LLCs as Real Estate Investment Vehicles
Real estate investment funds were historically structured as general or limited partnerships, primarily to exempt investors from corporate-level taxes. Limited liability companies, or “LLCs,” provide nearly identical tax benefits as partnerships, but avoid the unlimited liability risks associated with them.
LLCs were first used in Wyoming in 1977, but they received little attention until the Internal Revenue Service issued a ruling in 1988 treating them as partnerships for federal income tax purposes. Prior to that, it had been the IRS’s long-standing position that limited liability entities could not qualify for partnership treatment. Some additional confusion was resolved in 1996, when the IRS formulated “check-the-box” regulations that effectively made partnership treatment the default mode for most LLCs. LLCs are now an accepted business form in every state.
LLCs are hybrid entities. They provide equity holders with the same protection from liability as traditional corporations, yet they generally are exempt from entity-level taxes, in the same manner as traditional partnerships. This “flow-through” tax treatment is especially important to real estate ventures, as investors want to be able make use of the tax benefits of debt-financed depreciation deductions.
LLCs are flexible. The nature of their management structures as well as the financial relationships among their equity holders can be almost entirely determined by the parties in the LLC’s operating agreement; they are exempt from many of the formalities to which corporations must adhere. Additionally, there are no statutory restrictions on LLC membership; individuals, corporations, partnerships, trusts, and other entities (whether domestic or foreign) may be members of an LLC.
Equity holders in an LLC have a membership interest. The membership interest is made up of not only the economic interest (participating in profits and losses, sharing in distributions, etc.) but also information rights and certain rights to participate in the management of the entity – namely, voting rights. Depending on the operating agreement, members can sometimes transfer their economic interests, but not their non-economic rights, unless the transferee is formally admitted to the LLC.
LLCs can be managed by all their members together, but normally one (or a few) of the members, or a separate person or entity, is designated as the manager. Rights and duties of the LLC can be delegated among members and managers however the parties like, but normally power is somewhat concentrated in the manager, so that not every member has the power to bind the LLC in contracts with third parties.
Members and managers of an LLC generally cannot be held personally responsible for debts or other obligations of the entity solely by reason of their status as equity holders or managers. Unlike limited partnerships, this remains true even if they actively participate in the management of the business. However, members or managers are not protected from their own misconduct, even when committed in the name of the LLC.
The typical LLC is classified as a partnership under federal income tax rules, so that it is not itself subject to federal or state income tax. This means that distributions of cash or property generally will not give rise to current income tax liability for the LLC itself; it files a tax return only as a reporting function. Instead, members are required to report, on their own income tax returns, their allocated share of the LLC’s taxable income or loss substantially as if such income or loss had been recognized directly by the members.
Why don’t all businesses operate as an LLC? LLCs aren’t suitable for every business venture. Banks and insurance companies usually can’t operate as LLCs, and publicly traded companies are generally taxed as corporations regardless of their LLC status. A start-up company using venture capital funding would (if formed as an LLC) pass through “unrelated business income tax,” or UBIT, that is not attractive to tax-exempt investors. Also, companies wanting to use tax-qualified incentive stock option plans or similar equity compensation cannot do so under the LLC format.
The flexibility of pass-through taxation, limited liability, and management structure have made the LLC an increasingly popular choice of ownership entity, especially for the ownership of commercial investment real estate. As the LLC has evolved and increased in management flexibility, it has generally replaced limited partnerships as the investment vehicle of choice for real estate investors.