New California Rules for LLC Holdings

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1 New California Rules for LLC Holdings The state of California has implemented new rules (and costs) for business owners and holders of real estate located both within and outside California. These new rules are disturbing and draconian. Up until recently, because California has a weak asset protection law for LLCs, we structured many of our clients holdings as follows: In this fashion, you had the better protection of a Wyoming LLC. In Attack #1 where a tenant, for example, sues over a fall at the property (the inside attack), California law is going to apply. This is because the real estate in question is located in California. But for Attack #2 (the outside attack), the California real estate is not involved. You ve been in a car wreck and the judgment creditor (the car wreck victim who sued and got a court judgment against you) wants to get at your real estate assets (or your business assets). By having the Wyoming LLC in place, the victim has to hire a Wyoming attorney only to receive a charging order from the court in Wyoming. The charging order provides that the judgment creditor only receives distributions from the Wyoming LLC. If no distributions are made or if the money stays within the California LLC, then the judgment creditor must wait. Attorneys who bring these types of cases are usually on a contingency fee basis, meaning they only get paid when money is

2 collected. Attorneys, quite reasonably, don t like to wait to get paid. They especially don t like to have to hire a Wyoming attorney to get a court order in Wyoming which forces them to wait. The Wyoming LLC provides an excellent deterrent to frivolous litigation. By contrast, California s asset protection laws are very weak. In an Attack #2 scenario, California law allows the judgment creditor to get a court order to force a sale of the asset. This is why we like to have a Wyoming LLC in place to block such an outcome. The problem is that California now has an excessively broad definition of what doing business in their state means. The reason, of course, is money. The more businesses the state can hit with their $800 minimum annual fee the less they have to worry about controlling their own profligate spending. The state of California s tax department, the Franchise Tax Board (FTB) new rules for California residents and investors do not make rational sense. If you plan on investing or living in California it is important to know what is happening. For business, the new rule is as follows: If an out of state LLC has a managing member who is a California resident the out of state LLC is doing business in California. Pay the state their $800 annual fee. This is true even if the entity generates no money in the state of California. If the California resident member of the out of state LLC is only a passive investor and not in any way active in management the California filing may be avoided. But the operating agreement would have to state that the California member cannot act in any capacity for the foreign LLC. If you and your other investors value your management skills, it may be best to take an active role and just pay California the $800. For real estate, the following chart is helpful: Facts: Question: Managing member is a California resident. The LLC has no property in California. Must an out of state LLC register in California?

3 Vacation or second home in another state that is never rented Vacation or second home in another state that is rented Passive investor of investments held and managed by others outside California Rental property located outside California but managed by a California resident Not required Required Not required Required If your vacation home outside California is or was rented, the out of state LLC holding title to it will have to qualify to do business in California. Again, this is true even if there is no California source income. By never renting it out you can avoid that $800 California fee. (So if your cousins want to use the place, oddly enough, you may be ahead of the game by not charging them rent.) The rules are even murkier for investment real estate. If you are a passive investor of out of state real estate and that real estate is managed by a group outside of California you are probably all right. (We say probably as a hedge because California is notorious for changing how they define things.) For example, you invest into a Florida syndication managed by a Florida company. Your buy-in gives you 5% ownership of a Florida LLC and you have no right to manage the LLC. In that case the Florida LLC would not have to qualify to do business in California. (And if it did you can be sure the Florida syndicators would think twice about even letting you into the deal. Why subject yourself to the FTB when you don t have to.) But when you as a California resident manage real estate outside of California we have to deal with the twisted logic of the FTB. Suppose you own Idaho real estate and are the managing member of the Idaho LLC on title to the real estate. California s FTB holds that because you, as a California resident, are managing the Idaho LLC ergo the Idaho LLC is thus doing business in California. Pay us the $800. How then do we handle our first example, where we used a strong Wyoming LLC to protect a weak California LLC? In this case, the chart becomes:

4 Of course, this is a significant increase in annual costs. So how can one deal with this new broadening of California taxation? We offer several options. The first is to qualify the Wyoming entity in California and pay the $800 fee. The Wyoming LLC can be used to hold several California LLCs (each of which are already paying $800 per year). We don t need a new Wyoming LLC for each California LLC. As such, the structure would be as follows:

5 You will pay the $800 per year for each entity. Hopefully your real estate holdings are profitable and can handle the load. One item of concern is in Attack #2, the outside attack, whether California law (weak) or Wyoming law (strong) would apply. California courts have a habit of applying their local laws in many cases. An exception involves the internal governance of an entity, where if you set up in Wyoming, the laws of Wyoming apply as to governance matters, such as rules and operating agreement issues. So would the charging order protection, a Wyoming governance matter, hold up in a California court? There are no cases on it. But I like having the argument that Wyoming laws should apply. It is a much better law than California s. That said, your second option is to use a California LLC and be the member yourself, without using a Wyoming LLC. The structure would be this: In this scenario, an Attack #2 claim against you allows for a court order to sell the real estate. Knowing this, perhaps your strategy is to load up on umbrella and other insurance coverage to satisfy any such future claims. But know that insurance is not a 100% bulletproof option. Insurance companies can always find a reason not to cover you. Another strategy for those who will own only one or two properties or businesses in California would be to form a Wyoming LLC and qualify it to do business in California. This scenario would be as follows:

6 In this manner you will have a Wyoming LLC with Wyoming laws of governance. Will a California court apply California or Wyoming laws in an Attack #2 case? Again, we don t know as there aren t any cases on it. But again, I like having the Wyoming argument, which at $175 a year ($50 to Wyoming and $125 for the resident agent) is another reasonable form of insurance. There is one other option many of our clients are now considering: Don t invest in California real estate. While many are comfortable with investing locally and can cover whatever fees the FTB throws at them, others are starting to see a very disturbing trend and are voting with their feet. They are buying real estate elsewhere. This is especially true when one learns of California s draconian penalties for failing to qualify an out of state entity in California. These include: A penalty of $2,000, in addition to other failure to file penalties; The inability to bring a lawsuit in California; A penalty of $20 a day up to $10,000 for failing to file California tax returns; and The treatment of all members as general partners and thus imposing unlimited personal liability for all acts committed in California.

7 The last item is particularly galling. You have done the right thing in setting up an LLC. Because of a mistake or inadvertence or an unclear law which makes no rational sense, you fail to qualify in California. And the state of California s response is to strip you of any asset protection and allow you to be held personally liable for the claims of others. As you might imagine our clients react to this taxation regime in different ways. Some are so bothered by it all they are looking to move out of California. Others like living in California, continue to see opportunities and are planning to stay. Whatever your take, it is clear that asset protection for California real estate requires extra planning and care. If you would like to set up a consult to explore your options please feel free to contact us. If you are clear on the options and would like to speak with your account representative about changes please also call the office at

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