In our fourth and final installment of our continuing series on entity selection for owning real estate, we will address the business and tax law considerations concerning limited liability companies.
What is a Limited Liability Company?
Limited liability companies (LLCs) are the most popular choice of organizational form because of the inherent flexibility in most state statutes that enhances the ability of the entity to adopt features that best serve its objectives. LLCs are a very common choice for owning real estate because of their tax treatment, limited liability and flexibility in allocating power structure and management responsibilities.
The best way to understand the unique features of an LLC is to distinguish it from the other entities we’ve discussed in Parts I – III in this blog series. The principal purpose of the LLC is to obtain favorable tax benefits along with the limitation of liability.
Advantages and Disadvantages of an LLC
Real estate investors are well served by forming the LLC in a state that has favorable limited liability company act statutes, like Delaware (or Illinois after recent amendments to its Limited Liability Company Act). The goal is to pay no federal income tax at the entity level. An LLC provides an unlimited number of investors with the limited liability of a corporation but the tax advantages of a partnership.
On the other hand, significant disadvantages exist by using the corporate form for real estate investment. The individual shareholders cannot obtain any of the tax benefits generated by the investment. Unlike a partnership, no pass-through of the corporation’s income tax deductions exists. Corporation profits are also taxed twice - once at the corporate level though the payment of the corporate income tax and again at the shareholder level with the shareholder’s payment of individual income taxes on the distributions received from the corporation. An LLC allows the losses and gains to flow through to the investors.
Subchapter S-corporations allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits on to the shareholders while still providing them with limited liability. Nevertheless, an S-corp cannot have different power allocations among the shareholders. In other words, an S-corp is a corporation that will not allow the investors to establish an unbalanced management structure. The investors can decide who will be active in decision making, operating the property and spending time on a regular, continuous, and substantial basis.
How to Form and Operate an LLC
Two documents are needed to form and operate an LLC: Articles of Organization and an Operating Agreement.
An LLC is formed by filing Articles of Organization with the applicable Secretary of State and paying any applicable fees. The Articles of Organization must comply with the enabling legislation enacted in the state under whose laws the LLC is formed. Many states allow the filing to be done electronically, others require sending the paperwork in to the Secretary of State.
The Operating Agreement provides for the operation of the LLC. It is the controlling document that governs the relationship between the members, managers, and the obligations of each.
The Operating Agreement can spell out power allocations and management responsibilities of the members and managers as well as an exit strategy. There is no need for a board of directors or elections because the members just file forms and pay fees to the Secretary of State. The LLC also creates and maintains contractual flexibility. All of the members have the authority to make management decisions unless a different power structure is adopted.
An LLC can be manager- or member-managed. The managers or managing-members who make management decisions on behalf of an LLC generally have limited liability protection. They are not personally liable for the debts and liabilities of an LLC unless a basis to pierce the limited liability shield exists as may be required by public convenience, fairness, or necessity. An LLC will insulate a member’s personal assets from claims of outsiders and other members.
In many instances, an LLC provides investors with the best entity for their individual and collective needs. Unlike a C-corporation, there is no need for a board of directors, meetings, or elections because the members just file forms and pay fees. An LLC is free from qualification restraints imposed on a S-corp.
How to Dissolve an LLC
LLC organizers can provide for the LLC’s dissolution on a fixed date in the filed Articles of Organization or continuation in existence until dissolved by the consent of the members or on the occurrence of an event specified in the Operating Agreement. Insofar as the payment of claims, members can arrange for the liquidation of an LLC’s assets to pay current claims, fund reserves for the payment of contingent claims, and determine the proportion of the remaining assets distributable to each member based on the member’s capital account or other measure specified in the Operating Agreement. When the members are ready to wind down and terminate, an LLC can proceed to file Articles of Termination with the applicable Secretary of State after claims have been paid and all remaining assets have been distributed to members, file a Certificate of Cancellation canceling the LLC’s Certificate of Authority to transact business in states other than the state of its organization (if any), and arrange for the filing of a final income tax return for the LLC.
The LLC generally provides real estate investors with a superlative choice for their individual and collective needs. Nevertheless, individuals should consider the following factors in their entirety when selecting the business entity for purposes of owning real property:
- How long the investors wish to keep the property
- Nature of the relationships between them
- Personal liability
- Tax treatment
- Management structure
- Number of investors
- Duration of the entity
- Exit strategy
- Allocations of power within the entity
- Any other special provisions