Review Your Real Estate Business Structure for Ease and Flexibility
TOM KOSINSKI, CPA, MST
Choosing the right business structure for your real estate venture requires careful thought and analysis. A corporation is still an alternative that can provide many tax and legal benefits, but there are also many non-corporate alternatives, which generally are subject to fewer tax issues and regulations and may offer less complications and more flexibility. Some of these options may include general partnerships, limited liability companies (LLCs), and limited liability partnerships (LLPs).
Consider the Simplicity and Flexibility of a Partnership
One reason partnerships are popular choices for real estate activities are that they are very easy to set up. A partnership may get started by obtaining a business license and giving notice of the partnership’s name under your state’s assumed-name statute.
Partnerships are also popular because of their flexibility. Partners may draw up a customized agreement explaining many relevant operating details such as goals, management practices, capital investments, individual partner responsibilities, income distributions, resolution methods for disputes, and buyouts. Partnership agreements should be written and reviewed by an attorney.
Although general partnerships provide simplicity and management flexibility, they do not protect partners from personal liability for the actions and debts of the company — or the mistakes and actions of the other partners — so there is more legal risk in the existing real estate climate.
For income tax purposes, this structure is a “pass-through entity,” which means that owners generally report their allocation and share of the income or losses on their personal income tax returns, regardless of whether their income is paid to them with cash distributions. Each owner must also report losses and review whether they have equity or debt sufficient to claim tax losses.
Protect the Personal Liability Issues with an LLC
Another popular choice for real estate ventures is the limited liability company (LLC). This option offers both the flexibility of a partnership and the liability protection of a corporation.
Like the owners of a corporation, LLC owners are not personally liable for company debts or liabilities, unless they improperly use the corporation through fraud or other illegal activity. Creditors generally cannot recover debts from the owners’ personal assets. Unlike a corporation, however, an LLC isn’t required to allocate profits and losses in proportion to ownership interests.
The set up of an LLC begins by filing articles of organization with the relevant state and paying the applicable fee. LLC owners must elect officers to manage the company, and they are subject to state regulations on how they maintain records of operations and major decisions.
For income tax purposes, an LLC may be treated similar to a partnership and elect to be treated as a flow-through entity, with all tax paid at the individual member level.
Consider Other Partnership Options
Still another popular choice is the limited partnership. It provides personal liability protection to limited partners who provide financing but generally do not take an active role in operating the business. The management and operations of the business are assigned to general partners, who assume the personal liability in the partnership. All income tax is paid at the individual partner level, although limited partnerships may pay state and local taxes in some jurisdictions.
It is generally easier to attract investors with limited partnerships than with general partnerships, and the structure is often used to acquire and hold real estate. Similar to an LLC, creating a limited partnership requires filing documentation with the state and paying annual state fees.
You also may have heard about limited liability partnerships (LLPs). These entities operate much like a limited partnership, but allow all partners to be active in running the business and facing legal liability for only their negligence or for that of employees directly under their supervision. LLP partners are not subject to liability for actions by employees who are not under their direct supervision or by other partners. However, the LLP partners are liable for partnership debts that do not necessarily involve their own negligence.
The LLP is also a pass-through entity, so income taxes are paid at the individual partner level. Owners of LLPs can also agree to allocate proceeds and profits based on their own agreement. Some states recognize LLPs but limit the use of this choice to professional firms. You should consult an attorney to see if LLPs are available in your state or make sense for your situation.
Make an Informed Decision
Although non-corporate structures offer many benefits and advantages, a corporate structure may still be a better choice in some situations. So remember to get an informed opinion and consider all of your options.
No matter which type of business structure you choose, you must address many issues when you draw up the governing agreement. Carefully consider the purpose and goals of the real estate venture and the overall management and operations of the activity. By discussing these issues and working with your advisors, you can help ensure your venture gets off on the right path.
If you have any questions about reviewing your real estate business structure, contact Tom Kosinski at [email protected] or call him at 312.670.7444.
Transferring Ownership Interests can be GREAT with a GRAT
JEFF NEWMAN, CPA, JD
If you’re at the age when it’s time to consider retiring from the real estate business, make sure you look at the advantages of a grantor retained annuity trust, also known as a GRAT. It can provide substantial estate planning benefits.
A GRAT is an irrevocable trust funded by a one-time contribution of assets by the “grantor.” For example, if you’re the owner of a real estate development company, you can transfer some or all of your ownership interests in the business to the GRAT. The GRAT pays you, as the grantor, an annuity for a specific term.
The amount of the annuity payment is a fixed percentage of the initial contribution’s value or a fixed dollar amount; either way, the payment must be made at least annually. You maintain the right to the payments regardless of how much income the trust actually produces.
When the GRAT’s term expires, the assets remaining in the trust (known as the “remainder”) transfer to designated beneficiaries. But the amount of the gift for gift tax purposes is determined when the GRAT is funded and is equal to the “present value” of the remainder interest.
The remainder interest’s present value hinges in part on the IRS Section 7520 rate at the time of the GRAT’s creation, as well as on the value of the assets transferred to the GRAT. The value of an asset such as an ownership interest in a closely held real estate business should be determined by a valuation expert.
If the Sec. 7520 rate is low and the trust assets can generate a higher rate of return, the assets will be worth more when the trust terminates than the remainder interest’s gift tax value. So, the excess asset appreciation over the term of the trust passes to the beneficiaries free of gift and estate taxes.
In addition, if your business’s value is currently lower than it has been, the interests will have a lower value for gift tax purposes. And GRATs work particularly well with interests in closely held businesses or with partial interests of real estate because valuation discounts can reduce a gift’s value for tax purposes even more.
Since the GRAT is treated as a grantor trust for income tax purposes, you must report the income, gains and losses from the trust assets on your individual income tax return. But paying income tax on the trust asset income and gains is actually beneficial for estate planning purposes. Why? By paying the taxes yourself (rather than the GRAT paying them), you’re preserving the trust’s assets for the beneficiaries — essentially making additional tax-free gifts to them — and further reducing the size of your taxable estate.
One potential negative consequence is that if the grantor doesn’t survive to the end of the GRAT term, the gift is effectively “undone” for tax purposes, and the GRAT assets are included in the grantor’s estate at their current value. The benefit of transferring the appreciation out of the grantor’s estate will be lost, and you will be back at the same position you were at before creating the GRAT, less the costs of setting it up. So to reduce this mortality risk, it’s generally beneficial to make the GRAT’s term relatively short.
Congress has introduced several bills in recent years that would limit the benefits of GRATs by, for example, requiring a minimum term of 10 years. It’s likely that any successful legislation would apply only prospectively, though, leaving existing GRATs intact. So if you think a GRAT may be right for your family, you may want to set it up soon.
While the IRS accepts GRATs as valid vehicles for transferring assets, it does impose some rules on the trust instrument used to create a GRAT. The instrument must prohibit additional contributions to the GRAT, commutation (prepayment of the grantor’s annuity interest by the trustee), and payments to benefit anyone other than the grantor before the grantor’s retained interest expires.
Moreover, issuing a note, other debt instrument, option or similar financial arrangement to satisfy the annuity obligation isn’t allowed.
If you’re a baby boomer, succession planning might not be on the top of your to-do list. But it should be. If you would like to know more about whether a GRAT should be part of your plan, please contact Jeff Newman at [email protected].