You have just found the perfect commercial real estate asset to invest in, whether it is an apartment complex, a strip mall, or a building to house your expanding business. As you get ready to write the offer, your broker asks, “How are you going to take title?”
The answer to that question is very important for three reasons:
- Liability Protection: If something unexpected happens, do you really want
your personal assets at risk?
- Taxation: How you hold title will affect the way you will be taxed both
during the holding period and of course when you sell the asset.
- Exit Strategies: How you hold title can affect what exit strategies will
be available to you when it comes time to sell.
The overriding consideration and primary reason to create different “ownership baskets” is to build a liability shield for both personal and other assets. So long as the owner of an entity observes the entity formalities, a creditor should not be able to reach the owners assets to satisfy the liability of the entity.
Of course, once you start using entities for liability protection, then the next considerations that come into play are taxation and exit strategies.
The big consideration in taxation is using an entity that avoids creating extra levels of taxation as well as avoiding employment tax where possible. When these considerations are taken into account, the two top entity choices that emerge are Subchapter S Corporations (S Corps) and Limited Liability Companies, or (LLC).
S Corporation or an LLC?
The two predominant issues that will help you answer that question are the issues of self employment tax and the distribution of appreciated assets.
In S Corps there are no self employment taxes on the distribution of profits to owners. So if you own a profitable operating business and you take a reasonable salary, then you can take the remaining profits of the S corporation as distributions and avoid paying self employment taxes on those distributions. With an LLC you will generally be required to pay self employment taxes on distributions from the company. Therefore as a general rule if you are structuring for a profitable operating business you should use a S Corp.
Alternatively, if you are creating an entity that will hold appreciating assets, like real estate, then a primary consideration is whether you can distribute the appreciated assets to the owners of the entity without creating a deemed sale. Deemed sale means that for tax purposes the IRS will treat the conveyance as a sale of the property for fair market value, and tax the transferror as if a sale had taken place. Therefore there is a tax event without a cash event, thus creating undesirable phantom income.
In an S Corp, the transfer of an appreciated asset to the shareholders is deemed sale. In an LLC it is not. So, as a general rule if you are holding real property in an entity for the always important limitation of liability, then the proper entity is an LLC.
As an example: Joe Developer owns in his own name four apartment buildings in four different cities. If there is a liability-creating event in excess of Joe’s insurance limits, the creditor can take all four buildings and also Joe’s house.
A better ownership structure is for Joe to create four separate LLCs and convey each apartment building as a capital contribution to each separate LLC in exchange for the ownership interest in the LLC. That way, when the same liability event occurs, the creditor can take only the one apartment building where the event occurred and not the other buildings or Joe’s personal residence.
Another example: If Jane Manufacturer as a sole proprietor owns land and a building in which she operates a profitable manufacturing business, and if she suffers a large product liability judgment, the creditor can take Jane’s business, her land and building, and her house.
With proper structuring, by conveying the operating business assets in an S Corp, and the land and building in an LLC, each owned by Jane, and then creating an arms length lease between the two entities, the same judgment creditor could only take Jane’s manufacturing business, and not her land or her house.
As you can see from the examples above, how you take title to assets matters. With proper structuring of entities it is possible to minimize both tax consequences and liability exposure. As there are exceptions to every rule, both legal and tax wise, it is critical to involve competent legal and tax counsel in planning and creating these entities and this article is not meant in any way to be a substitute for tax or legal advice.
This article is based in large part on a presentation regularly delivered by Coni Rathbone, a partner in the law firm of Zupancic Rathbone Law Group PC, Lake Oswego, OR. Coni practices in the area of real estate transactions leasing and development, real estate securities, business transactions, and tenant-in-common syndications and workouts you can reach her at (503) 968-8200 X19 or Coni@ZupGroup.com