Investors in California real estate hope for returns on their investments, but they must also understand the inevitable risks. A real estate investment, whether it involves participating in a real estate syndicate, buying shares in a real estate investment trust or buying land for development, is a business venture. All business ventures involve risk, starting with the loss of the investment principal and continuing to the limits of the imagination. Investors should carefully consider their potential liabilities and plan a business entity accordingly. Proceeding without any formal legal structure creates a sole proprietorship or general partnership, which offers no protection from liability. California law allows real estate investors to form various business entities that can shield them from liability for business obligations, including a limited liability company (LLC).
One of the biggest disadvantages of a sole proprietorship or general partnership is a complete lack of liability protection. The owner of a sole proprietorship is personally liable for all business debts. A partner in a general partnership is jointly and severally liable for partnership debts, and they may be personally bound by business decisions undertaken by a partner.
The owners of an LLC are generally not personally liable for business debts. Courts have a strong presumption against holding LLC owners personally liable, known as “piercing the corporate veil.” They can only do this in extreme situations, such as a case involving illegal conduct or gross negligence by the owners.
Membership in a Limited Liability Company
LLCs bear similarities to both corporations and partnerships. With regard to ownership, LLCs are somewhat similar to corporations. Owners are known as “members” rather than “shareholders.” An LLC is created by filing “articles of organization” with the California Secretary of State. An operating agreement among the members—which should be in writing— governs the management of the business.
Members of an LLC have voting rights similar to those of shareholders. According to California law, all members owe one another a duty of good faith and fair dealing. Members who take an active role in managing the business owe the less active members duties of loyalty and care.
Management of a Limited Liability Company
Corporations have a regimented structure established by law, with shareholders, directors, and executives. LLCs have more flexibility. The default rule is that members manage the LLC directly. They can choose to delegate this role to “managers,” who serve a role similar to a corporate board of directors. Both the articles of organization and the operating agreement must state that the LLC will be manager-managed.
Allocation of Profits and Losses
The operating agreement of a real estate investment entity may establish how to allocate profits and losses among LLC members. In the absence of such provisions, allocations are made in proportion to each member’s capital contribution to the LLC.
Taxation of Limited Liability Companies
The IRS treats multi-member LLCs like partnerships for tax purposes, unless otherwise directed. The company itself does not pay income tax, but instead each member is taxed on their share of company profits. The members may elect, however, for the LLC to be taxed as a corporation.
Advantages and Disadvantages
The primary advantage of the LLC form over a general partnership is protection from liability. The main advantage over a corporation is flexibility in features like structure, governance, and taxation.
Perhaps the most significant disadvantage of the LLC is its youth. California’s new LLC statute took effect in 2014, and most states enacted their first LLC statutes in the 1990s. Corporations have been around for several centuries. In the event of a dispute among owners, courts simply have more experience and precedent in dealing with shareholders and directors than with members and managers.
More Blog Posts:
Business Forms for California Real Estate Investors: General Partnerships, Titles and Deeds, February 5, 2018
What California Real Estate Investors Need to Know About Homeowner Associations, Titles and Deeds, January 29, 2018
How the Foreign Investment in Real Property Tax Act Can Affect California Real Estate Investments, Titles and Deeds, December 8, 2017