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Forming an LLC Ownership Entity By: Michael Notaro, Esq. [email protected] (510)522-2666

How should you hold title to property? Should you form an ownership entity? This question is often asked by real estate investors - before acquisition, after acquisition or in light of a pending legal action. Whether you form an entity depends on your ownership objectives, risk tolerance, desire for limited liability and willingness to comply with statutory formalities. Most private owners with substantial real estate holdings opt for the LLC (Limited Liability Company) form of ownership, even if they are the sole owner. An LLC offers three potential benefits to the real estate owner-investor: 1.) A shield from most forms of personal liability 2.) Pass through taxation benefits 3.) Increased, but not absolute, investor privacy through designating a nominee LLC manager. Forming an LLC requires preparing articles of organization and paying a filing fee with the Secretary of State. Once properly filed, an LLC affords limited asset liability protection from most business creditors and judgments. An LLC allows tremendous flexibility in its owner-members. A member can be a corporation, living trust or even another LLC. Single member LLC's are also permitted. Furthermore, an existing partnership can be converted to an LLC. Your CPA can help insure this is not a taxable event if business events are continued and the owners keep the same capital ratios. (Note: An LLC will trigger tax liability if prior partners are relieved of tax liability by the new LLC). In addition to an LLC, owners might consider forming a corporation or partnership. This article will focus on LLC's which allow owners to pay business taxes on their individual income tax returns like partners, but provides the legal protection of limited liability for business debts and judgments. The twin benefits of pass through taxation and a qualified liability shield make LLC's immensely popular in California. In considering whether to form an LLC, I have developed a four part analysis I use with clients: First, what do you risk by not forming an LLC? Ascertain your maximum owner-investor liability. If everything went wrong and you were sued on the mortgage, contract, and tort theories, what is the total scope of your liability exposure? How much do you have personally at stake? Second, examine the scope and cost of your current property liability and casualty insurance policies. Find out how much coverage you have with special attention to "seams" in the policy. A seam reveals unprotected owner liability exposure. This may take careful review with your attorney as you uncover gaps in your policy.

Third, ascertain the cost and inconvenience (through compliance with statutory formalities) of forming an LLC. An LLC requires the filing of articles of organization with the Secretary of State and payment of fees. An annual $800 franchise fee is charged plus a percentage of gross receipts tax for receipts over $250,000, up to 11,250 per year. While an operating agreement is not mandatory, it is highly recommended to avoid the default provisions in the Corporation Code. There is also a $20 cost for filing of a statement of information which must be filed within 90 days of formation and biannually thereafter. Fourth, balance the cost and inconvenience of forming the LLC against the risk of depending on insurance alone to fight a legal claim. For large investors, the LLC is a nobrainer. For smaller investors, the cost and burdens of forming the LLC may be outweighed by the benefits afforded from purchasing additional insurance. What is the option to an LLC? For the single operator, it is the sole proprietor form of ownership - a simple way to avoid the red tape. For multi-party investors, it is a general partnership. The general partnership is a multi-party entity which can be formed with no required filing, no required agreement, no required statement of information, no required franchise tax and no annual fee. However, each partner is personally liable for all business debts and any claims or judgments against the partnership. It should be noted that the even LLC's do not shield members from some forms of personal liability (undercapitalization, intentional tort, ignoring formalities etc.). If you do decide to form an LLC, take the time to have the operating agreement properly drafted and negotiated. Recently, I had LLC members in my office haggling over a boilerplate operating agreement. The members had no idea what the agreement said and did not much care. A properly drafted agreement which considers allocations, distributions, termination, voting, capital requirements and other items will save much heartburn at the end of the transaction. Here are a few tips as you work with your attorney and draft an LLC agreement: 1.) Who belongs in the deal? Ascertain the confluence or divergence of member interests very early in the process. Generally, each party brings something to the table. One party may bring construction knowledge, another financing resources, another cash etc. While diverse expertise helps the LLC succeed, members must also share financial objectives, investment style and timelines for the project. One member may eschew cash, while another needs a steady cash flow. One member may need losses, while another needs profits. One member may be cash rich, while another is cash poor. Furthermore, development timelines may differ substantially. One member may desire a short holding period, while another desires an extended holding period. One member may want a 1031 exchange while another wants to cash out.

The divergence of goals and objectives is grounds for conflict, sometimes sooner rather than later. Strong conflicts require separate counsel and maybe cancellation of the whole idea. Often, the wisest decision is not to form any entity, despite willing associates, friends and family. I have seen lifetime friendships evaporate quickly when members have radically different ideas for funding and running their LLC. 2.) Get your accountant or CPA involved in the process very early. Forming an LLC can have significant tax consequences. Ask your advisor three questions: Is forming the LLC a good idea? How can tax benefits be maximized? How can adverse tax consequences be minimized? 3.) If you decide to form an LLC, do it before entering a real estate purchase agreement. Ideally, you should form the LLC as the first step. Assigning the contract to the LLC after the property is in contract may agitate the lender, increase costs and creates needless transactional liability. Starting with the LLC is the prudent choice. 4.) Parties should create a written operating agreement defining the rights and responsibilities of members. Identify trigger events like debt, disability, withdrawal, expulsion, divorce, bankruptcy, retirement etc. Members should discuss who will manage the LLC and how. Discuss these issues while member relations are amicable and memorialize decisions in the operating agreement. 5.) Carefully craft a procedure for determining interest valuation when a member leaves the LLC. The agreement should contemplate whether a member is entitled to be bought out upon leaving the LLC, and if so, how the buyout amount will be calculated and paid. Remember, the market will often discount the value of noncontrolling member interests. This discount may range from 0% to 25%. Agreeing upon the process for valuation in the agreement may save members from a contentious departure battle. 6.) Assess the willingness of members to abide by formalities and exercise discipline. Members must abide by statutory formalities, or the LLC will fail to shield members from liability. While not required, member meetings are recommended for major decisions. Fiscal discipline is vital to the success of the venture, and the operating agreement should expressly prohibit improper distributions. If members cash out the LLC, resulting in inadequate capitalization, an aggressive plaintiff has grounds for piercing the LLC veil. The obligation to maintain adequate capitalization continues throughout the life of the LLC. 7.) Is forming an LLC in another state a better choice? Most states have filing fees a fraction of those in charged in California with added liability protection. While your LLC must qualify to do business in California, it can be formed in Nevada or Delaware or any other state. Some states provide added savings through allowing series ownership of multiple properties with compartmentalized liability under one umbrella LLC. 8.) How will members deal with maintaining capital accounts and cash calls? If money is required, the members need to have a process for raising it. Will all members be required

to invest additional capital? What will happen if a member does not make a required contribution? Will non-contributing members experience a dilution in share value? Finally, what level of nonperformance entitles members to pull the plug and dissolve the LLC? These issues should be discussed and incorporated into the operating agreement. 9.) Insure that the LLC complies with security laws. A security is defined as the sale of an interest with the expectation of earning profits from the efforts of others. If each LLC member is active in the business, the LLC should not be considered an LLC. However, where all members are not managers, you must treat all sales of LLC interests, even sales to managing members, as security sales. The sale of "passive" investment interests activates security laws. This requires qualifying or seeking a security exemption for the sale of LLC interests. 10.) Use tenancy in common to reconcile differing exchange objectives. Some members may desire a 1031 tax deferred exchange while others want to cash out. Members can unwind the LLC a year before sale or consider holding the LLC in concert with one or more TIC (Tenants in Common) interests. A TIC provides the flexibility for owners to go their separate way on closing. 11.) Maximize the privacy benefits. Where desired, an LLC may help prevent your name from coming up in an asset search. For instance, a corporation can be designated as a nominee member. Choose an in state third party entity as agent for service of process. This method is not foolproof. You may still be compelled to disclose your interest in a valid debtor examination hearing.

Disclaimer: This article is intended to for the personal use and general information of the reader. The author makes no representations or guaranties regarding the accuracy of the information contained herein. Nothing in this article should be relied upon in dealing with a specific legal matter or answering a specific legal question. This information may not be reproduced without the permission of the author.


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