Limited liability companies, or LLCs, have become a very popular legal entity for taking title to commercial real estate in the United States. The LLC combines the limited liability of a corporation with the pass-through treatment afforded income taxation of a partnership or sole proprietorship. This is not to say that LLCs are the preferred choice in all situations but it does provide a worthy tool for real estate investors to consider. Regardless of whether they are purchasing an industrial building, a shopping center or even vacant land, LLCs can help.
The LLC is legally accepted in all 50 states and typically begins its legal existence when its articles of organization are filed with the Secretary of State’s office. The articles of organization are similar to the articles of incorporation that are typically required for both C- and S-corporations. In general, the filing fees as well as the annual report fees are modest. Although, they will vary from state depending on things such as the amount of capital contributions being made by the members to the entity. In some states such as Florida, a faxed copy of the articles of organization may be sufficient to complete the filing process—even though the original executed copy of both the articles of incorporation and the limited partnership agreement are still required for corporations and limited partnerships, respectively.
The operating agreement of the LLC is analogous to the bylaws of a corporation and may be as simple or as complicated as its members desire. The operating agreement will describe the various classes of members. In a multi-member LLC, these will often be the managing members who are overseeing the operation of the property and the other members who are typically investors in the project. The allocations of ownership interests are also important because many lenders will require any member, regardless of whether that member has any desire to participate in the management of the LLC, to be a guarantor of the loan if he or she has an ownership interest of at least 25% of the LLC. This 25% threshold may also trigger a “vetting” process of the member in question by the prospective lender. During this process, background checks may be initiated as part of the underwriting in order to verify compliance with things such as anti-terrorism statutes.
The LLC offers the prospect of limited liability for all of its members. This is a feature that is not available to the general partners of either a general partnership or a limited partnership. This protection is made available regardless of if the member is actively involved in the LLC management or not. But, this limitation of liability will do nothing to insulate real estate investors from the liability that they will incur by personally guaranteeing repayment of a commercial loan to a lender. Instead, this shield from liability protects members in their dealings with third parties doing business with the LLC itself as well as lawsuits that might arise such as; personal injuries suffered by a customer or vendor while on the property. The so-called “corporate veil” may be pierced in certain situations. These include instances in which the requisite formalities operating the LLC have not be followed by the members or the conduct of the members is deemed to be so shocking or outrageous as to warrant the imposition of personal liability. However, the burden of proof is on the plaintiff to show why the limitation on personal liability should be removed. This is not easily met when the LLC has been operated in a lawful and appropriate manner.
LLCs, like limited partnerships, can serve a useful purpose as an asset protection tool for its members. A creditor who obtains a judgment against a member of an LLC does not usually have the right to force a sale of the real property owned by the LLC in order to collect its judgment. Instead, it will typically be limited to seeking a charging order. A charging order is a court-approved directive mandating that the creditor receive any distributions that are paid to the debtor member. The problem with such a remedy is that it is only helpful when there are actual distributions being paid to the members of the LLC. If there are no profits to be distributed, then the judgment creditor will not receive anything because the debtor member is not receiving anything. The debtor member may be able to exploit this situation to negotiate a reduction in the judgment, particularly if he is able to control if and when the LLC makes any distributions in the future. This tool is not available to shareholders in a corporation.
Membership and Purposes of LLCs
Some states such as Florida allow LLCs to consist of a single member, whereas other states may require LLCs to have two or more members. The members may consist of corporate entities, actual individuals or any mix of the two. Like corporations, an LLC can also have many different ownership classes, each having its own unique set of rights, powers and obligations. In short, the ownership structure of the LLC can be as simple or complex as needed in order to accommodate the interests of all of its members.
Although it is customary for the articles of organization to specify the type of business that the LLC will be involved in, there really is no limit to the scope of activities that may be undertaken by the members of an LLC. Of course, it is a good idea that these activities do not entail such things as racketeering or murder-for-hire; many LLCs will simply state that they are authorized to engage in any activity that is permitted by state statute. However, it is also the case that some members of an LLC may want to have a far more limited scope of permissible activities. If the LLC was set up to take title to an office building, for example, then the members may prefer that the scope of permissible activities be limited to only those matters needed for the operation of the real estate itself.
Those who enjoy philosophical debates with the Internal Revenue Service will appreciate the simplicity of the “check the box” application (known as Form 8832 Entity Classification Election). This application permits unincorporated entities such as LLCs to elect to be taxed as either (i) a partnership (or sole proprietorship if only one member) or (ii) as a corporation. In general, the managers of most LLCs will elect to be taxed as a partnership so that they can avoid the double taxation of income and dividends that occurs with C-corporations. Unlike corporations, the LLC can also avoid the imposition of the alternative minimum tax, even though the members will have to determine their own such liability. Moreover, capital gains and capital losses in an LLC are passed through to the individual members..
As with everything else, the choice of whether to use an LLC or some other form of legal entity to take title to real property will depend on the unique conditions and circumstances of each transaction. The prospective members of the LLC should consult with the appropriate legal and business advisors to determine if the LLC format is the one best suited for their intended business activities.