By Sam Matthews
In today’s climate, hospitality owners struggle with rising food costs, rising labor costs, supply chain issues, labor shortages, patron COVID-related fears and concerns, and additional governmental regulations on a day-to-day basis. Since the onset of the Covid-19 pandemic, for example, food costs and labor costs have risen by approximately 25%. Increased food and labor costs have both significantly, and adversely, affected the bottom line. Together, all these issues have made the operational component of a hospitality owner’s job extremely challenging, and overall, less profitable.
Another major source of pressure for restaurateurs are increased risks of Department of Labor Wage and Hour Audits and Wage and Hour civil lawsuits. These audits and lawsuits typically name the employer as the respondent or the defendant. Fortunately, many restaurants are formed in the name of a legal entity, which affords the restaurant owner the legal protection of no personal liability. There are, of course, exceptions. Under certain circumstances, the “corporate shield” neither exists, nor protects the business owner from personal liability. These circumstances arise due to New York Business Corporation Law section 630(a), which subjects “The ten largest shareholders…of every domestic corporation or of any foreign corporation, when the unpaid services were performed in the state…shall jointly and severally be personally liable for all debts, wages or salaries due and owing to any of its laborers, servants or employees…for services performed by them for such corporation.” In other words, the ten largest shareholders are personally liable when these types of cases arise.
Typically, in the industry, there are no more than 2 major shareholders in restaurants. These shareholders tend to be the daily operators of their business, and thus have invested and continue to invest all their time and money to sustain and maintain their primary and sole source of income. This investment is of course compounded by the pressures of employing upwards of 40 plus employees. Understandably, the prospect of this personal liability exposure can be daunting for these shareholders, as it could potentially “wipe out” not only their business, but also their personal assets.
In order to limit or protect their primary residence from this personal liability, a “shareholder” may want to consider purchasing their residence in the name of a legal entity. The most preferable choice of legal entity, in this scenario, being a limited liability company. The protection of an LLC is similar to that offered by a corporation. An LLC can be made up of a single or multiple individuals, i.e., a spousal couple. The primary benefits of the LLC are (i) that it limits personal liability to third party claims, (ii) that it is easy to register, and (iii) that the individual members are taxed as sole proprietors, which is typically a lower tax bracket than a shareholder in a corporation.
Unfortunately, legal entities such as an LLC do also have disadvantages.
- The first disadvantage in this scenario is that the LLC originator will need to incur several expenses including (i) expenses to file and register the LLC with the state of formation, (ii) expenses to file the annual and separate tax returns for the LLC, and (iii) expenses to file and pay an annual registration fee for the LLC. Should the entity choose to hire an attorney or accountant to complete these tasks, the entity may also incur those costs.
- The second disadvantage is that, in the event of bankruptcy and forced sales, an LLC is typically not afforded the protection of the Homestead Protection Law. This effectively means that, should either of those situations occur, the LLC will lose capital gains deductions with the IRS.
- The third disadvantage is that, if the LLC is applying for financing to purchase the members primary residence, the LLC will traditionally have increased closing costs. Such closing costs include: (i) higher interest rates, (ii) higher closing origination lender fees, (iii) higher down payments, (iv) higher insurance premiums, and (v) the members will probably have to provide a personal guarantee on the loan.
These are all legitimate factors that a hospitality owner must consider before they decide to purchase their primary residence in the name of a legal entity. If you want to learn more about the pros and cons of this transaction, reach out to the knowledgeable transactional and litigation attorneys at KI Legal.
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