Business Entities for Real Estate Investors
Our office is often approached by individuals who are seeking to purchase real property for an investment. In some cases, the person who approached us is seeking to purchase the property with another person. This can be done informally, without any written documentation, or formally. If done informally, it may lead to problems later if the parties have disagreements about the investment or if outside factors intervene. It is best to establish the rights and obligations of the parties at the outset of the transaction so that all of the parties know what is expected of them and what they can expect from the investment. Many times the people are not sure what kind of business entity they should create to accomplish this purchase.
There are three basic forms of business entities to be considered in real estate investing. They are:
LIMITED LIABILITY COMPANIES (L.L.C.s)
We will consider the relative advantages and disadvantages of each.
A partnership must consist of two or more individuals. The persons who own the partnership are called partners. A partnership may be informal (no written agreement), called a de facto partnership, or it may be by way of a written partnership agreement. Obviously, a written agreement is preferred because it spells out the rights and obligations of the partners. A partnership must consist of at least two or more individuals. A partnership cannot consist of only one partner. If a partnership consists of two partners and one partner buys out the other partner, the partnership ceases to exist and the business becomes a sole proprietorship at that point.
- Easy to establish. It usually is created by the preparation of a partnership agreement. The partnership agreement is not filed with any state agency, but is kept between the partners. Thus, there are no state filing fees.
- Favorable tax treatment.-Income received by the partnership is not taxed to the partnership. Rather, the income to the partnership is passed through to the individual partners and taxed as income to them. Thus all income is only taxed once.
- No liability protection. Creditors can go after the assets of the partners jointly and severally. Thus, if the partnership is sued, creditors can proceed against the personal assets of each partner.
- The actions of one partner affect all the other partners. If one partner commits a fraud, the other partners may be responsible to the person who was defrauded.
- Marketability of interest may be an issue. It may be more difficult for one partner to sell his or her interest to their partners.
A corporation is a legal entity created by filing a certificate of incorporation with the State. After the corporation is created, the corporation issues shares of the corporate stock to the persons who own the corporation. Thus, the owners of the corporation are called shareholders. Their interest in the corporation is reflected by the number of shares they each own. Generally, there is no other written agreement between the shareholders to commence the corporation. A corporation may consist of a single shareholder.
- Liability protection. Creditors can sue the corporation, but cannot go after the assets of the individual shareholders.
- Good marketability of shares. It is easier for the shareholders to sell all or part of their shares to other persons.
- More complicated to establish than a partnership. Documents must be filed with the State to create the corporation.
- Double tax treatment. Income to the corporation is taxed to the corporation. When that income is distributed to the shareholders as a dividend it is taxed to the shareholders as income. Hence, the double taxation. (A Subchapter S corporation may prevent this.)
- There are many filings with the federal and state governments on an annual basis, which increases annual costs. (i.e. Cost of filing and having accountants prepare the forms.)
- There may be the need for additional documents to establish the relationship between shareholders. (Example: Buy-Sell Agreements)
Limited Liability Companies
The limited liability company is a relatively new business compared to partnerships and corporations. A limited liability company is created by filing a certificate of formation with State. The owners of the limited liability company are called members. Originally there had to be at least two members. However, New Jersey law now allows limited liability companies to consist of only one member. Like a partnership, there is a written document called the operating agreement which establishes the rights and obligations of the members. The member’s interest in the company is established in the operating agreement. The limited liability company is a cross between the partnership form of business entity and the corporation, combining the liability protection of a corporation with the tax benefits of a partnership. Thus, it has become a very attractive form of business entity for many small businesses.
- Liability protection like a corporation. Creditors cannot go after individual assets of members.
- Favorable tax treatment. Like partnerships, income is passed directly through to the members. Unlike a corporation, there is no double taxation.
- Easier marketability of membership interest.
- Fewer annual filings than a corporation.
- The Operating Agreement sets forth the relationship between the members. Usually there is no need for additional documents.
- Because the certificate of formation must be filed with the State, the limited liability company is more complicated to establish than a partnership.
As you can see, each of the different business entity forms has their own advantages and disadvantages. No one form is “best” for all persons. A person desiring to form a business entity with others should consult with an attorney and accountant as to which form of business entity is best suited for them.