Choosing a Legal Entity to Hold Real Estate

By Steven B. Gorin of the Private Client Pratice Area

A limited liability company (LLC) is a business entity that generally has liability protection similar to that of a corporation. However, for federal tax purposes, an LLC is treated as follows:

Disregarded Entity If it has only a single member (owner), it is disregarded for federal tax purposes, unless it elects otherwise. All of its activity is reported directly on the member's income tax return.

Partnership If it has more than one member, it is taxed as a partnership for federal tax purposes, unless it elects otherwise.

Corporation An LLC can elect to be taxed as a corporation for federal tax purposes. It may further elect taxation as an S corporation, if every unit of ownership has identical rights to distributions and liquidation proceeds.

Although an LLC can be taxed as a corporation, that taxation is not desirable for real estate. If the owners wish to part ways, each taking a parcel of real estate, in many cases the split-up will be taxable. However, if the LLC is taxed as a partnership and the real estate was either contributed to the LLC more than seven years ago or was bought by the LLC, in many cases the distribution would not be taxable. Finally, real estate held in a corporation that has not made an election is not eligible for favorable capital gain tax treatment.

Below are examples of situations when an LLC taxed as a sole proprietorship or partnership might be beneficial.

Sole Owner You hold one or more parcels of real estate. You would like to insulate your other assets from liability for what occurs on the real estate. Furthermore, you would like each parcel to be insulated from liability for what happens on each other parcel. A possible solution may be to form a separate LLC to hold each parcel. Because each LLC would be disregarded for federal tax purposes, forming the LLCs would not complicate your tax situation.

Co-Owners You own real estate with one or more other coowners. One of your co-owners manages the property, or perhaps you have a management company manage the property. In some situations, co-ownership is considered a general partnership even if there is no formal partnership agreement. If you are considered a general partner under state law, you are jointly and severally liable for acts or omissions by your coowners or those your "partnership" hires. Furthermore, if most, but not all, of the co-owners agree to sell or lease the property, the sale or lease cannot proceed without unanimous consent or court action. One dissenter could cause you to lose valuable business opportunities. Finally, if a co-owner gets into creditor problems, the creditor may take his place and try to sell the property prematurely, perhaps even going to court to force a sale. A possible solution may be to form an LLC to hold the property. The LLC might relieve you from joint and several liability and provide a mechanism for a majority to control the property. Any creditor who obtains an interest in the LLC would have no right to vote on how the LLC is run and should not be able to get a court order to sell the property.

One Business, Multiple Locations Your business has several locations, whether in the same city or even in different states. You would like each location to be insulated from the liabilities of other locations. Your business could set up a separate LLC for each location, but for federal income tax purposes nothing has changed.

If you have an operating business, you might consider forming an LLC to hold the real estate that the business uses. If your operating business is a regular corporation, the LLC entity has clear advantages over a corporation for holding real estate. If your operating business is taxed as a partnership, such an arrangement might also help you save self-employment taxes. The operating business can deduct reasonable rent payments against its business income, and the LLC's rental income usually would not be self-employment income.

If you form an LLC, you need to register it with the Secretary of State at inception. Future registrations are not necessary, except to the extent that the registration information changes. The Missouri Secretary of State has helpful information at http://www.sos.mo.gov/business/corporations/startBusiness.asp#entity and http://www.sos.mo.gov/BusinessEntity/BusinessEntitiesOnline/Help/MO/Notice.aspx.

As with any business entity, your LLC should have its own separate bank accounts, liability insurance, and cash reserves necessary to run it as a financially responsible business. Playing fast and loose can encourage a court to decide to disregard the liability protection provided by any type of business entity.

Finally, please consult with an attorney and a tax advisor (they might be the same person) before forming any business entity.

This article first appeared in The Missouri Bar's Law Day Series

http://www.mobar.org/