Risk is part of everyday life.  In both your business and personal life, you evaluate risk in any relevant decision you make.  Is this car safe?  Is this food healthy?  Will I lose money on this investment?  These are examples of how we analyze risk in our day to day lives.  For the small business owner, there may be less insulation between risk and possible loss than for a peer whose earnings come in the form of a salary paid by a larger corporation.  Hence, considering risk and ways to limit it should be part of the business owners’ regular review of the health and stability of their enterprise.

Marketing and advertising can help a small business focus on growth by finding more clients and creating either a broader or more profound presence in the marketplace.  However, a natural consequence of growth is increased risk exposure.  New clients or customers bring the possibility of financial rewards through serving their needs and sending those clients out to act as future referral sources.  But, that same new customer also represents an additional point of exposure to risk, as does a new vendor, new employee, new business partner, and so on.   A dishonest partner or sloppy employee can destroy a business in a fraction of the time it took to build it.  So, as you think about marketing and growth strategies, it is also important that you balance it with risk management strategies, as well.

Books on the topic of ‘risk management’ fill several shelves at the local bookstore or library.  However, even with all of the available analysis on the topic, good risk management can be accomplished using a basic three-part method; forming and operating a limited liability entity, using third-party insurance, and implementing sound business practices.  While there is no way to eliminate risk associated with running a business, implementing this three-part method will reduce significantly an owner’s personal liability for claims arising against the business.  What follows is a brief analysis of how each part works on its own and together.

Forming and Operating a Limited Liability Entity:

If you are operating a business that interacts with the public in any way, then your business has enough risk exposure to justify forming a limited liability entity.  Put simply, if you are operating a business, you should incorporate.  The primary benefit of forming a limited liability entity is that, when formed properly, state law recognizes that entity as a wholly separate legal ‘person’ distinct and separate from its owners and organizers.  The effect of this ‘legal fiction’ is that when the entity is properly formed, organized, and operated, the claims and liabilities arising against the entity will not pass through to the owners of the entity.  Those liabilities will be attributable to the entity alone.  While there are several forms of limited liability entities, such as S-Corporations, Limited Liability Companies, and Limited Liability Partnerships, each accomplishes the same basic purpose of shielding the personal assets of the entity’s owners from the creditors, judgments, or other obligations of the entity.

Third Party Insurance:

After forming a limited liability entity to shield a business owner against personal liability for business risk, the next step is to pool the business’s risk with other businesses and individuals.  This is done through purchasing insurance.  Buying insurance is the equivalent of purchasing admission into a club where all the other members are risk conscious businesses and individuals.  By agreement a portion of every members’ ‘admission’ is pooled to pay potential claims arising against the members.  If a limited liability entity is a shield protecting business owners from personal liability, third party insurance either funds the legal defense of the entity or pays claims that arise against it.  While limited liability entities protect business owners from losing their personal assets to business claims, third party insurance protects the business from losing business assets to claims.  Using an entity without insurance would make investment and growth of a business a moot point – while the owner’s home, car and personal funds would be shielded by the entity, only one major judgment against the business would wipe out all its assets without the backing of insurance.

Sound Business Practices:

Using sound business practices runs the gamut of sophistication for operating a business; from developing and refining detailed internal safety protocols to using good old-fashioned horse sense.  While incorporation and insurance are reactions to unseen risks, developing good business practices are proactive methods to steer clear of risks before they become liabilities.  So many business practices are industry-specific; it would be impossible to cover all of them for the purposes of this review.  However, some areas which affect almost all businesses are employees, premises, government, vendors, and customers.

For employees, some suggestions are using good screening and hiring practices, uniformly enforcing company employment policies, investing in training, and retention of quality workers.  For premises, some suggestions are complying with local licensing and permitting, keeping the premises safe for customers and employees, and developing a security or loss prevention plan.  Regarding government, know the regulations affecting your industry, especially in the area of taxation.  When dealing with vendors, know the markets for competitive prices, use good written contracts, and take the time to learn about your vendors to develop trust in their product, service and reputation.

Finally, and most importantly, for customers, use several of the previously mentioned techniques such as providing safe premises and using good written contracts where appropriate (or required by law).  But moreover, work to develop and maintain a reputation for excellent customer service.  In the most basic terms – happy customers don’t sue. Though it seems an oversimplification, customers, vendors and employees who are treated with professionalism, respect, patience, and fairness, even in the midst of serious disagreements, are less likely to turn to litigation (or violence!) to resolve the dispute.  While this is entirely within the control of a business owner, it is amazing how frequently it is overlooked.

If you are operating a business, even as a supplement to another job, or are otherwise self-employed and not using the techniques mentioned above, you could be compelled to pay the obligations of the business out of your personal bank account, with your car, a family heirloom, or even your home.  This should be sobering.  If you have employees, are you able to monitor them at all times?  If you are monitoring them at all times, why are you doing so?  The point of hiring others to assist you is to delegate responsibility so you can do other tasks.  Because you cannot be two places at once and may not be able to prevent an accident even if you could, you should implement these basic risk avoidance techniques.  Develop relationships with qualified insurance, accounting, and legal professionals.  Fortune 500 companies have insurance, accounting and legal departments; you should not act differently.   In doing so you will be on your way to minimizing risk, protecting personal assets, and improving your business’s chance for future success.  And you might find some peace of mind in the process.

Several years ago, hardly anyone had heard of limited liability companies (“LLC”). Now businesses operate as LLCs in all states, and the press and media have nothing but good things to say about them. Is all the hype justified? Much of it is, especially where the business involves the ownership of real estate. Limited liability companies offer an unprecedented combination of corporate-like liability protection and partnership pass-through taxation. In addition, if anonymity is a goal, you can achieve this by naming the LLC whatever name you desire so long as it is followed by the words “limited liability company” or a variation or abbreviation of these words.

Unlike limited partnerships, limited liability company “members” don’t have to limit their participation in the firm’s management to protect their personal assets from the firm’s creditors. Yet they can qualify for true partnership taxation.

LLCs also have a number of distinct advantages over S corporations for many businesses. They are not restricted to a single class of stock as S corporations are, so LLC members have a greater ability to allocate gains, losses, deductions, and credits. Also, there are no limits on the number or kind of shareholders, giving LLCs greater access to capital. In addition, LLCs have certain tax advantages over S corporations when it comes to the ownership of real estate.

All of this makes LLCs the entity of choice for holding real estate for start-up ventures. However, should established investments be transferred into an LLC? The answer is maybe. If the real estate is presently held in the name of one or more individuals, the property could and probably should be transferred and held in an LLC so as to achieve the liability protections to which the owners of LLCs are availed. In the case of multiple individual owners, holding property in an LLC will also provide for centralized management of the real estate, avoiding disputes that occasionally arise between individuals holding real estate as tenants-in-common. The transfer of real estate by an individual into an LLC generally will not result in a taxable event for income tax purposes.

Similarly, if the real estate is presently owned by a general partnership, the general partnership can usually be converted to an LLC, thus achieving liability protection, without causing a taxable event for income tax purposes. In fact, the conversion of a general partnership to an LLC can typically be accomplished without even changing your federal identification number because both entities are treated as partnerships under the tax code. There are very few circumstances today in which a general partnership is the entity of choice for real estate investments or for other types of businesses.

If the real estate is presently owned by an established corporation and the real estate has appreciated since it was purchased, the tax cost of converting to an LLC is probably prohibitive because distributing the real estate from the corporation will result in a taxable event.

In summary, most start-up real estate ventures should typically be organized as LLCs, and existing ventures should at least consider converting to an LLC.

If you’re like most people, you don’t like to think about planning your estate. But it’s an important part of ensuring the financial security of your loved ones. One of the easiest and most common tools used in estate planning is a program of giving gifts. Gifts can reduce the size of your estate that is subject to tax while still passing on wealth. Gifts can also serve a function in your income tax planning by shifting income-producing property to others who are in a lower tax bracket. Not only will gifts enable you to remove assets from your estate, but gifts will also enable you to remove future appreciation of such assets from your estate.

While many gifts are subject to gift taxation, you can give away up to $12,000 (2008) per recipient per year free of gift tax. These gifts also do not reduce the amount that you can pass free of estate tax. There is a great deal of flexibility in the types of property that can be transferred. Qualifying gifts can be money, real estate, stocks or other business interests, or even a life insurance policy. The gift may also be made through a trust so that the actual distribution of the property can be made at a time when the recipient has the maturity to deal with the asset.

You can give up to $24,000 (2008) per recipient per year if you’re married and your spouse consents to “split” your gifts. This is useful for spouses who do not own an equal amount of property. The spouse with less property can consent to gifts made by the wealthier spouse, thereby effectively doubling the amount that the wealthier spouse can give away tax free.

One important thing to remember when you make a gift of appreciated real estate is that the recipient must take your basis in the real estate. This means that if the recipient sells the real estate, any gain on the sale will be measured using what you paid for the real estate, not what the real estate was worth when he or she received it. In contrast, if real estate is transferred to another through your estate, the recipient can use the value of the real estate at that time in measuring any gain on the sale of the real estate. This increase in the tax basis is known as receiving a “stepped-up” basis. Consequently, choosing the right asset to give is an important aspect of any gift-giving program.

If used properly, a program of gift-giving can benefit everyone involved. If you have any questions about the best way of using gifts as part of your overall financial plan, please contact us.

A well-known, but sometimes overlooked, way to buy and sell real estate without paying tax at the time of the transaction is through the use of “like-kind” exchanges. In a like-kind exchange, investment property is traded for other investment property. The person transferring one piece of property receives different property but keeps the same basis as that for the old property. That way, the gain is deferred while other tax attributes are preserved.

Of particular interest are the flexible features that make a like-kind exchange an especially useful technique. First, properties do not have to be of identical type to qualify as like-kind. To take a few examples, commercial buildings may be exchanged for unimproved lots, farm land for city lots, and even cooperative housing stock carrying occupancy rights for a condominium interest in the same property.

Second, properties do not have to be exchanged at the same time. Therefore, it is not necessary to have already located the exchange property to make a like-kind exchange (an important consideration if the end of a tax year is looming). It is sufficient that the exchange property be identified within 45 days after the relinquished property is given up and that the identified property be received within 180 days.

To illustrate how these exchanges can work,
consider the following example:
Fred owns an interest in an office building. He bought it years ago for $10,000, but today it is worth at least $100,000. Fred has decided to move to Florida and convert his office building interest into an ownership share in a Florida apartment building. Allison wants to buy Fred’s office building interest, and for tax reasons she wants to own the building interest by December 31. Fred wants to avoid the high tax he would have to pay after a cash sale.

A solution is a deferred like-kind exchange. Fred transfers his building interest to Allison on December 31. Allison agrees to locate and buy a Florida apartment building interest of equal value suitable to Fred. (Fred can even insist that Allison put the purchase price in escrow, so long as Fred has no independent right to use the purchase price.) After Allison finds and buys the Florida property, she transfers it to Fred, and the like-kind exchange is completed. Provided the 45/180 day rules along with other requirements are satisfied, Fred receives the Florida property tax-free, with the same basis and holding period he had in the office building.

In fact, it is even possible to not include Allison in the latter transaction if a Qualified Intermediary is used. For example, Fred could sell his office building to Allison with the proceeds of the sale held by the Qualified Intermediary until Fred identifies a new piece of real estate (must be accomplished within 45 days) and closes on the new piece of real estate (must be accomplished within 180 days). At the second closing, the monies held by the Qualified Intermediary would be paid to the seller of the second piece of real estate and the like-kind exchange would be successfully completed without any further participation by Allison.

As you can see, a like-kind exchange can be an excellent planning tool. Even in situations where it is impractical to arrange a completely tax-free transaction, like-kind exchanges may still reduce the immediate tax consequences of altering your investment holdings. However, as with most tax planning strategies, in order to qualify for like-kind exchange tax treatment and benefit from the accompanying tax savings, certain technical requirements must be met. Careful planning should therefore be undertaken in arranging the transactions.