Contributed By McGuireWoods LLP
Real estate assets are typically held by limited liability companies (LLCs), corporations, and limited partnerships (LPs). Each of these types of entities offers varying degrees of liability protection to the individual investor. From a tax perspective, LLCs and LPs are preferred because corporations impose two layers of taxation – once at the corporate level and once at the shareholder level. LLCs and LPs typically elect to be taxed as partnerships for tax purposes, passing through the income to be taxed only once, at the partner level. In addition, partnerships offer significant flexibility in structuring the economic terms of a deal, whereas corporations are often restricted to the type and quantity of stock issued. There are also real estate investment trusts, which are corporations (or business trusts) that pass through the income to be taxed at the REIT shareholder level.
Corporate income is subject to two layers of taxation, resulting in a significant reduction in return, due to the structure. Furthermore, shareholders are often restricted in how profits can be shared. Despite these drawbacks, corporations are often utilized by foreign investors seeking to avoid withholding issues and tax-exempt investors seeking to jeopardize their exempt status. The pass-through nature of partnerships, though a benefit in many cases, serves the opposite in such instances.
LLCs and LPs offer the equity holders significant flexibility in how profits can be shared. In addition, the single layer of taxation allows investors to maximize returns. Because of the pass-through nature of partnerships, this allows for tax-planning opportunities whereby often the purchase of partnership interests effectuates an asset sale, allowing the buyer to take advantage of increased basis in assets acquired.
The primary drawbacks of electing to be classified as a corporation (as opposed to a partnership) is the double layer of taxation – once at the corporate level, and again at the shareholder level when receiving corporate dividends. There may be ways to achieve the same objective by being classified as a partnership for tax purposes. A key tax benefit is removing one level of taxation by forming a pass-through entity such as a partnership. Partnerships generally also allow for flexibility in allocating income among the partners, whereas a corporation is restricted to the stock it has issued. For example, in a partnership setting, different distributions of profits and losses allow for parties to arrange economics without corporate tax law rigidity getting in the way.
Articles of incorporation and corporate bylaws typically provide how a corporation operates. The articles of incorporation filed in a jurisdiction list the name, registered office and address of the corporation. Corporate bylaws provide how shareholders vote for members and how the board elects officers, among other things. Real estate investors should carefully review corporate and partnership governing documents to understand the rights and liabilities associated with such investment.