Real Estate and
the Limited Liability Company (LLC)
Background. Once upon a time, people owned investment real estate in their own names, even when the property was developed and producing income. When two or more people wanted to invest in real estate, they sometimes did so by holding title as tenants in common, or by forming a partnership and having one of the partners hold title on behalf of the other partners. Unfortunately, such arrangements often had unintended and undesirable consequences for the owners. For example, one who owned land in his or her own name was exposed to “unlimited” liability for personal injury to someone on the property. And when two or more people held title as co-tenants, the death of any one of them suddenly made the survivors co-tenants with the decendent's heirs, with whom the survivors might not be able to get along.
Different Types of “Limited Liability Entities”. To help avoid these situations, state laws have made it possible to form various kinds of “entities” that are separate from the people who own them. Examples include the venerable “corporation,” the “limited partnership” and, the more recently invented “limited liability company”. These entities have certain featured in common. First, they allow their owners to achieve “limited liability”, meaning that the liability of an owner for the acts of the entity are (with a few exceptions) limited to that owner’s investment in the entity. Second, they allow “centralized management”, meaning that the owners can elect or designate a representative (e.g., a corporate officer, or a general partner) to be in charge of the day to day affairs of the entity, and that third parties dealing with the entity can rely upon that representative’s word to bind the entire entity (i.e., it is not necessary for third parties to obtain the signatures of the sometimes numerous owners of the entity). Third, these entities have “perpetual existence”. They can continue to exist beyond the lives of any of their individual owners. This feature provides for business continuity without disruption by periodic dissolutions and probates caused by the death of the individual owners. Fourth, these entities each have (or can have) different income tax characteristics and tax benefits (e.g., 401(k) deferred compensation plans) that are not available to individuals. The choice of entity is therefore often driven by tax considerations. Each of these entities has advantages and disadvantages that are beyond the scope of this article. So, I recommend that you seek advice from your attorney and/or tax advisor before deciding upon which type of entity to use for your particular business or investment situation.
Differences in Terminology. There are some differences in terminology between the various types of entities. To avoid confusion, I think that it is helpful to know some of these differences. For example, the owners of a corporation are called “shareholders”. The people who manage the day to day operation of the corporation are call “officers” (e.g., president, treasurer, and secretary). The owners of a partnership (whether general or limited) are, of course, called “partners”. But in a limited partnership, only the “general partners” have authority to make decisions for the partnership. In an LLC, the owners are called “members”. As discussed below, an LLC can be managed either by its members, or by a “managing member” or “manager”.
Popularity of the LLC. As mentioned above, almost all limited liability entities provide to their owners the “big four” advantages of limited liability, centralized management, perpetual existence, and certain tax benefits. But the LLC also provides certain advantages not available to some other entities. Some examples follow:
Tax Flexibility. An LLC can elect to be taxed as a corporation, or as a partnership, depending upon which is most advantageous to its members. The LLC can also “allocate” cash flow, income, expenses, capital gains and capital losses among its members in almost any manner to which all members agree. This flexibility could, for example, allow a member in a lower tax bracket to receive more of the LLC’s taxable income (in a profitable year), while allowing another member who is in a higher tax bracket to receive a greater amount of the LLC’s tax deductible losses (in an unprofitable year).
Different Classes of Membership. An LLC can create different classes of membership, each with its unique rights, obligations and limitations. Having different classes of membership can be important when, for example, the members want to raise capital from “silent owners” of the LLC, or when the members of the LLC do not want the heirs of a deceased member to have voting or managerial rights.
Non-Perpetual Duration. Unlike corporations, an LLC can elect to have a fixed, rather than perpetual, duration of existence. The duration can be defined by a length of time (e.g., 20 years), or by the happening of an event (e.g., the death of a member whose skills were essential to the success of the LLC).
The LLC and Real Estate. In Washington and most other states the LLC has become the usual entity of choice for owning and managing real estate (other than a personal residence). If you intend to use an LLC for these purposes, I recommend that you seek the advice of your lender or mortgage broker (if applicable) and a real estate attorney before forming the LLC or buying the property. In some cases, it makes sense to purchase the property in the names of one or more of the individual investors, and then to form and transfer title to the LLC. In other cases, it makes sense to form the LLC first, and then to have the LLC buy the property. The following are some of the variables that can influence this decision:
- whether the borrowing LLC can obtain interest rates and terms that are as favorable as those available to individual borrowers;
- whether the deed of trust or mortgage contains a “due on sale” clause (these days almost all loan documents do contain such a clause);
- whether the lender is likely to enforce that clause upon a transfer of title from the individuals to the LLC;
- the cost and availability of a title insurance endorsement or new policy that will insure title in the new entity; and
- whether any of the members could benefit from buying the property individually or as co-tenants, in order to facilitate a “tax free exchange” under section 1031 of the Internal Revenue Code.
How to Form a "Simple" LLC. The procedures for forming a Washington LLC are contained in Revised Code of Washington (RCW) Chapter 25.15 (the "LLC Act). The procedures contained in the LLC Act do not address any of the state and federal tax related procedures and requirements that become applicable once the LLC is formed. I will briefly mention some of those procedures and requirements later in this article.
If the LLC will have only one member, or if the LLC will have only two members who are married to one another, then you might consider forming the LLC yourself, without the help of a lawyer. A do-it-yourself LLC can be formed quickly and inexpensively using the online forms provided by the Washington Secretary of State at its website, https://corps.secstate.wa.gov/llc/pages/startpage.aspx. The Secretary of State will not provide an LLC Operating Agreement. However, in these simplist of cases, the LLC members can probably do without one. Instead, the members can rely upon the detailed "default" provisions of RCW Chapter 25.15 (most of which apply unless the LLC members agree otherwise). In all other cases, I recommend that the members create and sign an LLC Operating Agreement. As of this writing, the cost of forming an LLC using the Secretary of State's online forms is approximately $175.00. The current fee schedule for forming LLCs and other entities can be found at the Secretary of State's website.
If the LLC will have only a few members, all of whom are related, or if there is otherwise an usually high degree of trust and cooperation among the members, then the members might want to consider using one of the numerous online entity formation services, such as Companies Incorporated (www.companiesinc.com), to form the LLC and to provide a generic Operating Agreement and other related forms. As of this writing, the cost (including registration fees payable to the Washington Secretary of State) of forming an LLC using such a service is approximately $400.
Regardless of how simple your circumstance might seem, I strongly recommend that you consult your tax advisor about whether an LLC is the best entity for you, and whether you could benefit from including in the LLC Agreement any special tax or estate planning provisions. If so, you might also want to consult with a tax and/or estate planning attorney to help you design and draft those provisions.
In all cases, after forming the LLC I recommend that you again consult with your tax advisor to make sure that the LLC completes all necessary tax and business license filings (e.g., application for a federal tax identification number, a Washington “master business license” and the related “unified business identifier” (UBI) number), properly sets up its books and files the required periodic tax and administrative reports.
LLCs with Two or More Unrelated Members. If two or more unrelated people (i.e., people whose financial interests differ) wish to form an LLC, things get a little bit more complicated. In these situations the prospective members need to make some important decisions before they form the entity. A few examples follow:
- If the LLC is to be managed by a managing member or manager (collectively, a “Manager”), rather than by taking a vote of the members for each decision, then the prospective members must decide who the initial Manager will be; whether the Manager’s powers and/or duties will be limited; whether and how the Manager will be compensated; and the circumstances under which a Manager can be replaced by one or more of the members.
- The prospective members also need to decide whether and how new members can be admitted, and what rights the heirs of a deceased member will have.
- The prospective members might also benefit from having the LLC Agreement provide for special tax allocations (of income, expenses, gains and losses).
- The LLC Agreement should address the circumstances under which the LLC can require members to make additional investments (capital calls), the consequences to member who fail to make these required additional investments.
The LLC is an extremely flexible tool. But, in order to make the best use of this flexibility the members need to make a relatively large number of informed decisions about the provisions to be included in the LLC Operating Agreement. Depending upon the number of prospective members, their relationships, and their objectives, I might recommend that the prospective members consult with an accountant, a tax attorney, an estate planning attorney, a securities attorney and/or a corporate attorney. Some attorneys and accountants can provide advice in several of these areas.
Bear in mind that ethical considerations and professional regulations prohibit (with some exceptions) an attorney from representing the LLC while also representing one of its individual members. The attorney is likewise prohibited (with some exceptions) from representing multiple members whose interests are potentially adverse. These limitations are intended to help avoid conflicts of interest in situations where the best interests of the LLC or a particular member are contrary to the interests of one or more other members.
Please remember that this article contains only the most basic information about its subject matter. I do not intend this article to contain detailed legal advice specific to any particular person or situation. Before entering into any agreement concerning real estate, I urge you to consult with a real estate lawyer and with your tax or estate planning advisor.