Owning Up

Alec J. Pacella, CCIM

Many years ago, I was meeting with a person that made an off-the-cuff remark of an ownership position in several high-profile properties and made several references to “he and his partners.” This caught me off guard a bit, as this person was relatively young and the portfolio of properties was substantial in value. As the years have passed, I have a better understanding of the many different ways to actually have an ownership position.

This month, we are going to discuss the most popular forms of ownership, because being an “owner” is not always what it may first appear.

Sole Proprietorship

This is ownership consisting of a single person. There are no costs to form this type of ownership; rather it legally exists the moment an individual does business with themselves. In addition to the simple and low/no cost to form, there are some other advantages. Income, expenses, gains and losses can be reported directly on the individual’s tax return. But this is offset by several significant disadvantages. The most problematic is unlimited liability; if I own a shopping center as a sole proprietorship and someone slips on the ice, they can come after any of my personal assets to satisfy a judgment.

[A key disadvantage of Sole Proprietorship] is unlimited liability; if I own a shopping center as a sole proprietorship and someone slips on the ice, they can come after any of my personal assets to satisfy a judgment.

General Partnership

A general partnership is the default form of ownership that consists of more than one person. Each member is considered a general partner and has equal rights, unless otherwise memorialized. Similar to sole proprietorship, there are no formalities or costs to form. It is the default the moment two or more people carry on as co-owners of a business for profit. Unlike a sole proprietorship, a general partnership is a pass-through entity – any tax liability is passed through the general partnership onto the underlying partner’s respective personal tax returns. One of the biggest disadvantages is again unlimited liability, even if another partner created the claim. A general partnership also has a finite life and, unless otherwise memo-realized, will terminate upon the death or withdrawal from any of the partners.

Limited Partnership (LP)

An LP is an entity made up of at least one general partner and one or more limited partners. The operation of the LP is governed by a partnership agreement, which results in cost and complexity. The general partner(s) are responsible for all business management of the partnership and have unlimited financial and legal liability. Limited partners take no role in day-to-day management and are afforded liability limited to their interest in the partnership. An LP is a pass-through entity and each partner will own an interest in the partnership and not the real estate itself. But an LP can have a finite life if the partnership contains a date on which the partnership will end.

Limited Liability Partnership (LLP)

An LLP is an entity made of up any number of limited partners. These are common for professional organizations, such as accounting, attorney or architectural firms. They are formed and governed by a partnership agreement. Partners in an LLP generally have limited liability, expected related to negligence, and one partner’s actions will not impact the other partners. Each investor has management rights, which precludes them from being a passive investor.

Limited Liability Company (LLC)

In 1988, the IRS approved the LLC structure, and it has become the preferred method of ownership for most real estate investors. The number of members of an LLC is unlimited and an operating agreement is required, as is the filing of articles of incorporation in its home state. There are two types – member-managed and manager-managed – but both types include limited liability for all partners. Members managed LLCs operate similar to an LLP as all members have equal say in business operations and decisions. All members can sign checks, enter contracts and otherwise legally bind the LLC. Manager managed LLCs are similar to a corporation, with a member(s) and/or an outside party appointed to run the business on behalf of all of the partners. LLCs are considered pass-through entities and can include different classes of investor, which can facilitate preferential allocation of benefits among the members. The title to real estate is held by the LLC and each member owns an interest in the LLC but not the property itself.

C Corporation

This is a legal and tax entity owned by one or more shareholders and managed by directors. A C-corp is organized within a particular state and subject to the governing laws of that state. In addition to articles of incorporation, it also needs bylaws, which outline the operating rules for the corporation. As a result, the formation of a C-corp is complicated and expensive. A C-corp offers limited liability for the shareholders and shares can be much more liquid, especially if the C-corp is publicly traded. The life of a C-corp is not tied to any specific shareholder, director or officer. A major disadvantage is a concept known as double taxation; profits are taxed once at the corporate level and then a second time upon distribution, typi- cally in the form of a dividend, to the shareholders. Another disadvantage is the inability of shareholders to take advantage of operating losses.

S Corporation

This is a type of corporation that elects to be taxed as an S-corp. It can be owned by individuals, estates or trusts. There are several requirements associated with establishing an S-corp, including not having more than 100 shareholders; all shareholders must be individuals, estate, trusts and no more than one class of stock; among others. Unlike a C-corp, an S-corp is considered a pass-through entity and offers limited liability to the shareholders.

Real Estate Investment Trusts (REITs)

This is a corporation otherwise tax-able as a C-corp that makes an election to be taxed as a REIT. They usually buy real estate and can be publicly or privately traded. The primary advantage is avoidance of double taxation. Unlike a C-corp, there is no federal tax paid on profits at the corporate level. Only distributions to the shareholders are taxed. There are several criteria that must be met to establish and maintain REIT status, including that at least 90% of the taxable income is distributed to shareholders; at least 75% of the assets are in real estate, cash or government securities; and at least 75% of income comes from real estate investments, among others.

Real Estate Investment Trusts [REITs] usually buy real estate and can be publicly or privately traded. The primary advantage is avoidance of double-taxation.

In a conversation several years later, I discovered that the young owner that had a position in that substantial real estate portfolio actually owned shares of a REIT and his “partners” were the other shareholders, most of whom he didn’t even actually know. Time to own up, indeed!

Alec Pacella for Properties Managzine December 2023