What Can We Learn from the Professionals?
In recent years, the U.S. real estate market has attracted a surge of investment demand for income property.
At this moment, a growing percentage of newly acquired properties are going into Limited Liability Companies (LLC’s) which offer critical self-protection and tax saving features. The LLC is certainly helpful in the current legal climate of blame, litigation and scapegoating.
Even so, too many real estate businesses are still being conducted as sole proprietorships and general partnerships. And others are still being operated under older business forms such as limited partnerships which may fall short in providing all the protection that is needed.
Inc.Plan(USA) provides a wide range of services to property owners who purchase real estate in many different forms: multi-family houses, condominiums, office buildings, shopping centers, etc.
While there certainly are important considerations in favor of limited partnerships, many of the features of the LLC provide additional advantages which should be carefully considered. The following questions and answers should provide helpful guidance in making this all-important decision.
Q: How does an LLC differ from an S Corp. or a Limited Partnership?
A: Like a partnership, the LLC is an unincorporated business entity. It is really a cross between an S Corp. and a Limited Partnership, basically taking the best from both.
The LLC differs from a Limited Partnership in one significant area: unlike a limited partnership where the partners are shielded from liability only if they do not participate in the operations of the business, the owners of the LLC are shielded completely, irrespective of their active or inactive status. (The only exception to this is in professional LLC’s where the lawyer or doctor or accountant may still have malpractice issues, individually, based upon his or her own actions in the particular matter).
Like a partnership, the members of the LLC enter into an agreement in which each is assigned duties and shares of the profits. All income and expenses of the LLC are, like a partnership, transferred to the individual owners. The LLC pays no tax of its own. Rather, each owner is taxed as if he or she were a sole proprietor of their respective shares.
Q: Why is the LLC particularly suited to the real estate business?
A: Real estate businesses are invariably linked to the individual properties owned. The income, expenses, problems, and liabilities of the properties vary greatly. Because of this, businesses in this field always seek to shield their better properties from those that are troublesome, especially in the area of liability. All of the assets of a business can be lost if the problems in one area result in judgments.
To prevent one property from placing all of the adverse properties at risk, owners should place each one separately into its own LLC. In that way, both the owners and the properties can be shielded.
Q: Who can own an LLC?
A: S Corporations include the requirement that each owner/ member must be a US citizen or resident and a person (as opposed to another company), and that there be no more than 75 owners. This is not so of the LLC. The LLC is governed by state law, and most states allow LLCs to have any number of owners, and, any of them can be people, corporations, partnerships or other LLCs. None of the owners of an LLC are required to be citizens or residents.
Q: Are there drawbacks to the LLC?
A: The only drawback to the LLC is in the area of Social Security Taxes and fringe benefits. For an LLC, as opposed to a C Corporation, since all income and expenses are passed through to the owners, all such payments are subject to social security tax, no matter how denominated. Different and varied rules may apply to the LLC owners, so it is advised that accounting professionals be contacted.
Q: Why select the LLC over the Limited Partnership?
A: Aside from the tax and liability issues, there is another important issue that argues in favor of selecting the LLC over the partnership; that is, the issue of control. Under the limited partnership, there is no liability protection for the partners who actually participate in the operation of the business. Thus, if two or more partners want to have an equal say in how the business operates, then there will, in fact, be no liability protection. Under the LLC, however, the liability extends to all participants, irrespective of their say in operations.
Q: On balance, is the LLC the preferred form of entity for residential and commercial real estate businesses?
A: The LLC is by far the most protective and efficient business form for real estate companies, both residential and commercial. Here is why:
- Each separate property can be owned by its own, individual LLC, thereby shielding not only the owners, but their other properties from cross-liability.
- Income and expenses are all passed through, for income tax purposes, to the owners in any proportions that the owners themselves agree to and specify.
- All owners may have a say in management without adversely affecting tax treatment or the owners’ shield from liability.
- There are no restrictions on the number of owners (2 or more) or on the nationality or business status of the owners (they can be individuals, partnerships or other corporations).