GROWTH STRATEGIES FOR REAL ESTATE DEVELOPERS:
This article examines why the choice of business structure and choice of business entity are critical to the growth potential of a real estate developer.
1. CHOICE OF BUSINESS ENTITY AND CHOICE OF BUSINESS STRUCTURE
A) Five Major Non-Tax Benefits to Consider
This section examines the major non-tax benefits to evaluate for choice of business entity and structure for a real estate developer. There are several other factors to consider but the intent of this article is to discuss the major growth strategies for real estate developers. The first non-tax factor to consider for choice of business entity and structure is:
1) Limited Liability Protection
Real Estate developers want personal limited liability protection from business creditors’ claims. Typically, most real estate developers are either S corporations (S corps), Limited Liability Corporations (LLCs), or Limited Partnerships (LPs). Therefore, this article will solely discuss the benefits and disadvantages of S corporations, LLCs, and LPs.
With S Corporations (S & C), shareholders are the owners of a corporation. Shareholders purchase stock and become investors in the company. Generally, shareholders solely risk the amount of money they invest in the real estate venture.
With a Limited Liability Corporation (LLC), members are similar to shareholders in that they own a membership interest (like shares of stock) in a company. A LLC also provides members or owners of LLCs limited liability protection.
Limited Partnerships (LPs) are comprised of two types of owners: at least one general partner and at least one limited partner. The general partner is responsible for managing the day to day operations of the real estate development. The general partner also does not have personal limited liability protection. Therefore, it is necessary to make the general partner an LLC, so the general partner does not have limited liability protection.
In contrasts, the limited partners are like shareholders of a publicly held company because they are investors without the power to manage the business or interfere with the business operations. Thus, limited partners are financial investors who want a return on investment without managing the business. Generally, limited partners have limited personal liability protection unless they become active in managing the business.
2) Management and Control Arrangements
S Corporations are centrally managed by a board of directors that acts in a representative capacity for the shareholders who elect them.
In contrast, LLCs and partnerships have more flexibility than corporations. Members in LLCs can specify each party’s managerial role through appropriate provisions in the LLC operating agreement. LLCs generally are more flexible and allow innovative management and control arrangements.
LPs are solely managed by a managing partner, which consists of at least one partner or a management team. LPs have less flexibility because limited partners are prohibited from managing the day to day affairs of the business.
3) Allocations of Income & Loss
With S Corporations, shareholders must allocate profits, losses, deductions, and capital proportionally to their shareholder’s interest.
On the contrary, members in LLCs may allocate profits, losses, deductions, and capital in accordance with their specific needs as long as they meet the business purpose test. Essentially, the business purpose test states that you may allocate items disproportional as long as there is a legitimate business purpose behind such decision. The business purpose test is an attempt by the Internal Revenue Service (IRS) to reduce the number of tax avoidance transactions.
LLCs offer real estate developers the flexibility to structure transactions to incentive investors to invest in real estate ventures. For example, Equity ABC Office, LLC is a real estate development company that recruits wealthy investors to invest in their real estate developments. Equity ABC Office, LLC specializes in converting multi-unit apartment buildings to condos and investing in multi-unit apartment complexes that bring a long-term return on investment. To attract investors, Equity ABC Office, LLC offers investors an annual return on investment of 7 %. Initially, Equity ABC Office, LLC struggles to secure investors because of two reasons: first, investors want a greater return on investment than 7%; and second, investors are concerned that their money is illiquid for a five year period.
Equity ABC Office, LLC is smart and offers two solutions to its’ investors; first, Equity ABC Office, LLC promises its’ two investors 45% of the losses a piece while the investors get a 10% interest in the company a piece. Due to the disproportionate losses, investors A & B realize a return on investment of 25 % instead of 7%. Why? The tax losses reduced their capital gains from other investments. Therefore, the tax losses combined with the return on investment produced a promising investment.
Additionally, Equity ABC Office, LLC solved its’ investors’ second concern because investors A & B received part of its’ investments back in Year 1, Year 2, Year 3, Year 4, & Year 5 through the tax losses. Therefore, Equity ABC Office, LLC reduced investors’ A & B’s’ risk of losing their entire investment and investors’ A & B investment was not liquid because they received some of their investment back in Year 1, Year 2, Year 3, Year 4, & Year 5. Investors A & B will have to pay additional capital gain taxes after they have exhausted their basis. However, most real estate developers will continue IRC 1031 like kind exchanges and hence, defer their tax payment. Instead, Investors A & B have used Uncle Sam’s money to re-invest into different properties and earn interest on money that should have been Uncle Sams.
Limited partnerships offer a lot of the same tax benefits as LLCs because LLCs and LPs are taxed as partnerships. Two rules limit passive real estate losses from offsetting passive gains in LLCs and LPs. First, the IRS does not allow passive real estate losses to offset ordinary income unless the real estate developer or investor works at least 751 hours in the real estate development field.
Essentially, this means that real estate investors must work about 15 hours a week in their own real estate ventures to offset passive real estate losses from their ordinary income. Second, if investors or real estate developers want to utilize tax losses, they must have the same type of passive capital gains to offset their passive losses. For instance, short term (less than 1 year) passive losses must offset short term passive gains where as long-term (greater than 1 year) capital passive losses must offset long-term passive gains. The tax benefits associated with real estate development projects significantly affect the return on investment of a real estate developer.
Therefore, the choice of business entity and the tax attributes of a business entity have a major impact on the profitability of a real estate developer.
4. State & Federal Securities law considerations
With S corporations, a real estate developer is limited in offering a small piece of business ownership to a prospective employee. Shares of stock for an S corporation are subject to State and Federal Securities laws. Therefore, a real estate developer must prepare a Private Placement Memorandum (PPM) to offer their key employee a percentage of ownership of the company. A PPM is a strategy to raise growth and capital to assist a real estate developer to further expand and develop. Drafting a PPM is a costly endeavor because an attorney must be consulted to comply with State and Federal Securities law. The attorney’s goal is to find applicable reasons to seek an exemption under State & Federal Securities laws. Therefore, S corporations are ill suited to offering shares in exchange for services.
Moreover, a real estate developer must consider LLCs because a membership interest in exchange for services in an LLC is generally not subject to State and Federal Securities laws. Small real estate developers typically lack capital to hire traditional key employees like a more established real estate developer.
Instead, a real estate developer should consider issuing a percentage of ownership of an LLC in exchange for services of key employees or executives. Successful entrepreneurs understand that a solid management team is essential to realizing a real estate developer’s potential. To realize growth potential, successful entrepreneurs must sacrifice some ownership interest to obtain high quality employees.
Additionally, entrepreneurs should consider entering into a probationary period where the key employee and the principals of the emerging growth company experience working with one another. After this probationary period, the real estate developer will offer a membership interest (% of ownership of LLC) in exchange for future profits. Generally, a future profits’ interest is not immediately taxable by the IRS because the key employees’ capital account is initially zero.
A future profits’ interest is a percentage of net profits of the real estate development company. For instance, ABC, LLC is a real estate company comprised of five managers. Managers A, B, & C have a 10 % membership interest while the two founders of the company own 35% each. ABC, LLC aims to make key employee F their comptroller in exchange for a 5 % future profits’ interest for his/her future services (ignore the fact that partners must reconfigure their percentage ownership interest).
At the end of the year, employee F will get 5 % of net profits in exchange for his or her services. Therefore, the purpose of a future profits’ interest is to attract and retain outstanding employees, to induce employees to remain with the company, and to encourage employees of the emerging growth company to think and perform like business owners.
4. FLEXIBILITY
Flexibility is crucial to any emerging growth business. Opportunities arise at a moments notice and the business structure must be flexible. With an S corporation, flexibility is limited because S corporations are limited to 100 shareholders and one class of stock. Generally, S corporations are able to have different types of common stock without violating the one class of stock rule.
In contrasts, LLCs are more flexible than S corporations because they are not limited to a particular number of shareholders or requirements against different types of ownership interest. For example, an LLC has the flexibility of issuing common membership units (like shares of stock) and preferred membership units (like shares of stock). A common membership interest has the following characteristics: first, common members in case of a dissolution, liquidation, or sale of the business get paid after the preferred members; second, common members typically enjoy greater growth potential in the company than preferred members due to their increased risks.
As a general proposition, preferred members are investors in the company with a fixed rate of return or a guaranteed payment. In contrasts, common members risk their investments with a strong chance of forfeiting their investment. Finally, a real estate development company when expanding nationally and internationally may have different opportunities requiring flexibility in their choice of business entity.
For instance, ABC, LLC is a real estate development company headquartered in Chicago, Illinois. ABC, LLC aims to set up different LLCs in various states and train different entrepreneurs in each state to operate a profitable real estate development company. In each state, the investors may have different capital commitments and demands, which necessitate different business arrangements. An emerging real estate development business must be flexible in designing its business structure.
With S corporations, shareholders must allocate profits, losses, deductions, and capital proportionally to their shareholder’s interest. This requirement can inhibit flexibility because the ownership interest in the corporation may not follow the business deal.
In contrasts, an LLC & LP has flexibility to allocate profits, losses, deductions, and capital proportional to their member’s interest. For instance, ABC, LLC is considering adding two investors in Texas in exchange for a membership interest in ABC, LLC. With an LLC, the two investors can get a disproportionate amount of losses initially to incentive its investment in ABC, LLC. Assume that investor A (10% interest holder) & investor B (25% interest holder) want a 10 % return on investment.
With an LLC, investor A can get 40% of the losses while investor B can get 50% of the losses of ABC Texas, LLC. Note that investors A & B are getting a greater percentage of losses than their ownership interest in ABC Texas, LLC. This result is not possible with an S corporation. The additional losses for investors A & B may be the selling point for investing in ABC Texas, LLC.
Secondly, the disproportionate losses can ensure that investors A & B receive money back immediately to decrease the likelihood of losing their initial investment.
In conclusion, flexibility is a critical consideration for real estate development companies.
Sean L. Robertson is a Wealth Preservation Attorney that concentrates in Commercial Transactions, Wills and Trusts, Asset Protection, and Estate Planning. Sean is Principal of Robertson Law Group, LLC and has extensive experience in representing business owners, real estate investors and developers. Sean can be reached at 312-498-6080 or RobertsonLawGroup@gmail.com.
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