Sunday, September 23, 2007

Protect Your Properties Using the Proper Entities

You need to protect yourself when investing in commercial real estate. When purchasing properties, you do not want to purchase anything in your own name. If you leave properties in your own name, you run the risk of being unprotected. Others can easily identify what you own. They can then come after these properties, along with your personal assets, if they want to. Always use an attorney to set up your partnership or corporation, no matter what type of entity you structure, so that you are legally protected.

The following are the different types of entities you, as an investor, can form to protect your properties when you buy them. You can determine which one best suits your situation. 1. Sole Proprietorship 2. General Partnerships 3. Limited Liability Partnership (LLP) 4. Limited Liability Corporation (LLC) 5. C Corporation 6. S Corporation 7. Trusts

Below is a brief description of each entity along with some of its advantages and disadvantages.

Sole Proprietorship - Until you set up some type of formal entity you are by default the sole-proprietor, or single owner. In this case, if the business makes a profit it will be considered income to you. If the business has any debt you incur that debt.

Advantages: -A sole proprietorship is easy to set up, finance and manage. -Tax reporting is simple because it is done on an individual return.

Disadvantages: -If the business gets sued for any reason, you will be sued as well. -Owners have "no" limited liability. They are responsible for the debt of the business. -This is the least recommended form of ownership due to its lack of protection.

General Partnerships - These partnerships are for two or more investors. Each general partnership is regulated by the State in which it resides. An attorney should draft your partnership agreement. The agreement should address operation issues and specify what happens if one of the partners decides to quit. Clarifying key issues in your partnership agreement will help eliminate any cause of disruption in the business should disagreements arise. In this type of setup each general partner shares equally in the management of the property and the title to the property is held in the partnership. The property title is held in the partnership, not individually.

Advantages: -General partnerships have low start-up costs and are easy to run. -Tax reporting is simple because each partner simply reports their share of taxable income on their own personal tax return.

Disadvantages: -Liability is not "limited" to the amount of money a partner puts into the business. -Both partners are personally responsible for "all" the debts of the partnership, regardless of the dollar amount of those debts.

Limited Liability Partnership (LLP) - A limited liability partnership is formed between two or more investors. It is one of the more popular forms of ownership for commercial real estate investing. With an LLP, one partner will handle all management responsibilities and take on all of the liability of the partnership.

Advantages: -Additional compensation can be given to the managing partner who takes on all of the responsibilities and liability of the partnership. -The other partners have limited liability and therefore have limited risk.

Disadvantages. -The managing partner takes on all of the liability. -While the other partners have limited liability, they also have very limited control over how the company is run. -LLPs can be expensive to form and run. -Obtaining financing can be a challenge.

Limited Liability Corporation (LLC) - This type of corporation is quickly becoming the most popular choice when forming a corporation in real estate for investors. The main difference between an LLC and an LLP is that the LLP is a partnership and the LLC is a corporation. An LLC combines many of the features of a partnership with those of an S type corporation. An LLC allows each member to be involved in management activities.

Advantages: -One of the key benefits is that "limited liability" is allowed for each member of the group. -Another key advantage is that the LLC is a "flow-through" entity that files the same Federal income tax forms as a partnership. Therefore, it is not subject to double taxation as with other corporations.

Disadvantages: -LLCs can be expensive to form and to run. -Obtaining financing can be a challenge.

C Corporation - The "C" Corporation is your "standard" corporation. This type entity is a separate legal and tax entity that is owned by one or more shareholders. You can have unlimited shareholders (investors). Shareholders own the corporation and the corporation owns the property. Income and expenses from the property are reported on the corporate tax returns. The shareholders receive cash distributions in the form of dividends. Each corporation has its own articles of incorporation and bylaws.

Advantages: -Shareholders have no personal liability, are not responsible for the debts of the corporation, and can only lose their equity investment. -Also, if one or all of the shareholders die, the company lives on.

Disadvantages: -One of the major disadvantages is double taxation! -C Corporations are also expensive to form. -C Corporations must report annually to the State and Federal Government. -C Corporations are not eligible for a 1031 exchange.

S Corporation - The "S" type corporation is a "flow-through" entity much as a partnership. It is a separate legal entity but not a separate tax entity. The S corporation can be owned by a group of investors or by an individual.

Advantages: -Partners have limited liability. -Income flows through to each shareholder's individual tax returns - no double taxation!

Disadvantages: -Rental Income cannot exceed 20% of gross income.

Trusts - Trusts are formed by two or more individuals known as Beneficiaries. A Trustee manages the company. The Trustee usually is not a beneficiary (although could be one).

Advantages: -Individuals have limited liability. -Income trusts receive is reported on individual tax returns. -Trusts help avoid probate expenses.

Disadvantages: -The trustee has the power to sell the property in the trust, without receiving consent of the beneficiaries. -Financing can be hard to obtain.

It is wise to set up an entity to protect your properties and yourself. With so many choices available, you should consult your real estate attorney along with your tax attorney and/or accountant. Working with your knowledgeable team of experts, you can decide the best entity choice as it relates to your individual situation.

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