. When creating the Nevada LLC, be sure to use a Nevada address for your entity. We provide such a service through our sister company, Business Office Suite Services, “BOSS”.
Step 2 – Create a Land Trust
Set up a California land trust to hold title to your California property. Deed the property into the trust then assign the beneficial trust interest to the Nevada LLC. The land trust will need a bank account to receive rents and pay bills. If the LLC collects the rent then it will be transacting business in California and subject to registration.
A land trust is not subject to the FTB fees, therefore by keeping the rental business contained in the trust and not involving the Nevada LLC in the management of the property, it will remain outside of the FTB’s cross hairs.
Working in and around California can be time consuming and expensive. Thankfully with a little effort and proper planning, many of these hindrances can be minimized.