How to Protect Real Estate Investments From Business Liabilities
Don’t lose your business real estate investment should your operating business “hit the rocks” with a large uninsured liability. For example, what happens if multiple restaurant patrons die from trichinosis food poisoning, and their heirs sue your restaurant because an employee mistakenly served undercooked pork at a pig roast?
What happens when the restaurant operating company faces multiple lawsuits with clear causation, liability, and damages that exceed insurance coverage limits? While the restaurant company will soon become insolvent, the judgment creditors would look to see what other company assets are available for post-judgment collections. If your restaurant has been successful over many years, it may own the real estate where it operates. This real estate is used to run the business. Be aware that with careful planning ahead of the loss, the real estate asset can be saved from the company’s creditors.
Real estate is passive and not a lightning rod that attracts liability. Real estate is also a large store of value. If the restaurant company holds title to the real estate, then you have taken a big risk that was easily avoidable. You should never let real estate be exposed to creditors of the business. In contrast, if set up through a separate titleholder LLC leasing the building to the operating restaurant LLC, the equity in the real estate’s “sticks, bricks, and dirt” would not be subject to creditor claims from the heirs of food poisoning decedent estates, provided the two businesses operated at arms-length with a lease and separate books.
A court would treat the two separately, allowing the real estate owner to protect real estate assets and that value for the LLC owner. If both entities were LLCs formed in Delaware, then the protection would be virtually guaranteed; even if the Delaware LLC is operating in other states or countries!
To this point, smart business owners separate their assets using a two-entity Delaware LLC design known as an OpCo-PropCo structure.
Here is what an OpCo and PropCo are, how they work, and why this two-structured-design is the ultimate protective mechanism for Delaware operational business owners.
What Is an Operating Company (OpCo)?
An OpCo is an LLC created to contain the daily customer-facing side of a business. In other words, an OpCo is the engine room in a ship where all the daily grind happens. This engine room is where the hiring of employees, the transactions from customers, inventory maintenance, supplies, and other public facing daily functions all take place. It is the revenue machine and cost center.
Because the OpCo ends up being the front line of the business, it inevitably carries almost all of the operational liability. Whether it is a customer slipping on the floor, an employee making a mistake, or a dispute with a supplier, any lawsuit or legal action taken against the daily operations of the business will be targeted against the OpCo.
What is a Property Company (PropCo)?
A PropCo is a separate entity created to hold title to the physical real estate, building, and land where the business sits. It does not deal with daily commercial operations (hiring staff, public interaction, logistical maintenance) but instead acts as the sole vault for your real estate. Think of it as the functional building itself, separate from business operations. It exists whether or not there is active labor or presence inside of its building walls.
Because the real estate is safely tucked away like a sibling owned by the same parent but not responsible for the actions of its siblings. It is insulated from the daily risks that occur inside of that building. This is because there is an arm’s length lease between the OpCo tenant and PropCo landlord with adequate hazard insurance for foreseeable liabilities.
Why Have Both for One Piece of Real Estate?
Owning both an OpCo and a PropCo, allows an owner to protect their two major business functionalities from each other. If the business suffers an operational disaster, like a customer slipping in a puddle of pasta sauce, that liability belongs entirely to the active business entity. On the other hand, if the business suffers a more structural or maintenance issue, like physical building decay, the day-to-day operations and cash flow from those operations remain safe and guarded. It separates both functions from each other and prevents a bad day on either the operational or the structural side from wiping out the business as a whole. It is a tried and true best-practice way to segregate a safe valuable asset from a dangerous, risky asset.
Can I Use a Delaware LLC for Both Entities?
Yes, Delaware LLCs are the ideal mechanism for both an OpCo and a PropCo. You can form two distinct Delaware LLCs in order to utilize Delaware’s world-class liability protection to wall off each aspect of your business. To make sure this works correctly, all you have to do is ensure each entity stays in its proper business functionality. The OpCo LLC must focus solely on the operational side of the business, while the PropCo LLC deals exclusively with the physical property side.
As long as you maintain an arm’s length lease, separate bank accounts, distinct accounting records, and make sure they are two distinct legal entities operating under one roof, Delaware law will ensure that both sides of your business are effectively protected. LLCs formed in other states are risky because many state laws allow creditors arguments for piercing the liability shield, unavailable to a creditor of an LLC formed in Delaware, no matter where it operates.
What Are the Tax Advantages of the OpCo PropCo Structure?
The LLC-owning real estate PropCo is a pass-through partnership or sole proprietorship that allows any appreciation to be taxed as long-term capital gain at a lower tax rate than ordinary income to either an S-Corp or a C-Corp. Also, income from rent is not subject to self-employment tax because it is a passive activity. The LLC owning the OpCo would make an S-election to be taxed as an S-Corp to reduce the owner’s self-employment tax exposure. The S-Corp allows income to be split evenly between self-employment income subject to FICA taxes of Medicare and Social Security, and an S-dividend not subject to self-employment tax, saving the owner thousands of dollars of taxes per year.
How to Form an OpCo PropCo Structure
At first, these structures may seem intimidating or complex because they have different designations than a traditional LLC, but in reality, an “OpCo” or “PropCo” is solely a descriptive label on how these traditional LLCs are being used.
When it comes to forming them, both LLCs can be formed contemporaneously, or you can start with one and form the second one afterwards when deemed necessary. Selecting which one to form first depends mainly on your current operational needs. If you are buying commercial property first, you might need the PropCo immediately. But if you are already running an active business leasing from someone else, a PropCo wouldn’t be necessary because you don’t actively own the real estate.
Importantly, each LLC should be “brother-sister” entities owned separately and not structured as parent-child subsidiary relationships. Stacking entities where one LLC owns the second LLC in this context could defeat the asset protection and tax planning advantages of separating them.
Another mistake would be to form the LLCs in one of the dozens of states with weak LLC protections, such as California or Pennsylvania. The best practice is to form these LLCs in Delaware.
Takeaway
Use two LLCs: one for daily operations (OpCo) and one for real estate (PropCo). The OpCo handles customer-facing activities, liabilities, and operational risks. The PropCo owns real estate, which is insulated from operational liabilities. This structure offers tax advantages and separates risks, safeguarding assets and cash flow. Delaware LLCs offer strong liability protection, even across states or countries.