Feature
by George R. Wilson
Much has been written regarding the use of Limited Liability Companies (LLC) since they were first created by the State of Wyoming in 1977. Over the past seven years, I have witnessed the transition from complete ignorance of LLCs to almost universal acceptance.
Legal Entities for Real Estate
LLCs are, in fact, useful entities that generally offer the liability protection of a corporation with the flexibility and tax benefits of a partnership. As a result, many attorneys and accountants recommend using an LLC for a client’s real estate business without much thought. In this article, I intend to introduce a consideration into the decision of whether property owners should use LLCs to hold their real estate.
Larry Landowner and his brother, Lance, just inherited five apartment buildings in San Francisco from their mother. Their attorney has recommended that they transfer their properties to a legal entity for liability protection. The lenders require that each property should be held by a separate legal entity. Larry and Lance agree and would like to use entities that are taxed as partnerships for federal income tax purposes in order to minimize the tax impact of holding their properties in legal entities.
Prior to the introduction of LLCs, the standard practice in the real estate industry was a structure based on a limited partnership with a corporate general partner that owned 1 percent of the partnership. This structure functioned effectively and would have been the best choice for Larry and Lance. A limited partnership must have at least one general partner. General partners have unlimited liability for the partnership’s debts. If Larry and Lance pursue this approach in order to fully protect themselves, they must form a corporation to act as the general partner of the limited partnership. An election typically is made to treat the corporate general partner as a sub-chapter S corporation for the optimum tax results. Unlike a regular, or “C Corporation,” an S corporation is generally not subject to income tax. Instead, like a partnership or LLC, the profits/losses of the S corporation flow out to the shareholders and are taxed at the shareholder level. This may prevent the double taxation of income which can occur with C corporations. Larry and Lance must own both the limited partnership and the corporate general partner. They also need to comply with the rule that limited partners are restricted from participating in the management of the partnership.
With this structure, Larry and Lance achieve liability protection with the tax advantages of a partnership. Nonetheless, two legal entities (the limited partnership and the corporate general partner) are required for each property. Larry and Lance’s five buildings, therefore, require the formation and maintenance of 10 entities. Each entity requires annual corporate filings and tax returns.
The creation of LLCs offer taxpayers another option. LLCs are taxed like limited partnerships, provide their owners with liability protection, but do not require a general partner. Additionally, the owners of the LLC are not restricted from managing the entity the way limited partners are with a limited partnership. Consequently, they have quickly become the favored entity for real estate. Thousands of LLCs in California have been formed over the past few years replacing the traditional structure of limited partner(s) and a corporate general partner. If Larry and Lance use the LCC structure, they could achieve their desired results, yet only form and maintain five entities.
The Consideration: California Taxes
Generally, California does not apply an income tax to limited partnerships, LLCs and S corporations. Instead, the state taxes the owners of these entities. It does, however, apply at least three other types of taxes to the entities. First, the state imposes an $800 minimum annual franchise tax (MFT) on LLCs and limited partnerships. Second, it applies a 1.5 percent tax on the net income of S corporations, one that must be at least $800. Third, California imposes a tax on the gross receipts of LLCs at graduated rates. The tax on an LLC with $500,000 in gross receipts is $2,500.
Assume that each of Larry and Lance’s five buildings generates $500,000 in annual gross rents and has $400,000 in expenses (net income of $100,000). On the previous page is a comparison of the impact of the California taxes discussed above if Larry and Lance used limited partnerships (with a corporate general partner) or used LLCs to hold their real estate.
| A. Limited partnership and S corporation* general partner (10 entities). | |
| MFT on Limited Partnership 1.5% | $800 |
| Tax on S corp (min. $800) | $800 |
| Sub-Total (per building) | $1,600 |
| Total per year for all entities | $8,000 |
| B. LLCs (5 entities) | |
| MFT on LLC | $800 |
| Gross Receipts Tax on LLC | $2,500 |
| Sub-Total (per building) | $3,300 |
| Total per year for all entities | $16,500 |
(*The S corporation owns 1 percent of the limited partnership, and therefore it is allocated 1 percent of the partnership’s net income or $1,000.)
Conclusion
As shown on the chart on the previous page, using LLCs will cost Larry and Lance $8,500 more per year in California taxes than using limited partnerships. The result of the above comparison will vary considerably depending on the number of properties involved and the rents/expenses of the properties. To further complicate this analysis, some of the above California taxes are deductible against federal and state income taxes thus reducing their impact. Also, do not ignore the fact that there are costs (both in terms of money and time) associated with forming and maintaining the extra entities required when using limited partnerships. These costs may or may not outweigh the California tax savings of using limited partnerships. Many people would gladly pay a few thousand dollars more a year for the simplicity of using LLCs.
I have made many generalizations and unstated assumptions in this analysis and omitted many tax and legal issues that should be considered. By no means am I recommending that property owners decline to use LLCs, since Larry and Lance would pay less in California taxes if they used limited partnerships. My only goal is to demonstrate that real estate owners should consider all costs before deciding to use LLCs in California.
Nothing in this article should be construed as legal advice or a legal opinion. Any individual considering the possibility of forming an LLC or other legal entity should consult their tax advisor regarding the tax impact.
The opinions expressed in this article are those of the author and do not necessarily reect the viewpoint of the SFAA or the SF Apartment Magazine. Jeffery P. Woo is the principalof the law firm of Woo& Associates. He can be reached at 415.705.6470 or by email atwoo@mypropertyrights.com. Copyright © 2003 San Francisco Apartment Magazine