California real estate investors are faced with a unique problem – the State of California. If you invest in California or you are a California resident investing anywhere in the known Universe, pre-planning is necessary to avoid falling prey to the California’s Empire.
The first problem for real estate investors involves creating a California business entity. If you need asset protection or tax savings and are not willing to wait the obligatory 5 months for an employee in Fresno to file your entity then you should consider creating your business outside of California. Currently, from the time you submit your business filing in California, 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 disturbing issue for real estate investors 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 be subject to 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, as I have been reminded by my wife on multiple occasions during our marriage that I lack common sense, I believe even in this she must agree with me. The FTB’s 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, is ultimately lacking in common sense.
Consider the situation of my clients Groucho and Harpo Marx. The Marx’s brothers, California residents, created Starship Holdings, LLC, a Interstellar limited liability company taxed as a partnership, to own Girmaldi crater on the moon. (I think they negotiated the purchase through Governor Jerry “Moonbeam” Brown.) After the creation of Starship Holdings, LLC, Charlie contracted with Marvin Martian to administer a new colony built on this location. Two years after the establishment of Starship Holdings, LLC, the FTB contacted Groucho and Harpo and requested they file California Form 568 for their Interstellar limited liability company. According to this form, the FTB views Starship Holdings, LLC as conducting business in California via Groucho and Harpo’s ownership. Thus, the FTB subjected the Interstellar limited liability company to the $800 annual franchise fee.
Groucho and Harpo were not pleased with the FTB’s position. Neither could understand how a moon colony was connected to California. Unfortunately, those in the FTB can make the case with a straight face (see FTB Instructions for Form 568). I wonder if it is the water or a different flavor of Jim Jones Kool-aid that expands a person thinking to reach illogical ends.
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.
Establishing a New California Business
If you don’t have 5 months to wait to begin conducting business, consider establishing a Nevada entity (these can be filed within 24 hours), then registering it as a foreign entity 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. Even though you must wait 5 months for California to recognize your foreign filing, you can begin business immediately while you wait.
If you are a California resident setting up an out of state LLC, best practice dictates that it be a disregarded entity. If you choose partnership taxation, it will result in a K-1 that will be reported on your California State return. Groucho and Harpo discovered this to their detriment. The filing of a partnership return is a direct invitation for the FTB camel into your tent. If you know the saying, once he is in the tent, there is no getting him out. So pile up your Benjamins because you will be forced to pay $800 per year for your out of state LLC. A disregarded LLC is ignored for tax purposes; thus nothing is attached to your individual return that will invite the camel out for a look.
Land Trusts - a California Real Estate Investors Best Friend
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 Oregon, his first step in protecting the property would be the creation of a land trust, followed by an Oregon LLC to hold the beneficial interest of the trust. Typically, the land trust and LLC are established in the State where the real estate is located. However, this is just standard practice but I am not aware of any legal requirement that requires the LLC be created in the State where the trust is created. This is dimply done for ease of administration e.g., the avoidance of multiple bank accounts. However, if you are not adverse to added complexity it can result in an $800 per year savings. Here is how:
Step 1 – Establish 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 – Form a Land Trust
Set up a California land trust to hold title to your California real estate. Deed the real estate 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.