The Problem with Business Entities for Real Estate Investors
If you own rental property you have probably explored the idea of forming an LLC or corporation to protect your assets. After all, you don't want to be sued because of a problem at your rental properties, whether they are residential or commercial.
In exploring potential business entities, you likely talked to a CPA, an attorney, or your insurance agent. They likely advised you that you certainly can form an LLC or corporation - it would provide you the liability protection you seek - but it may not be the best idea for two reasons:
- Franchise and Excise Tax. LLCs and corporations have Tennessee franchise and excise tax exposure. While under some circumstances these taxes can be avoided, most LLCs and corporations are going to be subjected to taxation, especially if you own commercial property or multi-unit residential properties.
- Annual Filing Fees. The State of Tennessee attaches a fee to being able to have liability protection. Every year, you must file the annual report along with an fee to continue to ensure your LLC or corporation is in good standing with the state.
So what is the advice that most CPAs and attorneys give their clients? Just load up with higher liability insurance limits. Skip forming an LLC or corporation. Having greater amounts of insurance will provide cushion for you if you are personally sued for an issue with your properties.
But is that the best solution? Paying more for higher insurance premiums in the hope that your policy limits will be enough if you are taken to court?
For some, that may make sense. It's simple. It's logical. But it costs you more money in the long run. You have to pay the taxes and filing fees.
Is there a better solution? One that give you the best of both worlds – liability protection and tax and fee avoidance without having to pay increased insurance premiums every year?
Yes, there is an alternative that not too many people know about.
The Solution - The Tennessee Investment Service Trust (TIST)
Well what's the solution? In short, it's a special type of asset protection trust that only Tennessee has. The trust is called the Tennessee Investment Service Trust – or TIST – for short. TISTs allow you to enjoy:
- The same liability protection you get from an LLC or corporation
- Avoid paying the franchise and excise tax and annual filing fees
Here's how the TIST works:
You create the TIST and name a close family member or business partner as the trustee of the trust. (The trustee must be a resident of Tennessee). You name yourself as the beneficiary of the trust. Because you do not personally own the assets – the TIST does – you have no personal liability. The trust provides the same liability protection as an LLC or corporation. When assets are held by these businesses entities, the members have complete liability protection.
What's more, because these TISTs are not “business entities” such as an LLC or corporation, there is no need to file annual reports with the state or to any other regulator. Additionally, the Tennessee franchise and excise tax does not apply because it only governs certain business entities.
Before we get into the details of the TIST, understand that this is an asset protection trust. As such, if you create an asset protection trust you must give up some control over the assets. Fortunately, Tennessee laws give very liberal powers to you as the grantor – or creator of the trust. I have summarized some of those laws below but they are not exhaustive.
Rights of the Creator of the TIST
Here are your basic rights as the creator of the trust:
- Right to receive all income from the trust. Whatever income you make on the trust will be distributed to you by the trustee. So if you make $1,000.00 a month on a rental property, the trustee will distribute those funds to you.
- Right to receive up to five percent (5%) of the trust assets per year. Let's say that the trust held cash or securities. You could direct the trustee to distribute 5% of those assets per year to you no matter what.
- Right to remove and replace the trustee. Let's say that you initially appoint your spouse as your trustee. What happens if you divorce? Or what happens if you have a falling out with a child who is trustee. You have the right to remove them as trustee and replace them with someone else. The only catch is that if you had to appoint someone else, you cannot appoint a family member.
- Right to manage the investments of trust as the Investment Advisor. You have the ability to direct the trustee to invest the assets of the TIST in certain funds or property. You can basically call the shots as to how the assets are invested.
- Right to Veto Distributions of the TIST. If the trustee wants to distribute certain assets, you can veto any such distribution.
- Right to Maintain a Power of Appointment. You have the right to ultimately say where the assets held in the TIST are distributed at your death.
So what does all that mean? Well from an asset standpoint, it provides great advantages. You have the right to receive all income your properties earn and you have the right to receive 5% of the principal of the trust without question.
Additionally, and perhaps most importantly, the law allows the trustee to distribute an indefinite amount of TIST assets to you based upon the standard of the trust – generally the health, education, maintenance, and support of the beneficiary. Take a moment and think about what each of those categories mean. Pretty broad, right? Because that standard is so extensive, it leaves the trustee with enormous flexibility to distribute the principal to you as beneficiary.
How does all this have to do with rental properties? Great question. To answer it, let's look at an example:
Example of How a TIST Works
James personally owns a commercial property in Tennessee. In the past, he has discussed with his advisors about forming an LLC or corporation to shield him from any liability that may arise from owning the property. However, due to the expense of the franchise and excise tax, he decides to just hold the properties in his personal name and increase his liability insurance.
Instead of keeping the property in his name, James could take the property and place it in a TIST. He could name his wife as trustee of the trust and he would be the beneficiary. His wife would manage the trust for his benefit and he would still have some significant control over how those assets are managed. Moreover, he would still have the ability to personally keep all the income produced by the property. If the property ever needed to be sold, he could direct the trustee to sell the property and purchase another. He could even direct his wife to move the assets to another different investment.
If James is ever sued, he has 100% liability protection because he does not own the assets himself. If a person was injured on his property, the property itself has exposure because it is in the trust, but James' personal bank accounts and home are protected.
Additionally, what happens if James is sued for causing a car accident? Would the assets inside the TIST have exposure? No. They are completely protected from any personal liability James may face. This feature is distinguishable from traditional LLCs and corporations as creditors can go to court and attach the assets of those entities.
Qualified Affidavit Required
If you want to achieve liability protection, you must file a qualified affidavit every time you place assets in the TIST. Tennessee has specific laws on what must be on the affidavit. Here is a summary of what the affidavit must say:
- At the time of transfer, you personally own the assets conveyed to TIST
- Your transfer of the assets to the TIST will not render you insolvent
- You are not intending to defraud creditors
- All current court actions or administrative proceedings must be listed
- You do not intend to file bankruptcy
- All assets transferred to the trust were not derived illegally
Once both the TIST and the qualified affidavit are executed, the TIST does provide complete asset protection from debts which arise after the TIST is created. For example, if you create the TIST January 1 and on July 1 you have a judgment against you, the assets in the TIST are completely protected.
For any debts that existed prior to the formation of the TIST, after two (2) years those assets are complete protected from creditors. This two-year period can be shortened to six (6) months if the creditors have notice for the transfer of assets to the TIST.
Taxation of TISTs
TISTs are called “grantor trusts,” meaning that they are taxed under the personal tax rate of the creator of the trust. Many trusts are taxed directly and pay a substantially higher tax rate that individuals. For example, for some trusts, the tax rate if roughly 40% of any income over $12,000.00. The TIST avoids these higher tax rates by allowing the creator to be taxed on the income instead of the trust itself.
Dissolution of TISTs
So what happens when you want to close out the TIST? The simple solution is to simply have the trustee distribute all the assets to you. At that point the trust is simply an empty shell. It holds no property. Alternatively, you can file a petition with the Court to terminate the trust. As long as the trustee joins in the petition, there should be no problem terminating the trust.
How TISTs are Alternatives to Traditional Business Organizations
The way you can use the TIST as an alternative to typical business organization is fairly straight forward:
- Have to have two (or more) partners create two (2) TISTs. One for each partner.
- Each partner names the other as their own trustees. By doing so, each partner controls the other partner's trust.
- The two trusts then form a general partnership. This partnership is then used to purchase investment property. The partnership owns the property and the two TISTs are its members. Each partner has control over the partnership and they each can have control of how the partnership will be run.
This general partnership with the TISTs as the partners has substantial advantages over traditional business entities. Consider the following:
- Avoids the Franchise and Excise Tax
- Avoids the annual filing fees of LLCs and Corporations
- All income is taxed personallyto the individual partners
- Provides the equivalent liability protection of an LLC or corporation
What about discord among the partners? If the partners have a falling out or desired to close their business, the simplest course of action would be for each partner - as trustee - to distribute the TIST property/assets back to the other partner. This action would defund the TIST entirely leaving nothing in it, rendering it a moot entity.
Obviously, TISTs would not be useful for active businesses such as retail, restaurants, etc. Its primary benefit is for married couples or business partners looking to rent, flip, or develop real estate, whether residential or commercial. It would provide them with the liability protection they seek without exposure to the franchise and excise tax and annual state filing fees.
The Key Takeaway
If you are considering investing in real estate or already have properties, considering forming a TIST. They are a great alternative to traditional business entities such as partnerships, LLCs, and corporations. This type of trust provides superior asset protection and allows the creator to have significant control over the investment of the assets within the trust. TISTs have no exposure to the franchise and excise tax and no filing fee is required.
If you have business partners that are investing with you, a general partnership made up of TISTs is a great way to structure a business that provides the same protection as other business entities without the hassle of Tennessee taxes and filing fees.