USE OF LIMITED LIABILITY COMPANIES IN COMMERCIAL REAL ESTATE
In 1977 Wyoming adopted the first Limited Liability Company statute in the United States, Florida was next in 1982, and as the other states, including Illinois, have since adopted similar statutes, owners and operators of commercial real estate have increasingly used limited liability companies (“LLC’s”) as their entity of choice to acquire, own and operate commercial real estate. There are many reasons for this phenomenon and this article will address some of the more common benefits of an LLC for commercial real estate transactions.
Flexibility and Liability Protection. First, LLC’s are flexible and convenient. They are relatively inexpensive to form, and require only a modest annual fee to maintain. As with certain other entities, LLC’s offer a layer of limited liability for their owners, called “members,” whereby individual members are not personally liable for debts and obligations of the company, absent some sort of fraud or misconduct. This veil of protection means that investors generally risk only their actual cash investment in the LLC, without the exposure of losing their homes or other individual assets in the event of a judgment against the company.
Pass-Through Tax Treatment. Second, LLC’s offer favorable “pass-through” tax treatment to its members for items of income, expense, profit and loss, and are usually taxed as a partnership, withouthaving the liability exposure of a partnership or direct individual ownership. This means that each investor reports these items on the investor’s personal income tax forms each year. There is no “double taxation” as there is with C-Corporations that pay a corporate level income tax on its earnings, with the shareholders then paying personal income taxes if the earnings are distributed to them as dividends.
Membership Flexibility. Third, LLC’s can have an unlimited number of members and there is no restriction on the form that such membership can take. As a result, individuals, trusts, corporations and even other LLC’s can be members of an LLC. By contrast, the S-Corporation, while it offers favorable pass-through tax treatment and limited liability, differs from an LLC in that it is limited to a maximum of 100 shareholders, and certain types of trusts and other entities, such as C-Corporations, cannot be shareholders of an S-Corporation. So while similar to the S-Corporation in some respects, the fewer restrictions placed on LLC’s in terms of membership provides greater planning opportunities for investors and their counsel.
Classes of Membership. An important corollary to the quantity and nature of LLC membership is that LLC’s can maintain multiple classes of membership interest, each with its own special rights and privileges, such as voting and non-voting interests, preferred economic returns or simple returns based solely on percentage of ownership. With S-Corporations, all shareholders must be treated with economic parity, which make S-Corporations a less attractive investment vehicle because incentives cannot come from preferred returns to a specific “preferred” class of shareholders.
Governance - Operating Agreements. Once business terms are agreed upon by the owners, the financial arrangement and other business terms should be addressed in an LLC’s governing document called an “Operating Agreement” that is executed by all of its members. An LLC that does not have a signed Operating Agreement, though not desirable, will be governed by the default rules set forth in the applicable state Limited Liability Company Act, which would then control every aspect of formation, management, distributions and the ultimate winding-up of the company’s affairs.
Use of LLC’s In Real Estate Transactions. For the reasons described above, LLC’s have in recent years overtaken other forms of ownership for commercial real estate assets. For active operating businesses, such as manufacturing companies or medical offices, an LLC will often be used to own the real estate on which the operating company physically resides and then lease the real estate, building and improvements to the company that operates the business.
Such arrangements help maintain the separateness of real estate assets from the other assets of the operating company and vice versa. This is desirable from both a liability point of view as well as an economic point of view. If an operating company engages in lawful but hazardous activities, claims made against the company will be limited to the assets of the operating company in the event of an adverse ruling or judgment, while the real estate will be shielded because of its separate ownership. Moreover, operating companies may wish to offer equity incentives in the business to their key employees that do not also involve ownership in the underlying real estate, which may be owned by a long-standing family group, trust or unrelated group of investors.
People seeking to diversify their portfolios often invest in LLC’s that own income producing property because it provides a passive investment that is easy to track and report on an annual basis. At the end of each calendar year, members of LLC’s taxed as a partnership are furnished with a K-1 statement showing their pro-rata share of the LLC’s profits and losses for the year, which they then include on their personal income tax returns
LLC’s are often used in commercial real estate transactions by a project’s promoter so that the promoter can attract investors and provide incentives through the use of preferred returns and priority repayments. While the Internal Revenue Code and IRS regulations have complicated rules governing the taxation of membership distributions, as a general rule, allocations will be respected for tax purposes if they have “substantial economic effect” and reflect the parties’ true economic deal.
The Operating Agreement outlines these investor incentives, which often include priority distributions and a preferred rate of return on a member’s equity contribution, which are sometimes as high as 12%-15%. A member’s subsequent participation in the ongoing profits from real estate can increase an investor’s return well above these initial preferred returns. The “promoter” of the deal, who often serves as the day-to-day manager of the project, typically receives its financial benefits only after the investors have recouped their capital investment or achieved a certain return benchmark.
Conclusion. This article only covers some of the reasons to use LLC’s for commercial real estate investments. A determination of the best entity and structure for a real estate venture, such as the new Series LLCs now allowed in Illinois and other states, requires consultation with a client’s tax and legal advisors and an analysis of the goals for the particular project.
By Jay E. Presser
TEMPORARY ESTATE AND GIFT TAX RELIEF
The enactment of the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (the “Act”) on December 17, 2010 provides some new estate planning opportunities and new planning issues. Instead of the reversion to a $1 million estate tax exemption on January 1, 2011, the federal estate tax exemption was increased to $5 million, but only for two years (2011 and 2012), and, surprisingly, the estate tax was reinstated for 2010, but with an election available to opt out of the estate tax for 2010. Since the Act’s provisions will expire in 2013, the planning uncertainties remain, but there are measures that can be taken to take advantage of the two year increased exemption, and to address the reinstatement of the Illinois Estate Tax, effective January 1, 2011, with only a $2 million exemption.
Provisions of the Act
Estate Tax in 2010. In the case of a person who died in 2010, the Act reinstates the federal estate tax and stepped-up basis rules, which were repealed for the year 2010. The Act grants each estate a $5 million exemption for property subject to estate tax. Estates in excess of $5 million are subject to a 35% estate tax rate. In addition, property in the estate will receive a basis equal to the property’s fair market value on the date of the decedent’ death or on a alternate valuation date (i.e. usually 6 months after the decedent’s date of death). The Act provides estates of persons dying in 2010 with the ability to elect out of the estate tax and to apply the laws in effect prior to the enactment of the Act. If the opt-out election is made, the decedent’s estate will not be subject to estate tax but will be subject to the modified carryover basis rules. Under the modified carryover basis rules, the basis of a decedent’s assets will generally be equal to the decedent’s basis in the assets. The assets of the estate can receive up to a $1.3 million increase in basis, and assets received by a surviving spouse can receive up to an additional $3 million increase in basis for assets received by the spouse which are considered to be qualified spousal property. For decedent’s dying in 2010, the Act extends the filing date for an estate tax return and paying any estate tax due to September 17, 2011.
Estate and Gift Tax in 2011 and 2012. For persons dying and gifts made in 2011 and 2012, the lifetime gift and estate tax exemption is reunified at $5 million per person, adjusted for inflation beginning in 2012. The exemption is first applied to the person’s taxable gifts; any exemption remaining at the person’s death will then be applied to the person’s taxable estate. Prior to the Act the gift tax exemption was limited to $1 million. If a decedent was married at the time of his or her death and dies after December 31, 2010, then any of the $5 million exemption the decedent’s estate does not use is generally available for use by the surviving spouse, in addition to the surviving spouse’s own $5 million exemption, but this is presently only in effect for 2011 and 2012.
Estates in excess of $5 million are subject to a 35% estate tax rate and the property in the estate will receive a basis equal to the property’s fair market value on the date of the decedent’s death or, if applicable, on the alternate valuation date.
The Generation Skipping Transfer Tax in 2010, 2011 and 2012. The generation skipping transfer tax exemption for decedents dying or gifts made in 2010, 2011 and 2012 is equal to the applicable exclusion amount for estate tax purposes (i.e. $5 million in 2010). The generation skipping transfer tax rate for transfers made during 2010 is 0% and for transfers made in 2011 and 2012 it is equal to the highest estate and gift tax rate in effect for such year (i.e. 35%).
Expiration of the Act. Under the Act, the above discussed federal estate and gift tax provisions will expire on December 31, 2012, at which time the $1 million exemption is scheduled to return along with a top tax rate of 55 percent.
Illinois Estate Tax. An Illinois resident was not subject to Illinois estate tax after 2009. However, Illinois has just reinstated the $2 million exemption that was in effect prior to January 1, 2010, which subjects estates greater than $2 million to Illinois estate tax, effective January 1, 2011. In order to take advantage of the full federal estate tax exemption without incurring Illinois estate tax, a special Illinois QTIP Trust can be used for the value of an estate over $2 million, up to $5 million.
Planning Opportunities. Since the $5 million federal estate, gift and generation skipping transfer exemption is only in effect for two years, and is scheduled to revert to $1 million in 2013, everyone should review their estate plans to determine how best to provide flexibility in their estate plan documents, to address the increased exemption, to provide for the possibility ofa smaller federal exemptionin 2013, and to avoid Illinois estate tax on estates over $2 million. In addition, it is now a good time to consider opportunities for gifting to children and grandchildren using the increased gift tax exemption.
By Eileen B. Cozzi
Schoenberg Finkel Newman & Rosenberg, LLC (312) 648-2300
This newsletter is not intended to be legal or tax advice and is not a substitute for obtaining legal or tax advice. This Newsletter is deemed to be advertising material by the Illinois Supreme Court.