Choice Of Entity Considerations For Real Estate Investors
One of the most difficult choices for investors in real estate, either new or seasoned, is determining how to take and hold title to their real estate investments. The underlying complication does not lie in determining what entities are available; the difficulty lies in the fact that there is typically no one “right answer” when it comes to finding an entity that will meet the investors objectives. Accordingly, the process is best viewed as determining which of the investor’s objectives are of primary importance, and selecting a “choice of entity” that best fits those objectives.
As a preliminary matter, it is important that investors understand that the purpose of this article is not to advocate a particular entity choice; the purpose of this article is merely to introduce investors to the various manners/forms in which they may choose to conduct business and the benefits/restrictions inherent in each choice. Making an informed choice of entity requires investors to work closely with their advisors to communicate their basic objectives and concerns for their real estate ventures and allow their advisors to describe the various alternatives available to them, the tax and non-tax consequences associated with each choice, and finally make a recommendation if requested to do so. Accordingly, any decisions regarding a choice of entity or any questions that arise from this article are those that should be discussed with a qualified tax and/or legal advisor.
While the types of entities available to conduct business in the United States are expansive, and vary depending on the state in which the entity is formed, the most overwhelmingly common business entities utilized for investing in real estate in the U.S. today are the: (1) Sole proprietorship; (2) General partnership; (3) Limited partnership; (4) Limited liability company; and (5) Corporation of various kinds, including “C” corporations, statutory close corporations; “S” corporations, etc.
The first and most commonly known form in which to conduct business is the “sole proprietorship”. This is frequently used by real estate investors because it is the simplest form in which to operate their business, with the least technical/legal complications. In a sole proprietorship, the real estate investor has total management authority over the business itself, and may elect to conduct some business activities through agents or employees. It is important that investors be aware that while this election is possible, using agents and/or employees to manage or conduct the activities of their real estate investments may increase their risk of personal liability under legal principles known as “agency” and “respondeat superior”, and would be well advised to discuss these risks with their legal advisors.
One of the most features of the sole proprietorship that is unerring attractive to investors in real estate is the overall lack of corporate formalities. Other than compliance with any applicable state licensing requirements, there are no formalities required to conduct business as a sole proprietor in the state of California. Even the licensing requirements for a sole proprietorship in the state of California are minimal: if the sole proprietorship is conducted under a name which does not include the owner's surname, or implies the existence of additional owners, then the owner is required to file a Fictitious Business Name Statement and publish the notice as provided in Bus. & Prof. C. § 17900 et seq., and will be barred from maintaining legal action to enforce an obligation owing to the business until the certificate is filed appropriately. Bus. & Prof. C. § 17918. Finally, disposing of a sole proprietorship in the state of California is equally easy: the sole proprietor may sell the business at will, so that the duration of the business is governed only by the owner’s intent, which is a striking contrast to the restrictions on duration imposed by other entity choices.
Despite the clear advantages of the sole proprietorship in ease of establishment and administration, it is important for real estate investors to realize that a sole proprietorship is not a legal entity in and of itself; at law the owner of the sole proprietorship is still directly responsible for its actions and its debts. This is a very important distinction for real estate investors to be aware of: while this characteristic means that while all profits belong to the business owner, the owner is also solely responsible for any debts and/or losses. Thus, where a sole proprietorship is the elected choice of entity and the business is unprofitable or liabilities are incurred, the owner/sole proprietor is personally liable for those debts/liabilities and all of the owner’s personal assets and wealth are potentially at risk. Further, in community property states like California the community property of the sole proprietor and their spouse is also at risk for the activities of the sole proprietorship, as the community property is subject to attachment by creditors to fulfill the obligations of proprietorship incurred during marriage. [Fam. C. § 910(a)]
The state of California defines a general partnership as a “form of business entity in which two or more co-owners engage in business for profit”. [Corps. C. § 16202(a)]. This definition highlights one of the more problematic aspects of the general partnership, which is that as long as the parties have jointly agreed to carry on a business for profit, they may be considered to be general partners at law even if they have not specifically intended to be 'general partners', drafted a formal partnership agreement or reached an agreement on how to share profits or losses. Since the formation of a general partnership in the state of California is not dependent on particular formalities, this means that there is no corollary requirement that the formation of the partnership be evidencing by writing and that a general partnership may arguably be formed simply by an oral agreement, if that agreement is subject to litigation and is supported by a preponderance of evidence. Accordingly, real estate investors are well advised to discuss informal partnership arrangements with their legal counselors and make sure adequate protections are in place to prevent the relationship as being characterized as a legal general partnership where that is not the intent of the parties.
Unlike a sole proprietorship, a general partnership has some of the attributes of a legal entity separate from the owner. In most important respects, a general partnership is simply a form of co-ownership by several persons; i.e., the partners together own the business assets and are personally liable for all business debts and split the profits and losses amongst themselves, either proportionately or disproportionately, in accordance with a legal document negotiated and drafted at the formation of the partnership evidencing the agreement amongst the parties, referred to as a “partnership agreement”. [Corps. C. § 16306(a)] While the ability to disproportionately allocate profits and losses is frequently one of the characteristics real estate investors find attractive about the partnership entity, investors should be aware that in the absence of a formalized partnership agreement supporting disproportionate allocations, the profits are shared equally after repayment of the initial contributions to the partnership. [Corps. C. § 16401(b)] Partners without written partnership agreements often try to circumvent this restriction later on by characterizing preferential distributions as payment for services rendered by one of the partners; however, in a partnership typically no partner has the right to receive compensation for services performed for the partnership, unless the other partners have specifically agreed to the compensation by written agreement. [Corps. C. § 16401(h)]
When investors acquire title to real estate as a partnership, each general partner has equal right to participate in management and control of the asset. From a practical standpoint, this means determining the manner in which disagreements arising in the ordinary course business will be handled is of preeminent importance. Unless otherwise specified by the partnership agreement, disagreements in the ordinary course of business are typically decided by a vote of the majority of the partners; disagreements over extraordinary matters and changes to the entity’s organizational documents themselves typically require unanimous consent. These requirements are only the standards provided under California’s “default” rules [ [Corps. C. § § 16103(a), 16401(f),(j)]; the partnership is free to determine any other manner of decision-making and provide for it in writing in either the partnership agreement and/or an amendment thereto.
One of the most important aspects of the partnership form of entity is the relationship it creates between the partners. By becoming partners at law, the members of the partnership have agreed carry out the business of the entity with the highest good faith and fair dealing toward each other, and have assumed the fiduciary duties of due care and loyalty to the partnership and each other personally. [Corps. C. § § 16103(b)(3)-(5)]. Partners have potential liability for failing uphold these increased duties of care and loyalty with respect to the partners and the partnership itself.
The large amount of flexibility to allocate profits, losses and/or rights and liabilities among partners comes with correspondingly high levels of personal liability to prevent and/or protect the partners in case of abuse. Generally, the partnership form of entity carries with it liability for each general partner of the partnership as the law treats the partners as “jointly and severally liable” for the debts and obligations of the business of the partnership. [Corps. C. § 16306(a)]. As a practical consideration then, it is paramount for investors in real estate to carefully consider the people that will serve as general partners in the partnership and determine whether or not their relationship is substantial enough and/or secure enough to risk the good deal of personal liability inherent in the general partnership structure. Further, the risk of liability is exacerbated by the fact that generally each general partner is also deemed to be the agent of the partnership in dealings with third persons when acting in the ordinary course of business as defined by the courts, so that each partner may be further jointly and severally liable for liabilities to third parties incurred by a co-partner acting in the ordinary course of partnership business. [Corps. C. § § 16301(1), 16305, 16306]
While it is the common perception that rights and liabilities are negotiable between the underlying partners and may be addressed by the controlling document, such as the partnership agreement, this is not the case when it comes to allocation of liabilities. While the partners may agree among themselves to disproportional allocation of losses and debts, those internal negotiations are not binding on the rights of creditors and/or other claimants who are at law entitled to recover in full from any one or more of the partners as membership in a general partnership. This form a liability is referred to as “joint and several liability”, and means that if one particular partner has incurred liability, all the other general partners may be held equally accountable for that liability. While the other affected partners subjected to joint and several liability may be entitled to contribution or indemnification in accordance with the negotiated partnership agreement, or absent such agreement, in accordance with their respective shares in partnership profits, there is no way for these partners to effectively limit the creditor’s ability to initially attach their partnership interest. [Corps. C. § 16401(b),(c).
Despite the flexibility inherent in the partnership form of entity, the general partners typically can not admit any additional parties to the partnership without unanimous consent of the existing partners, unless the ability to do so has specifically been provided for by the partnership agreement. [Corps. C. § 16401(i)] This restriction does not extend to the ability to assign partnership interests however; the partners typically have significantly more freedom when it comes to deciding whom may receive the benefits of their partnership interest, so that unless otherwise provided for by the partnership agreement, the right to profits, losses and/or right to receive distributions may be assigned to any parties deemed fit. [Corps. C. § § 16502, 16503(a)] Accordingly, partnership interests are generally deemed to be transferable and a judgment creditor may attach a partner's 'transferable interest' to satisfy a judgment lien. [Corps. C. § 16504] Real estate investors may take small comfort in the fact that under the above described scenario, the creditor would only have the ability to acquire the debtor partner's interest in the partnership and any distributions etc. derived wherefrom and would not obtain any rights to property of the partnership or gain any ability to participate the business of the partnership. [Corps. C. § §16503, 16504]
Many times investors are confused by the difference between a “joint venture” and a general partnership. A joint venture typically takes the form of a general partnership, but one that has been formed for the specific purpose of completing a particular transaction, rather than one established for continuous business purposes. This distinction is important for investors in real estate to understand, as joint ventures are particularly effective as a means by which to partner with other existing investors and/or companies that may bring relevant skills or equity to the table to complete a project, without subjecting the partners to an ongoing relationship that may or may not make sense for all parties involved.
One of the major drawbacks of the partnership form of entity is its limited duration at law and the ease in which a partnership may unintentionally dissolved or terminated. The conditions under which a partnership may be dissolved in part depends on the type of partnership it is. If the general partnership at issue is considered to be “at will”, then it may be dissolved by the mere “express will to dissolve” of the majority of the partners. [Corps. C. § 16801(1)]. If however the partnership is deemed to be a partnership of “definite term” or “particular undertaking”, then there are more barriers in place to prevent dissolution. In order to dissolve a partnership of term before the expiration of that term or purpose, one of two conditions must be met: (1) dissolution must be the express will of all partners (not just a majority) or (2) there has been a major event effecting the partnership, such as a partner's death, a bankruptcy filing, a voluntary withdrawal by one or more partners in breach of partnership agreement and/or a judicial expulsion of partners for breach of duty, wrongful conduct, or other impermissible behavior and a majority of the partners have not filed an agreement to continue the partnership within ninety (90) days of the occurrence. [Corps. C. § § 16601(6)-(10), 16801(2)]
There is an important distinction between dissolution of a general partnership for legal purposes and a termination of that partnership for tax purposes. For tax purposes, a partnership terminates on the occurrence of either: (1) the sale or exchange of partnership interests that account for fifty percent (50%) or greater of the outstanding partnership interests [IRC § 708(b)(1)(B); Treas.Regs. § 1.708- 1(b)(1)(ii)] or (2) when no part of the partnership’s business or financial operations are carried on by any partner. [IRC § 708(b)(1)(A)]. The real concern with this provision is that the determination of whether or not the fifty percent of outstanding interests have been transferred is based on transfers occurring over a twelve month period and includes the total interests in partnership capital and profits transferred by the existing partners during that period. This means that if one or more partners sell or exchange interests that equal fifty (50) percent or more of the total interest in partnership capital and fifty (50) percent or more of the total interest in partnership profits within a period of twelve (12) consecutive months and the interests are sold or exchanged on different dates, the percentages are added as of the date of each sale. Accordingly, it is foreseeable (and unfortunately quite common) for two separate partners to transfer their total (capital and profits) respective interests to third party purchasers over a twelve month period and, despite the fact that neither party individually transferred greater than fifty (50) percent of the outstanding total interests in the partnership outright or intended to terminate the partnership, their individual transfers when aggregated under Section 708 effectively terminate the partnership for tax purposes.
Investors interested in the benefits and flexibility of the general partnership structure, but concerned about the inherent personal liability may want to consider a similar form of entity, referred to as a “limited partnership”. The limited partnership has many of the same features as the general partnership, but is comprised of one or more 'general' partners, who have all the same rights and liabilities as they would as members of a general partnership, and one or more 'limited' partners. The limited partners’ responsibilities to the limited partnership are merely the contribution of capital; limited partners have no management rights or responsibilities and accordingly, can not be held liable for any of the partnership obligations in excess of their capital contributions. [Corps. C. § 15611].
In order to legally form a limited partnership in the state of California, interested investors merely need file a certificate of limited partnership with the Secretary of State that has been signed and acknowledged by the general partners of the partnership with their names and addresses, the partnership's principal place of business, and other pertinent information. The filing does not reflect the names and legal information of the limited partners, which need not be disclosed. [Corps. C. § 15621]. While the partners are not required by law to draft a formal partnership agreement, investors should understand that one of the primary purposes of negotiating such an agreement is to make sure that there is a consensus amongst the partners as to the purpose of the enterprise, the manner in which daily business will be conducted and the partner’s respective rights and liabilities, and that drafting the agreement prior to formation greatly reduces the potential for later misunderstandings and/or litigation. [Corps. C. § § 15611(w), 15621(a)].
The limited partnership entity is typically the best partnership vehicle for passive investors in real estate, as it allows them to invest in the enterprise and share in their allocation of profits if the project is a success, but their status as limited partners typically precludes them from incurring liabilities in excess of their initial capital contributions. It is important to note that while the liability of general partners seems expansive, it does not extend to limited partners; general partners are deemed to be jointly and severally liable only to third parties for causes of action arising from actions undertaken in the course of partnership and are not liable to the limited partners for the actions of another general partner unless they either participated in the action or negligently allowed it to occur. This does not mean that the general partners are completely insulated from the misdoings of other general partners; all the general partners may be forced to share in any loss of partnership capital in accordance with the partnership agreement’s predetermined allocation of profits and losses. Further, limited partners should be aware that there is no requirement that the general partner(s) in a limited partnership be an individual; it is perfectly permissible for the general partners to deal with the liability inherent in their position by appointing corporate entities to serve as the general partner(s). While the corporate general partner(s) will owe a fiduciary duty to the limited partners, the shareholders of the corporation will typically not be personally liable for the debts of the partnership and the shareholders, officers and/or directors of the corporate general partner may also serve as limited partners in the partnership without losing their limited liability. [Corps. C. § 15632(b)(1)].
When investors opt to become partners in a limited partnership, they must understand that their role is passive and that they typically will have no rights related to managing the day to day business of the entity. This does not mean that the limited partners have no rights; even with their “passive” status in management, the limited partners have the right to information, reports and accountings from the partnership, the right to inspect partnership records, and the right to attend partnership meetings. [Corps. C. § § 15634-15637]. It is important to note that limited partners must be very careful to restrict their involvement in the day to day business so the partnership to these functions, or risk losing the limitation on personal liability that their “limited” status provides; if any creditors can show that a limited partner participated in control of the partnership business at the time that creditor extended credit, so that the creditor reasonably believed that the partner was a general partner, then the partner may be deemed personally liable to that creditor despite their limited status.[Corps. C. § 15632(a)]. This is obviously a cause of concern for limited partners of any given limited partnership, who will want to make sure their actions are deemed passive enough to prevent incurring the liability of a general partner and at the same time frustrating, as the regulations do not specifically define what actions constitute sufficient “participation in the control of the business” to risk recharacterization as a general partner. The regulations do however list examples of behavior that would typically result in such a characterization: (1) acting as an employee, agent or contractor for the limited partnership or a general partner; (2) consulting with and advising a general partner on partnership business, or serving on a committee that approves actions of the general partner; (3) being an officer, director or shareholder of a corporate general partner; (4) being a beneficiary, or a trustee, executor or other administrator, of an estate or trust that is a general partner; (5) being a partnership creditor or debtor, or supplying collateral for the partnership, or guaranteeing partnership debts; (6) voting on various fundamental matters; and (7) acting to wind up the partnership after it has been dissolved. [Corps. C. § 15632(b)]
One of the distinct differences between being a general and a limited partnership in a limited partnership is the actual ownership of the partnership assets: the limited partners have absolutely no ownership interest in the assets themselves, merely a right to a designated return on their capital and a share of the profits generated by the partnership. [Corps. C. § 15671] Like general partnerships, limited partnerships typically provide that the profits, losses and distributions of the partnership are allocated in proportion to the partners' respective contributions to the partnership, unless the partnership agreement has provided for preferential distributions. [Corps. C. § § 15653, 15654, 15664]. Real estate investors may want to evaluate the consequence of this particular restriction of the limited partnership form of entity as it will prevent them from being directly on title to the real property they purchase, which can result in limitation in the personal legal and tax planning they may participate in with respect to the property.
Limited and general partnership interests are similar in that both interests typically permit the partner to has assign the interest in part or in whole to a third person. With limited partnerships however, the assignment merely transfers the limited partner’s right to receive distributions from the partnership, and does not entitle the assignee to become a limited partner unless specifically provided for in the partnership agreement and/or there is majority consent on behalf of the limited partners and unanimous consent amongst general partners at the assignee should be admitted to the partnership. [Corps. C. § § 15672, 15674; see Corps. C. § 15611(o),(u)].
As stated above, a limited partnership must have one or more general partners who manage the business and are personally liable for partnership debts. However, it is not necessary that an individual serve as general partner and thereby be exposed to creditors' claims. Rather, as discussed above, corporation may be the general partner and the shareholders of the corporation will ordinarily not be held personally liable for the corporate general partner’s debts; further, these same shareholders, officers and/or directors of the corporate general partner may also serve as limited partners themselves without losing their limited liability as shareholders of the corporate general partner. [Corps. C. § 15632(b)(1)]
Limited partnerships have many of the same termination considerations as general partnerships. Typically the death, withdrawal, removal, incompetence, bankruptcy or dissolution of a general partner dissolves the limited partnership unless: (1) the partnership agreement provides otherwise; (2) all remaining general partners continue the business; or (3) where there is no remaining general partner, the limited partners holding a in interest in current profits agree in writing to continue the business and to admit one or more substitute general partners within six months after the last remaining general partner ceased to be a general partner. [Corps. C. § 15681(c); Corps. C. § § 15611(o) & (u), 15642] It is important to note that this provision applies only to general partners; typically the death or incapacitation of a limited partner(s) has no effect on the partnership as the executor or representative succeeds to the limited partnership interest and has the ability to assign and transfer the limited partnership interest to the appropriate parties. [Corps. C. § 15675(a)]
Limited Liability Company
Many investors are already acquainted with the Limited Liability Company or “LLC”, as it has quickly become one of the most popular entities in which to do business in many states. An LLC is most simply described as a sort of hybrid between a partnership and a corporation that combines the “pass-through” tax attributes of partnerships with the limited liability available to corporate shareholders. [Corps. C. § 17000]
The existence of a California LLC begins upon the filing of “articles of organization” with the Secretary of State on the prescribed form. [Corps. C. § 17050] The articles of organization will require the new member/members of the LLC to designate of a qualified initial agent for service of process and submit a statement indicating whether the LLC will be managed by one manager, more than one manager, or the member/members. [Corps. C. § § 17051, 17151] Unlike the certificate of formation required for partnerships, the articles of organization required for an LLC do not require disclosure of the member(s) and/or manager(s) name(s) or their respective initial capital contributions. The requirements for valid articles of organization are similar to a certificate of formation in that the members do not have to codify their agreement in writing; while the regulations do require that an operating agreement be entered into by the members either before or after filing the articles, they do not specify that the agreement be in writing. [Corps. C. § § 17001(b), 17050(a)] It is however important to note that the negotiation process serves the same role in the formation of an LLC as it does in a limited partnership; negotiating the purpose of the enterprise, and the partner’s respective rights and liabilities, and codifying that agreement prior to formation will again greatly reduce the potential for disagreement and/or litigation down the road.
Once the articles of organization have been duly filed with the Secretary of State, for legal purposes the multiple-member LLC is now recognized as an entity separate and apart from its members. [Corps. C. § § 17003, 17101] As a result, the LLC can only be held responsible for the entity's debts, and the members are typically not personally liable for the entity's obligations and/or liabilities. [Corps. C. § 17101(a)] As with limited partnerships, there are some narrow exceptions: LLC members may be personally liable for the entity's obligations if they have personally guaranteed the obligations, or if they have failed to hold or observe formalities pertaining to LLC. [Corps. C. § 17101(b), (c)]
Unlike other forms of business entities, the LLC structure allows some flexibility in the manner in which the members’ initially provide consideration for their interests in the entity. A member's capital contribution to the LLC may validly consist of money, property, services rendered, or a binding obligation to contribute such at a later date; typically the only limitations on contribution are those provided in the articles of incorporation or the operating agreement. [Corps. C. § § 17001(g), 17200(a)]. This stands in sharp contrast to both limited partnerships, which don’t require any contribution by a prospective partner in return for a membership interest, and corporations, in which a contribution of services or property is not lawful consideration for issuance of shares. [Corps. C. § 15651; Corps. C. § 409(a)(1)] No matter how the interest is initially secured, once made these capital contributions determine how the LLC profits, losses and distributions of money or property are made amongst the members unless the operating agreement specifically establishes a differing allocation. [Corps. C. § 17202; Corps. C. § 17250]]
The authority to manage the LLC's business is typically vested in all its members unless the articles of organization specifically provide otherwise. Where the articles of organization do not provide for a manager, the LLC members' management and control rights are similar to those of general partners of a general partnership: typically each member has the right to vote in proportion with their interest in the current profits of the LLC and that in the majority of situations (except for certain fundamental matters) a the vote of a majority in interest suffices. [Corps. C. § 17103(a)(1),(3)]. There are certain circumstances in which a unanimous vote by all the members of the LLC is required, but these tend to be fundamental matters such as an amendment to the articles of incorporation and/or the operating agreement. [Corps. C. § 17103(a)(2)].
Real estate investors should seriously consider forming an LLC that is managed by one or more members, as there are some distinct disadvantages to more than one member taking on the responsibility of managing the entity themselves. In a member-managed LLC, each member is deemed an “agent” of the LLC and as such may bind the LLC in dealings with third persons in the same manner a general partner may bind a partnership. [Corps. C. § 17157]. As a result, each members’ action creates risk: since the members are generally not personally liable for LLC obligations, the risk is not that the members will be to personal liability (as with a partnership), but rather the risk is that the action of the members may incur liability on behalf of the entity itself. If this increased level of risk is something that makes investors uncomfortable, they may take solace in that most states allow for “centralized management”, so that the affairs of the LLC may be managed by or under the authority of one or more designated managers, whom may be parties outside of the original members of the LLC if provided for by the articles of organization. [Corps. C. § 17151]. There is no real disadvantage to appointing an outside party to serve as manager of the LLC, in that at law, the manager will owe the same fiduciary duties of care and loyalty to the LLC and all its members as are owed by a partner to a partnership and its partners, and these duties may only be modified by a written amendment to the operating agreement after the members’ informed consent and disclosure of the anticipated consequences of such modifications. [Corps. C. § 17153; Corps. C. § 17005(d)]. There is no inherent disincentive for a prospective outside manager either: at law no LLC manager may be held personally liable for any LLC debt, obligation or liability solely by reason of being a manager unless the manager specifically agreed to accept personal liability in either the LLC’s articles of organization or a written operating agreement, or an ancillary written contract that has been incorporated by reference. [Corps. C. § 17158] All that the outside manager must be concerned with is the basic level of personal liability that faces any similarly situated corporate office or director, which is typically personal liability to third persons harmed by the manager’s wrongful acts either for themselves or behalf of the company.
One of the major benefits of electing to do business as an LLC is the lack of formal requirements to validly transfer membership interests. While typically no new members may be added by issuance of new membership interests or transfer of existing interests without the consent of members having a majority in interest (excluding the vote of the person acquiring the membership interest), this is typically a much lighter burden than the restrictions on transfer posed by other business forms. [Corps. C. § § 17100(a)(1), 17303(a)] As discussed above, the limited partnership form typically requires that no party may be admitted as a partner without the consent of all the general partners and a majority in interest of any limited partners. Holders of membership interests in an LLC are also free to assign their economic interests, such as rights to share in profits, losses, distributions, and may do so without fearing an accidental dissolution of the LLC, unless such dissolution has been specifically provided for in the articles of organization or operating agreement.
The intentional termination of an LLC is also relatively easy for the members to accomplish. Generally, an LLC will be dissolved: (1) at the date and time specified in the articles of organization; (2) upon the occurrence of an event/events specified in the articles or a written operating agreement or; (3) by the vote of a majority in interest of its members and/or whichever interest holders are specified in the articles or a written operating agreement. [Corps. C. § § 17051(c)(3), 17350]. What this means practically for real estate investors is that the LLC form of business entity provides somewhat more reliable continuity of interest than a partnership because the death, withdrawal, resignation, bankruptcy, or some other voluntary/involuntary removal of an LLC member does not automatically trigger a buy-out or dissolution of the LLC unless specifically provided for in the articles of organization and/or the operating agreement.
Of all the various forms of business entities, investors are typically best acquainted with the “corporation” but are unsure as to what specifics are required under the form and how those requirements will affect the ability their ability to operate a business whose primary aim is investment in real estate. Like the other forms of business entities, corporations are deemed to be legal entities separate and distinct from the person(s) who created it and from the shareholders who own it. As distinct entities, corporations have the power to act on their own behalf in any way permitted by the law and/or its chartering documents, including the ability to contract, to own and convey property, maintain civil causes of action, and may be accused of both civil and criminal wrongdoing in its own name. Like the other forms of business entities, there are certain steps required to validly form a corporation in the state of California; formation in the state require substantial compliance with the General Corporation Law, which list of number of basic requirements including filing of articles of incorporation containing certain essential provisions, prepayment of certain fees, etc.
While doing business as a corporation does assure the investor a great deal of separation from the entity and any liabilities created in the ordinary course of business, investors should be aware that there are circumstances under which the corporate form will be disregarded and the liabilities passed through to the investors themselves. This is typically referred to as “piercing the corporate veil”, and is usually occurs in situations where the shareholders fail to treat the corporate form as an entity independent of themselves, but rather treat it as an extension of their personal selves or an “alter ego”. Courts will typically evaluate a situation for two basic criteria before finding “alter ego” liability: (1) the shareholders sought to be held liable have treated the corporation as their ‘alter ego,‘ rather than as a separate, independent entity and; (2) upholding the corporate entity and allowing the shareholders to escape personal liability would, under the circumstances, sanction fraud or injustice. Las Palmas Associates v. Las Palmas Center Associates (1991) 235 CA3d 1220, 1249, 1 CR2d 301, 317; SEC v. Hickey (9th Cir. 2003) 322 F3d 1123, 1128, amended 335 F3d 834 (applying Calif. law)].
Investors may take limited comfort in the knowledge that there is generally a presumption against alter ego liability, and courts typically will only make the finding alter ego liability where there is an extreme abuse of corporate form. Investors in real estate should however be aware that the typical situation in which the “alter ego” doctrine is applied is one which they could accidentally find themselves: a corporate entity with only a few shareholders whom have, through their actions and/or representations, failed to respect the corporations separate identity in a myriad of ways, such as failing to contribute capital, issue stock, or otherwise complete the formation of the entity itself, using corporate assets for personal business and/or the commingling of personal and corporate funds, and most commonly, failing to respect the necessary formalities (elections, meetings, etc.) of the corporate form. [See Associated Vendors, Inc. v. Oakland Meat Co. (1962) 210 CA2d 825, 838–840, 26 CR 806, 813–815; Mid-Century Ins. Co. v. Gardner (1992) 9 CA4th 1205, 1212–1213, 11 CR2d 918, 922 & fn. 3; Jack Farenbaugh & Son v. Belmont Const., Inc. (1987) 194 CA3d 1023, 1033–1034, 240 CR 78, 83–84].
The “alter ego” doctrine is not the only source of personal liability that may arise under the corporate entity. Apart from potential liability under the alter ego doctrine, shareholders may be found to have personal liability for their actions f they directly ordered, authorized or participated in a corporation's wrongful conduct. In these circumstances, the shareholders' liability is similar to the liability incurred by directors and officers, in that it does not arise from their positions as shareholders, but rather from their own affirmative misconduct. Filet Menu, Inc. v. C.C.L. & G., Inc. (2000) 79 CA4th 852, 866, 94 CR2d 438, 447.
As discussed throughout this article, one of the most important concerns for a real estate investor interested in participating in an investment entity is the potential for personal liability in excess of the initial capital contribution for debts incurred by the business enterprise. The corporate form of business allows shareholders a limitation on personal liability similar to that under the LLC or limited partnership form of entity, in that shareholders may only be held liable for the amount initially invested, without recourse to any additional personal assets. Investors should however be aware that this general limitation on liability may be compromised by outside agreements; it is common practice for banks and other business entities extending credit and/or long term corporate obligations to a new and/or smaller corporate entity to require the shareholders of that entity to give their personal guarantees for the obligations of the corporation. Where such guarantees are required, the shareholders personal assets will be available to satisfy the corporate obligations and the typical non-recourse liability provided by the business form will not apply to the specifically guaranteed obligation.
One of the distinct advantages of the corporate form is its highly centralized structure for management and control. Under the corporate form of entity, shareholders elect directors, who then appoint officers to run the day to day business of the entity. These directors and officers are not required to be shareholders, which mean that in circumstances where some of the investors do not intend to be active in the management of the entity, or where investors intend to appoint outside parties to act as management for the corporation, the corporate form of entity has a distinct advantage other forms of business entities in that it allows all of the owners that wish to have a say in the conduct of the business to do so by acting as directors of the corporation but prevents the members from having the power to bind each other personally. One of the ancillary benefits of this centralized form of management is increased privacy for shareholders. In general, the corporate form best assures privacy and anonymity of ownership: while a corporation is required to file a biennial statement disclosing its officers and directors, there is no requirement for disclosure of shareholder identities. [See Corps. C. § 1502] There are however disadvantages to this centralized management in the form of increased formalities; the centralized management aspect of the corporate form of business means that record-keeping is required to have a board of directors, corporate officers, annual shareholder meetings, and to maintain separate books and records, and failure to respect these formalities may result in personal liability for shareholders.
Another discrete benefit of the corporate form of business entity is the ease with which the interests in the entity may be transferred. Absent restrictions imposed by applicable securities laws and/or third party agreement, shares of corporate stock are freely transferable. Typically, restrictions on the transfers of interest are only found in corporations categorized as “closely-held corporations”, in which the shareholders have entered willingly into an agreement, typically referred to as a “buy-sell agreement” or “right of first refusal” provisions, which restrict their right to transfer their shares to outside parties. Shareholders of closely held corporations are usually not opposed to entering into such agreements, as there is typically a very limited market for interests in closely-held corporations, and their transfer is often subject to federal and state securities law restrictions.
As discussed throughout this article, the manner and ease with which the business entity may be terminated is a relevant consideration in choosing the form of entity. While the termination provisions in the other entity choices have become increasingly liberal over time, the corporate form of entity still enjoys a distinct advantage in that the corporation’s existence is independent of its shareholders, and is thus, in many ways immortal. While the same result may be achieved under present law with an LLC, in that the LLC will continue on indefinitely unless the operating agreement specifically provides for termination, the partnership form of entity requires specific and careful drafting of the controlling documents to prevent the general partner's death or withdrawal from causing dissociation or dissolution of the partnership.
As a final consideration, it is important to take note that this article is only intended to serve as an overview of the basic entity choices available to investors in real estate, and to discuss some of the basic provisions inherent within each. There are a number of different choices available to specific types of professionals, and additional considerations that must be carefully considered before a true “choice of entity” is made, taking into account both the personal needs of the investors as individuals and a whole, as well as the economic and tax outlook for the entity itself. It is worth repeating that investors should understand that in most situations, there is no one “right answer” to the question of which entity will best serve their interest, and that it should be understood that the “choice of entity” process itself really is the process of distilling the investors down to their most basic level, and then comes to finding an entity that overall meets as many objectives as possible, and the sound advice of tax and legal counsel is paramount to making an informed decision.
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