For individuals who wish to invest in commercial real property, there is a great deal of interest in what is the best entity in which that property should be held. What entity offers the greatest tax advantages, and the least liability?
For this answer, most turn to the Limited Liability Company. A completely different animal from the standard Subchapter C or S corporation, the LLC has become the favored choice for those with real estate holdings.
What are some of the advantages??
• Liability protection for the “shareholders” known as managers and members
• Flow-thru tax status on the company’s profits and losses – ie; report on your personal return
• Flexibility in practices – no requirements to follow state laws mandating allocation of profits to shareholders, annual meetings, etc.
• Ease of transfer of properties in and out of the entity with minimal tax consequences to the members
• Less administrative paperwork
• Ease of passing of assets upon death
Let’s explore some of these advantages, and discuss some of the differences between LLCs and S-Corps and C-Corps.
TAXATION: With the standard C-corporation, there is a double taxation issue. Upon filing of the corporate tax returns, the corporation is subject to corporate income tax, and then when the monies remaining are distributed to the shareholders as dividends, those dividends are taxed on the individual shareholder’s personal return. This “double taxation” led to the reliance on the Subchapter S-Corporation. The S-corp became an attractive business entity in that the income from this type of corporation is “passed through” to the individual, and thus reported on the individual’s personal return. Like the S-corp, the LLC offers the same type of pass through taxation, thus relieving the members of the double taxation.
STRUCTURE: With a corporation, each state has its corporate laws that dictate the activity of the corporation. There are often restrictions on who can be shareholders – no more than 75 shareholders are allowed, and there are restrictions on residency from state to state. There are strict requirements for record-keeping, and there is a board of directors which manages the company. There are restrictions on how profits are divided. Under corporate laws, profits must be divided based on the amount of stock each shareholder owns. Therefore, there can be no adjustments made in profits distributed to those who may be responsible for the day to day operations of the company. If a shareholder only owns 10% of the stock, they can only receive 10% of the profit, even if that shareholder does 80% of the work. With the LLC, there is greater flexibility, and no requirements for record-keeping. There are no restrictions on distributions of profit to the managers and members, and managers do NOT have to be members or owners.
LIABILITY ISSUES: The LLC offers the members protection from liability. For commercial property owners, this is a great advantage. Suppose someone slips and falls on your property, or worse yet, trespasses on your property without permission and gets injured? These situations could drastically impact your personal financial situation if you are not insulated somehow from liability. Of course, having an LLC hold your properties is no substitution for carrying the requisite amount of liability insurance. In fact, if you are purchasing property, the lender will require that you carry enough insurance on the property commensurate with the value of the loan they are extending. Keep in mind, however, that the insulation from liability offered by the LLC DOES NOT EXTEND TO your personal guaranty to your lender. That is something the owners are wholly responsible for and the corporate entity offers no insulation on that level.
TRANSFER (CONVERSION OR TRADE): If the property owner would like to convert the commercial property to personal use property, or trade the property in a like/kind exchange for tax purposes, the LLC can be a handy tool. Such a transfer, under the rules governing S-Corps, would be deemed a sale, and thus a taxable transfer. If such transactions are conducted within the confines of the LLC structure, these tax implications can be avoided with careful planning and the assistance of a tax professional who is well-versed in LLCs.
THE LLC AND ESTATE PLANNING: The LLC offers a useful tool for the transfer of estate assets. Since the LLC has complete flexibility in structure, it can act like a corporation or a partnership. For estate purposes, it can be structured like a Family Limited Partnership. The designated managers (general partners) are responsible for the management of the company and its assets. The members (limited partners) are more like investors, whose role is really quite passive. The members are not in control. The transfer of assets is similar to the limited partnership in that the transferors (the parents) form the LLC, make themselves both members as investors and managers, responsible for the operations of the company and its assets. The heirs (children, grandchildren) are the members, with a passive role in the company and its assets. Just as would be the case with a Family Limited Partnership, over time, the managers transfer membership interests to the heirs, by gifting within the guidelines of the federal gift tax exclusion amounts, while the parents, as managers, maintain control of the operations and assets of the company. This type of estate planning technique is controlled by IRC section 2036. Again, the use of the LLC entity as an estate planning tool should only be done under the supervision of an attorney who is well versed in this type of transaction, and the Internal Revenue Code section sited herein.
While there are certainly many advantages to the formation of an LLC to hold and transfer real estate investments, there are also disadvantages. Some of these include, but are not limited to, the imposition of self-employment tax on the members, lack of uniformity among state statutes governing LLCs, and lower minority discounts in regards to estate planning issues.
Is the LLC the right entity for you to set up to hold your real property assets? In order for you to answer that question, you must sit down with both an attorney and a tax professional who knows LLCs inside and out. Each individual circumstance must be examined on its own set of facts. However, if it is indeed the right fit for you, it can be a simple, and useful way to control your investment, and transfer it to your heirs with ease, and peace of mind.
** Please note that this article is provided as opinion and information only. Kindly check with your legal or tax professional for legal or tax advice**
