Source: http://www.exeter1031.com/choice_of_entity_considerations.aspx
Timestamp: 2019-04-25 06:33:20+00:00

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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.
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.
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.
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).
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.
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)].
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)].
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.
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.

References: § 17900
 § 17918
 § 16202
 § 16103
 § 16103
 § 16401
 § 708
 § 1
 § 708
 § 15611
 § 15621
 § 15611
 § 15632
 § 15671
 § 15653
 § 15672
 § 15611
 § 17050
 § 17051
 § 17001
 § 17103
 § 17103
 § 17157
 § 17151
 § 17153
 § 17005
 § 17158
 § 17100
 § 17051
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 § 1502