<h2>What is a Limited Liability Company?</h2>

<p>Limited liability companies (LLCs) are the most popular choice of organizational form because of the inherent flexibility in most state statutes that enhances the ability of the entity to adopt features that best serve its objectives. LLCs are a very common choice for owning real estate because of their tax treatment, limited liability and flexibility in allocating power structure and management responsibilities.</p>

<p>The best way to understand the unique features of an LLC is to distinguish it from the other entities we’ve discussed in Parts I – III in this blog series. The principal purpose of the LLC is to obtain favorable tax benefits along with the limitation of liability.</p>

<h2>Advantages and Disadvantages of an LLC</h2>

<p>Real estate investors are well served by forming the LLC in a state that has favorable limited liability company act statutes, like Delaware (or Illinois after recent amendments to its Limited Liability Company Act). The goal is to pay no federal income tax at the entity level. An LLC provides an unlimited number of investors with the limited liability of a corporation but the tax advantages of a partnership.</p>

<p>On the other hand, significant disadvantages exist by using the corporate form for real estate investment. The individual shareholders cannot obtain any of the tax benefits generated by the investment. <a href="/blog/selecting-entity-real-estate-purchase-–-partnerships">Unlike a partnership</a>, no pass-through of the corporation’s income tax deductions exists. <a href="/blog/selecting-entity-real-estate-purchase-–-corporations">Corporation profits are also taxed twice</a> - once at the corporate level though the payment of the corporate income tax and again at the shareholder level with the shareholder’s payment of individual income taxes on the distributions received from the corporation. An LLC allows the losses and gains to flow through to the investors.</p>

<p>Subchapter S-corporations allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits on to the shareholders while still providing them with limited liability. Nevertheless, an S-corp cannot have different power allocations among the shareholders. In other words, an S-corp is a corporation that will not allow the investors to establish an unbalanced management structure. The investors can decide who will be active in decision making, operating the property and spending time on a regular, continuous, and substantial basis.</p>

<h2>How to Form and Operate an LLC</h2>

<p>Two documents are needed to form and operate an LLC: Articles of Organization and an Operating Agreement.</p>

<p>An LLC is formed by filing Articles of Organization with the applicable Secretary of State and paying any applicable fees. The Articles of Organization must comply with the enabling legislation enacted in the state under whose laws the LLC is formed. Many states allow the filing to be done electronically, others require sending the paperwork in to the Secretary of State.</p>

<p>The Operating Agreement provides for the operation of the LLC. It is the controlling document that governs the relationship between the members, managers, and the obligations of each.</p>

<p>The Operating Agreement can spell out power allocations and management responsibilities of the members and managers as well as an exit strategy. There is no need for a board of directors or elections because the members just file forms and pay fees to the Secretary of State. The LLC also creates and maintains contractual flexibility. All of the members have the authority to make management decisions unless a different power structure is adopted.</p>

<p>An LLC can be manager- or member-managed. The managers or managing-members who make management decisions on behalf of an LLC generally have limited liability protection. They are not personally liable for the debts and liabilities of an LLC unless a basis to pierce the limited liability shield exists as may be required by public convenience, fairness, or necessity. An LLC will insulate a member’s personal assets from claims of outsiders and other members.</p>

<p>In many instances, an LLC provides investors with the best entity for their individual and collective needs. Unlike a C-corporation, there is no need for a board of directors, meetings, or elections because the members just file forms and pay fees. An LLC is free from qualification restraints imposed on a S-corp.</p>

<h2>How to Dissolve an LLC</h2>

<p>LLC organizers can provide for the LLC’s dissolution on a fixed date in the filed Articles of Organization or continuation in existence until dissolved by the consent of the members or on the occurrence of an event specified in the Operating Agreement. Insofar as the payment of claims, members can arrange for the liquidation of an LLC’s assets to pay current claims, fund reserves for the payment of contingent claims, and determine the proportion of the remaining assets distributable to each member based on the member’s capital account or other measure specified in the Operating Agreement. When the members are ready to wind down and terminate, an LLC can proceed to file Articles of Termination with the applicable Secretary of State after claims have been paid and all remaining assets have been distributed to members, file a Certificate of Cancellation canceling the LLC’s Certificate of Authority to transact business in states other than the state of its organization (if any), and arrange for the filing of a final income tax return for the LLC.</p>

<h2>Summary</h2>

<p>The LLC generally provides real estate investors with a superlative choice for their individual and collective needs. Nevertheless, individuals should consider the following factors in their entirety when selecting the business entity for purposes of owning real property:</p>

<ul>
<li>How long the investors wish to keep the property</li>
<li>Nature of the relationships between them</li>
<li>Personal liability</li>
<li>Tax treatment</li>
<li>Management structure</li>
<li>Number of investors</li>
<li>Duration of the entity</li>
<li>Exit strategy</li>
<li>Allocations of power within the entity</li>
<li>Any other special provisions</li>
</ul>

<p style="margin-left:.25in">&nbsp;</p>

<p>&nbsp;</p>

<h2>C-Corporations</h2>

<p>Corporations are one of the oldest forms of legal entities.&nbsp; A significant body of case law and statutes exist defining the rights and liabilities of shareholders, officers, directors, and third parties dealing with the corporate entity.&nbsp; Certain states, like Delaware, have particularly favorable business corporation statues.&nbsp; As a result, many firms will strategically organize in those states in order to obtain the benefit of those advantageous laws. &nbsp;</p>

<p>Unlike a general partnership that can come into existence without filing anything affirmative, a corporation has a separate legal existence.&nbsp; The corporate structure serves to insulate most of the debts from the shareholders.&nbsp; A corporation is able to hold property in its own name and provide its shareholders with limited liability so long as the shareholders do not commingle funds or engage in other prohibited, self-serving activities. &nbsp;</p>

<p>By-laws are controlling documents enacted by the incorporator who organizes the entity.&nbsp; The by-laws govern the actions of the corporation and relationships of the shareholders, directors, officers and third-parties dealing with the entity.&nbsp; They set forth the framework within which the corporation must operate regarding important aspects, such as management, distributions and dissolution.&nbsp; The board of directors and officers of the corporation provide the management. &nbsp;</p>

<p>Some advantages of c-corporations are:</p>

<ul>
<li>a perpetual life</li>
<li>no restrictions with regard to the participation in management</li>
<li>the permissibility of any power structure &nbsp;</li>
</ul>

<p>One particularly important benefit of utilizing the corporate form of ownership is the limitation of liability for officers and directors of the corporation.&nbsp; Unlike a limited partnership, the corporation’s shield of limited liability is not lost by the shareholder’s participating in the management of the corporation or its property. &nbsp;</p>

<p>Nevertheless, officers of corporations that own real estate must be aware of the potential for personal liability in certain circumstances.&nbsp; A court may decide to “pierce the corporate veil” whenever required by public convenience, fairness, or necessity. &nbsp;</p>

<p>For example, the corporate form may be disregarded by a court when there is such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist.&nbsp; In other words, the corporation must strictly observe the formalities associated with this form of ownership or else risk having personal liability. &nbsp;</p>

<p>Another example where personal liability could potentially be imposed in a real estate ownership context is for environmental hazards under statutes like the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), known also as “Superfund.”&nbsp;</p>

<p>Significant disadvantages exist when using the corporate form for real estate investment.&nbsp; First and foremost, the individual shareholders cannot obtain any of the tax benefits generated by the investment.&nbsp; Unlike a partnership, no pass-through of the corporation’s income tax deductions exists.&nbsp; The corporation’s profits are taxed twice at the corporate level through the payment of the corporate income tax and at the shareholder level by the shareholder’s payment of individual income taxes on the distributions they receive from the corporation.&nbsp; States also impose corporate income and franchise taxes which can materially and adversely affect the financial considerations of owning real estate in a corporation.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; &nbsp;</p>

<h2>S-Corporations</h2>

<p>Subchapter-S corporations are c-corporations that have filed an election with the IRS using Form 2553.&nbsp; S-corps allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits onto the shareholders while still providing them with limited liability. &nbsp;</p>

<p>Nevertheless, certain limitations apply to Subchapter-S corporations such as: &nbsp;</p>

<ul>
<li>There can be no more than one class of stock.</li>
<li>There can be no more than 75 stockholders.</li>
<li>Essentially all investors must be individuals.</li>
</ul>

<p>Profits and losses pass through to the shareholders without a corporate income tax.&nbsp; Shareholders of S-corps are taxed the same as partners, and the taxable income is treated as partnership income. &nbsp;</p>

<p>A disadvantage of S-corps is the difficulty in transferring real estate and other property held by the corporation caused by the limitation on the number of investors.&nbsp; Also, S-corps are subject to the IRS passive loss rules.&nbsp; Lastly, an additional problem imposed by Subchapter-S occurs in the event of liquidation of the corporation or the conveyance of its assets to an operating entity.&nbsp; The corporation could be required to pay corporate level capital gains tax. &nbsp;</p>

<p>In part four of our continuing series of blogs, we will discuss limited liability companies as a form of real estate ownership.</p>

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<h2>Benefits of a Trust</h2>

<p>There are many reasons why a person may choose to hold assets in a trust rather than in other holding capacities.&nbsp; One of the primary reasons is to bypass probate proceedings.&nbsp; When a person’s assets are held in a trust, the trust extends beyond the person’s death. Property held by the trust doesn’t go through probate.</p>

<p>Another benefit of trusts is that they can effectively double the amount of wealth that can be passed on to heirs, and they can be structured to address special needs, for instance the appointment of a trustee for heirs such as minors, handicapped persons, or those with alcohol , drug or gambling addictions.</p>

<h2>Parties to a Trust</h2>

<ul>
<li>Grantor or Settlor - The person who creates the trust, granting or settling assets into the trust.</li>
<li>Trustee - The person responsible for administering the trust</li>
<li>Beneficiary - The person who inherits funds from or otherwise benefit from the trust.&nbsp;</li>
</ul>

<h2><span style="tab-stops:260.45pt">Revocable Trusts&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp; </span></h2>

<p>Revocable trusts are the most common type of trust.&nbsp; As evidenced by the name, this type of trust may be revoked, modified or amended at any time by the grantor.&nbsp; Other names for such trusts include living trusts, self-declared trusts and inter vivos trusts.</p>

<p>With revocable trusts, the grantor, trustee and beneficiary are often one and the same person. These are “tax disregarded” entities and are taxed to the grantor using his or her social security number.&nbsp; The grantor of such a trust can meet the <a aria-label="1031 Exchange Same Taxpayer Requirements" href="/blog/same-taxpayer-requirement-1031-tax-deferred-exchange" title="1031 Exchange Same Taxpayer Requirements">same taxpayer requirement</a> of a 1031 exchange individually, as the trust or even as a single member LLC in which the grantor or the trust is the sole member.&nbsp;</p>

<h2>Irrevocable Trusts</h2>

<p>Irrevocable Trusts also work as their name implies.&nbsp; Once they are set up and funded, they cannot be changed in light of subsequent events.&nbsp; These trusts can be structured to minimize taxes and also can protect assets from creditor claims.&nbsp; An irrevocable trust has its own tax identification number and is not, for tax purposes, &nbsp;treated interchangeably with the grantor/settlor.</p>

<h2>Trust under Will</h2>

<p>A will can provide for a trust to come into being upon the death of the person leaving the will or testator.&nbsp; A testator may have been caring for a handicapped child and, upon his or her death, wishes to ensure that funds are on hand indefinitely to provide continuing care. Or, if beneficiaries of the will are be minors, a trust can set up to hold the assets for them until they are of a specified age.&nbsp; Once these types of trust come into being, they are irrevocable subject to the terms of the trust.&nbsp; Also, once the testator dies and the trust is established, a separate tax identification number is applied to the trust and used going forward.</p>

<h2>Land Trusts</h2>

<p>Land trusts can only hold real estate interests, and they will typically have a corporate trustee, such as a bank or trust company. Some states make broad use of land trusts while others do not recognize them &nbsp;due to technicalities of common law brought over from England when the various state laws were forming.&nbsp; Land trusts are like other revocable trusts; they can be revoked or amended while the primary beneficiary is living.&nbsp; Such a trust may name other persons as successor beneficiaries upon the death of the primary beneficiary.&nbsp;</p>

<p>Under Section 1031, there is a restriction against doing an exchange of a beneficial interest in an asset.&nbsp; However, the drafters of the code section had other types of investments in mind when they wrote this.&nbsp; In order to avoid confusion, the IRS released Revenue Ruling 92-105 stating that the owner of a beneficial interest in a land trust could participate in a 1031 exchange.</p>

<h2>Probate</h2>

<p>If a person dies without a trust, a court-supervised probate proceeding may be necessary to determine who inherits the assets from the deceased person.&nbsp; If the person dies with a will, it is referred to as a testate proceeding.&nbsp; If the person dies without a will, the proceeding is intestate, and the rules of heirship in their state of residence will dictate which heirs receive interests and at what percentage. If there is a will, an executor is named to carry out the distribution of the estate.&nbsp; If there is no will, that person will act as the administrator of the estate. &nbsp;As already mentioned, the existence of a trust will generally obviate the use of the will to transfer ownership of the assets left by the deceased. &nbsp;To the extent that any asset was unintentionally left out of the trust, the will sometimes “pours over” those assets into the trust upon death and the will which accompanies the trust is referred to as a <i>pour-over will</i>.</p>

<h2>Death during Pendency of a 1031 Exchange</h2>

<p>Normally in a 1031 exchange, the same person who sells a property is required to buy the new property, but sometimes the taxpayer sells relinquished property as part of a 1031 exchange and passes away before the exchange transaction is completed. &nbsp;Notwithstanding the old adage about death and taxes, the representative of the estate can, in this scenario, seek to complete the exchange and defer the taxes. In the event the exchange is not completed, the gains on the sale of the relinquished property would be paid as part of the deceased’s final tax return.</p>

<h2>General Partnerships</h2>

<p>A general partnership is essentially an association of two or more people to carry on a business as co-owners. No written agreement is necessary to have a general partnership. One advantage of the general partnership form of ownership is tax benefits. No taxable event happens at the partnership level. In other words, no double taxation occurs in a general partnership. The usual test the IRS uses to determine if a partnership exists is whether the partners share profits and losses, jointly own the capital and assets, and jointly control and manage the business.</p>

<h2>General Partnership Advantages and Disadvantages</h2>

<p>Other advantages of general partnerships include the following:</p>

<ul>
<li>Each partner can participate in the management of a general partnership.</li>
<li>Continuity of the general partnership can be established.</li>
<li>The ownership interest in a general partnership is treated as personalty rather than realty.</li>
</ul>

<p>The disadvantages of owning property in a general partnership include:</p>

<ul>
<li>There is unlimited liability for general partnership partners.</li>
<li>The decisions of one partner can bind the other partners.</li>
<li>The life of a general partnership is not perpetual in duration.</li>
<li>Each partner’s interest may not be easily marketable to third-party purchasers.</li>
</ul>

<p>The structuring of a 1031 exchange by a subsection of the partners is one of the most common questions asked by taxpayers and addressed in the article, <a href="/blog/1031-drop-and-swap-out-partnership-or-llc">“1031 Drop and Swap out of a Partnership or LLC.”</a></p>

<h2>Limited Partnerships</h2>

<p>A limited partnership is an association of two or more people in which the entity has one or more general partners and one or more limited partners. The limited partnership is usually established by filing a Certificate of Limited Partnership with the clerk of the county in which the partnership will be doing business or with the applicable Secretary of State’s office or similar agency.</p>

<h2>Limited Partnership Advantages and Disadvantages</h2>

<p>The major advantages of using a limited partnership to own real estate include</p>

<ul>
<li>A limited partnership allows a passive investor,not active in the management decisions of the partnership, to participate in the investment.</li>
<li>The liability of each partner is limited to the amount of capital that the investor has agreed to put “at-risk.”</li>
<li>There is continuity of a limited partnership in the event of death, bankruptcy, or withdrawal of one of its partners.</li>
</ul>

<p>The disadvantages of owning property in a general partnership include:</p>

<ul>
<li>In order for their liability to be limited, the limited partners cannot engage in the management of the partnership or its property.</li>
<li>The general partner is responsible for making management decisions concerning the limited partnership.</li>
<li>A limited partnership is difficult to market to third-party purchasers.</li>
<li>The limited partners must rely on the ability and expertise of the general partner or else they risk losing their limited liability.</li>
</ul>

<h2>Summary</h2>

<p>In the first of this series on selecting a real estate entity, we looked at sole proprietorships and tenant in common entities; in this installment we examined the advantages and disadvantages of two types of partnerships. <a href="/blog/selecting-entity-real-estate-purchase-–-corporations">In part three, we discuss corporations and the corporate form of ownership</a>.</p>

<p>Recently, I have spoken with a number of taxpayers who have heard about Opportunity Zones and want to know if they are a viable alternative to a 1031 exchange. My answer is usually “it depends.” Here, I provide an overview of opportunity zones and their differences from 1031 exchanges.</p>

<h2>Qualified Opportunity Funds</h2>

<p>An investment under the O-Zone code provision and proposed regulations has to be into a qualified opportunity zone listed by the Community Development Financial Institutions Fund. Typically, the zones are areas where most of the population live well below the poverty level and the O-Zone provisions are obviously designed to encourage investment into Qualified Opportunity Funds (QOF) that have, in turn, invested in qualifying new or used property or qualified businesses after December 31, 2017. These investments may not fit the taxpayer’s property investment goals.</p>

<p>Much like Section 1031, the reinvestment window for a QOF investment is 180 days after the sale. However, unlike Section 1031, the taxpayer has to purchase shares of stock or partnership interest in a QOF invested in the O-Zone. The upside for the taxpayer is that unlike the typical 1031 exchange, which requires a reinvestment of 100% of exchange value for 100% gain deferral, the investor in an O-Zone only has to reinvest the capital gain portion and can draw out the basis on the sale of the relinquished asset. The trade-off for being able to pull out the cash is the obligation to comply with the myriad of rules designed to ensure that the QOF meets the O-Zone requirements.</p>

<h2>Partial Ownership of Real Estate</h2>

<p>When a taxpayer invests into a qualified opportunity zone, they are not purchasing a discrete, solely-owned real property interest (although the taxpayer could conceivably create their own QOF). Most often the investment will comprise ownership of stock or partnership interest in the QOF. This may be an issue for most taxpayers who are used to sole control of their investments. These are the same investors who are uncomfortable with <a href="/blog/fractional-ownership-real-estate">TIC or DST ownership interests</a>.</p>

<h2>Potential for Capital Gains Deferral</h2>

<p>Investing in an O-Zone results in something different than the potential 100% deferral of capital gains achieved with Section 1031 exchanges over the course of ownership of investment or business use property. With an O-Zone investment, the taxpayer can obtain a potential exclusion of capital gain up to 15% between the acquisition of the property during the 2018-2019 window and the end of 2026 (or the earlier sale of the QOF interest). The taxpayer may also achieve 100% capital gain exclusion if the investment is held for 10 years and sale occurs before 2047. Realistically, the gain will probably only be deferred for eight years or the end of 2026, and the gain will have to be reported on the taxpayer’s 2026 return.</p>

<h2>Opportunity Zone Regulations</h2>

<p>Finally, the proposed regulations for O-Zones are complicated and are still a work in progress. For example, there is still no clear definition of what “substantially all” means for purposes of the holdings of the QOF within the qualified O-Zone. There are ongoing annual certification requirements, strict timetables for reinvestment if a QOF investment is sold, a new set of forms for election of deferral and certification, minimum investment requirements for property types, etc.</p>

<h2>Summary</h2>

<p>While O-Zone investments are not a replacement for 1031 real property exchanges, they afford benefits to taxpayers who are willing to invest in the types of properties present in the designated zones and limit their gain deferral to less than the potential 100% deferral available in a 1031 exchange. Certainly, the Treasury will continue to refine the O-Zone regulations, and most likely a whole industry will emerge around these kinds of investments. The key for taxpayers is to learn of the pitfalls and the potential benefits, find advisors who know the rules, perform their due diligence and not to get lost in the O-Zone.</p>

<p>The safe harbor transactions fit within the parameters of the safe harbor created in September 2000 by Revenue Procedure 2000-37 and governs those transactions in which the property is parked no longer than 180 days. However, there are instances in which, for a number of reasons, the replacement property must be parked for longer than 180 days.&nbsp; Common examples are those in which the relinquished property will take longer to market and sell than 180 days or in which construction of improvements are required on the replacement property.</p>

<p>While Revenue Procedure 2000-37 does not cover so-called non-safe harbor transactions, it takes the position of no negative inference merely because certain structures are pre-approved due to the safe harbor:</p>

<blockquote>
<p>Further, the Service recognizes that 'parking' transactions can be accomplished outside of the safe harbor provided in this revenue procedure. Accordingly, no inference is intended with respect to the federal income tax treatment of 'parking' transactions that do not satisfy the terms of the safe harbor provided in this revenue procedure, whether entered into prior to or after the effective date of this revenue procedure.</p>
</blockquote>

<p>Some exchangers mistakenly believe that if a parking period extends past the 180-day deadline they can somehow allow the transaction to keep running and simply conclude their exchange without any adverse consequences. This approach to “blown” safe harbor deals has apparently found some support in a recent court case, <a href="/blog/bartell-decision-non-safe-harbor-parking-exchanges-have-just-become-safer">Bartell v. Commissioner, 147 T.C. No. 5</a>,&nbsp;&nbsp; decided August 10, 2016.&nbsp; In Bartell, the U.S. Tax Court ruled, among other things, that even though the taxpayer entered into what was essentially a safe harbor transaction on August 1, 2000 and the parking period lasted until December 31, 2001, the taxpayer’s <a href="/services/1031-exchange">1031 exchange</a> should not have been disallowed by the IRS. &nbsp;</p>

<p>In Bartell, the court overlooked the 17-month timeline even though the property was purchased by an exchange facilitator with loan funds secured by the taxpayer, the taxpayer managed the construction portion of the deal and the taxpayer was in possession of the property during the parking period.&nbsp; It is clear the parking entity did not really have any true benefits and burdens of ownership.&nbsp; Accruit believes the Bartell case should not be relied on in current similar situations for a number of reasons including the facts that the parking transaction was commenced prior to the issuance of Rev. Proc. 2000-37, it originated in the taxpayer friendly 9th Circuit and, most importantly, the IRS has since made it clear they will not acquiesce to the decision as precedent in other cases.</p>

<p>When, for any number of reasons, more than 180 days is required, the best approach may be to utilize what is referred to as a non-safe harbor reverse exchange which is specifically structured to last longer than 180 days and create true benefits and burdens of ownership in the parking entity.&nbsp; Since these are not typical parking arrangements, each transaction must be structured differently based upon the facts presented.&nbsp; The taxpayer’s CPA’s, attorneys and other advisors working for the taxpayer need to be involved in the process.&nbsp; Accruit has the necessary experience and expertise to assist the taxpayer and all of the other essential parties to the exchange process in navigating transactions outside the safe harbor.</p>