Contributed By Allen Matkins Leck Gamble Mallory & Natsis LLP
There are three main legal entities: corporations, partnerships, and limited liability companies (or LLCs). LLCs are generally the preferred entity to hold real estate.
Corporations are generally subject to double taxation: both the earnings of the corporation and dividends distributed to shareholders are taxed. Partnerships are pass-through entities, whereby income and earnings are passed through to the partners and taxed at the partner level. LLCs are by default treated like partnerships for tax purposes (ie, as pass-through entities), and are very flexible in that they can reflect myriad arrangements for economic, management, and exit considerations and strategies. Additionally, any liability that the LLC may incur generally stays in the LLC, shielding its members.
Corporations are subject to double taxation and are very limited in how profits can be shared. They are generally thought to be tax-inefficient for holding real estate or appreciable assets, and are better for holding operating businesses, although this thinking may change somewhat with lower corporate tax rates.
Partnerships and LLCs generally allow partners and members to move in and out of real estate investments that have appreciated with relative ease, minimizing taxation. In some jurisdictions, an LLC may be prohibited from holding a real estate license or general contractor’s license, while a corporation may be permitted to do so. Corporations may be less flexible in how profits can be shared, however.
Partnerships and LLCs offer flexibility in reflecting the business arrangement of the partners or members. LLCs are useful in documenting varied economic arrangements, and are also very flexible in assigning day-to-day control, management and implementation, such as the right to sell property, refinance, or change business plans or budgets.
Partnerships and LLCs also allow for individually tailored exit provisions for partners and members.
Corporate shareholders, like LLC members, are generally shielded from liability, as liability remains fixed in the corporate entity. In partnerships, only the general partners or sometimes all the partners may be subject to liability. For this reason and those above, the LLC is often the preferred and most widely utilized vehicle for real estate investments.
Corporations are subject to double taxation: earnings of the corporation may be subject to tax, and dividend distributions may be taxable to the shareholders.
Partnerships and LLCs are pass-through entities, whose profits are generally taxed only at the partner and member level.
Corporations may be less costly to document than a partnership or LLC. All of the substantive terms of a partnership or LLC agreement may be subject to negotiation, which would make it more costly to document. Additionally, in certain situations, corporations may be the preferred vehicle for foreign investors of real estate because of the nature and interaction of US and foreign tax laws.
Corporations require articles of incorporation to be filed in the state or jurisdiction where it is being formed. Incorporating in Delaware is popular because the jurisdiction allows for the waiver of fiduciary duties, which can then be defined and limited by contract. Delaware has a highly developed body of business law that generally defers to the defined contract terms.
The bylaws of a corporation set forth shareholder rights, provide for management through a board of directors, and set out officer provisions. The board is elected by the shareholders and is responsible for setting policy. Officers implement the policies of the board of directors.
For partnerships, a partnership certificate is generally filed in the state in which it seeks to be governed, and then the partners enter into a partnership agreement.
LLCs generally file a certificate of formation or articles of organization. LLC and partnership agreements are often very similar in substance.
Delaware entities that own California real estate generally qualify to do business in California by registering with the California Secretary of State and paying an annual $800 minimum franchise tax.