By Garrett Sutton, Esq
The state of California has implemented rules (and costs) for business owners and holders of real estate located within California. 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 and their attorney are subject to Wyoming’s charging order law. 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 collected. Attorneys, quite reasonably, don’t like to wait to get paid. Hopefully, you have enough insurance, including an umbrella policy, to cover the claim. But with having LLCs in place making further collection difficult you have set up an excellent roadblock
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 forestall such an outcome.
The problem is that California has a very 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. (California’s pension liability to state workers is now $1 trillion!)
Just recently the state of California’s tax department, the Franchise Tax Board (FTB), has determined that if a California LLC has an out-of-state entity as a member then that member entity is doing business in California and must pay the $800 minimum annual fee. So in our previous example, the chart becomes:
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:
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:
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 disturbing trend and are voting with their feet. They are buying real estate elsewhere.
Of course, the state of California has its say when their residents invest out-of-state. Suppose a California resident invests in an Arizona duplex. A chart helps to explain how this can be structured:
In this case, the Arizona LLC is on title to the local real estate. The Wyoming LLC owns the Arizona LLC and thus we have the better asset protection in the event of an Attack #2 claim. Wyoming in turn is owned by our California resident, who will pay California taxes on any income earned from the Arizona real estate activities.
But that is not enough for the FTB. Their position is that if the California resident is managing the Wyoming LLC from California then the Wyoming LLC is doing business in California. As such, the $800 minimum annual fee is due. While this is frustrating and offensive for many of our clients, this is the state of affairs in California. It is your choice on how to handle it.
Please know that, the laws and taxation of California are ever changing. The best strategy is to call our offices for assistance with California asset protection.
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 at 1-800-600-1760 or by filling out a form on this page.