Commercial Real Estate Ownership Structures: LLCs Versus LPs
Of the many factors that go into a decision to own income-producing properties, one of the most underrated aspects is ownership structure. Ownership structure refers to the manner in which the title to a property or properties is held.
As an attorney (thankfully no longer in practice), I always shudder when I see a title to a property being held in an individual capacity. The reason for this is simple—liability. Without the personal protection offered by various ownership entity structures, an individual on a title is potentially exposed to unlimited liability for things that happen on the property. This means that a person with a legal claim relating to a piece of property can potentially go after the property itself, as well as the individual owner’s personal property, to satisfy a judgment.
The simplest and most commonly used way to mitigate the unlimited liability associated with real estate ownership in an individual capacity is to form a limited liability company (“LLC”) or limited partnership (“LP”) to hold title to the property.
This article will provide some basic information regarding commercial real estate ownership structures.
What are the liability differences between LLC’s and LP’s?
An LLC ownership structure can provide personal asset protection to its members, meaning that LLC owners are protected from personal liability for business debts. In this situation, creditors often will not have a legal claim against an LLC member’s house, car, or other personal possessions for a claim against the LLC. Business debts are paid off only by the LLC business assets, so the individual owner(s) typically only stand to lose monies invested in the LLC.
In contrast to an LLC, a limited partnership only offers personal liability protection to its limited partners. General partners, on the other hand, still maintain personal liability for business debts. A company can sue a general partner individually for debts incurred by the partnership, and that partner’s personal assets can be awarded to creditors as repayment for debts. Often in an LP, the general partner will actually be an LLC in order to mitigate this potential exposure.
What is the Management Structure Difference of a Limited Liability Company and a Limited Partnership?
An LLC can have one or more members. The LLC is managed according to its operating agreement, which is created and agreed to by the members. Thus, members have full control over the financial contributions made by each member, how profits are distributed, and who is responsible for management decisions. The operating agreement can be changed at any time pursuant to the terms it contains.
Unlike an LLC, a limited partnership must have at least two members: one general partner and one limited partner. Limited partners are presumed to be passive owners and have no control over the daily operations of the business, and in return, have no personal liability outside their initial investment. General partners, on the other hand, have complete control over daily operations and maintain the liability described above. This is often an important consideration to the creators of LPs, particularly when they have many investors in a deal and want to make sure the operations stay within the control of the general partner.
Steps to Form an LLC or LP
Forming an LLC or LP is not particularly difficult or expensive, but certain requirements must be met. These vary from state to state, so it is important to consult with a trusted professional to make sure the business is set up pursuant to the laws of the state of formation.
The first step in forming an LLC or an LP is to choose a name for the entity. For an LLC, the name must contain the initials “LLC” or “limited liability company.” Similarly, an LP must contain the initials “LP” or the phrase “limited partnership.”
The second step is to designate a registered agent who will be responsible for accepting legal documents.
The third step is to file certain documents with the state’s Secretary of State. To form an LLC in California, you must file a document titled “Articles of Organization,” which provides the basic information regarding your LLC. To form an LP, you must file a “Certificate of Limited Partnership,” which contains content fairly similar to the content of Articles of Organization. A small fee is also paid to the Secretary of State.
The next step is to create an internal document that outlines how the entity will be run. For an LLC, this is called an operating agreement, and for an LP, it is called a limited partnership agreement. This document is critical, as it describes the true nature of the agreement between the owners of the entity.
After being processed by the Secretary of State, your new legal entity has officially been formed and is ready to do business. The entity will also need a federal tax ID and will be responsible for filing federal and state taxes.
When a decision is made to acquire income-producing property, due consideration ought to be paid to the manner in which the title will be held. There are many different ownership structures allowed under the laws of the United States, but the LLC and LP are two of the most common choices. Both reduce liability exposure, albeit in different ways and to different degrees. It is worth talking to your CPA or legal counsel to decide which entity is right for you.
Sam Levy is a Vice President at Slatt Capital. Prior to becoming a mortgage banker, Sam practiced real estate and tax law in California, appearing before state, federal, and U.S. tax courts. Sam no longer actively practices law but still uses his legal background and expertise in conjunction with borrowers’ counsel to facilitate the completion of complex lending transactions. Nothing in this article is intended as legal advice.