Real Estate Private Equity Choice of Entity Considerations

Selecting the appropriate investment vehicle for a real estate transaction can be crucial to the success of an acquisition, repositioning or development opportunity.  Why? Choosing the wrong form of entity can discourage participation by investors in a transaction or require expensive restructuring of the project entity.

This note briefly summarizes some of the issues a project sponsor and private equity investor may consider when choosing one of the two most frequently used forms of entity in real estate transactions: the limited liability company (“LLC”) and the limited partnership (“LP”).

  1. Number of Participants – Initial and Continuing

Most LLC statutes allow single member LLCs, so an LLC can be formed with one member and continue with one member if necessary through its life.

Limited partnerships generally require at least two members, the general partner (who must be fully liable for the obligations of the business) and at least one limited partner.  At formation, this issue is easy to control.

However, once the business is operating, if either the sole general partner or the sole limited partner withdraws from the limited partnership, the partnership could dissolve as a matter of law.  In California, a general partner can withdraw from a limited partnership at any time, whether rightfully or wrongfully.  A limited partnership agreement cannot eliminate that power.  While a general partner that wrongfully withdraws will likely cause the general partner to incur liability for damages if the withdrawal violates the terms of the limited partnership agreement, damages may not be a practical deterrent.  Damages can be speculative or difficult to prove and, depending on the structure of the deal, damages may be effectively limited to the distributions a party is entitled to receive.

Limited partners generally do not have the right to dissociate as a limited partner before the termination of the partnership.  However, there are exceptions.  For example, if the limited partner entity is terminated as a matter of law, or if there is a conversion or merger of a limited partner entity and the limited partner entity does not survive the merger, the limited partner is dissociated.  At that point, the limited partnership may terminate if a new limited partner is not admitted.  In a troubled deal or a bad economy, finding a replacement limited partner can be difficult.

  1. Extent of Involvement by Investors

A limited partner in a partnership generally has no personal liability for the obligations of the limited partnership.  However, private equity investors typically demand a substantial degree of control over the business decisions of the partnership, because they are contributing most of the capital required for the business’ operations.  If a limited partner intends to be extensively involved in the business, the limited partner could be rendered a general partner of the partnership by operation of law.  As a result, the limited partner could lose the cloak of limited liability, meaning that the limited partner becomes personally liable for the business of the limited partnership.

An LLC has much more flexibility in structuring entity governance.  An LLC operating agreement typically goes into great detail on management, voting rights, and the extent of each member’s participation of the LLC’s decision-making.  Unlike an active limited partner, an LLC member retains the cloak of limited liability despite the LLC member’s active and intense involvement in the operations of the company.

  1. Implied Duties

Partners generally have implied duties to one another, including fiduciary duties, duties of fairness and loyalty, duties of care, and the duty of good faith and fair dealing.  In some states, these duties can be limited or waived in the limited partnership agreement.

State laws may also impose on LLC members implied duties unless limited or waived in the limited liability company’s operating agreement.  Delaware, for example, allows great latitude in permitting the parties to define the scope of implied duties in their limited liability company operating agreement; however, LLC members may not eliminate the implied contractual covenant of good faith and fair dealing.

  1. Tax Matters

A limited partnership offers pass through tax treatment, which means the income, gains, losses, deductions, and credits of the limited partnership will be passed through to the partners for reporting on their personal tax returns.

A limited liability company will be classified as a partnership for income tax purposes, unless the LLC affirmatively elects otherwise.  A limited liability company that elects to be classified as a partnership will enjoy pass through tax treatment.

Some jurisdictions impose heavy entity-level taxes on limited liability companies but not on partnerships.  It is important to review the structuring of your transaction with your tax advisor to avoid tax pitfalls.

Limited Liability Companies May Now Hold a Contractor’s License In California

Beginning Jan. 1, 2012, California’s contractor licensing authority must now begin issuing contractor’s licenses to limited liability companies.  Previously, contractor’s licenses were only available to individuals, corporations and partnerships.   

The limited liablity company is the preferred form of entity for most real estate owners, developers and investors.  A limited liability company is a superior form of entity not only because of its limited liability features, but also because of its flexibility and ability to act as a pass-through entity for tax purposes if properly structured.

However, for many years, limited liability companies (or LLCs) could not hold a contractor’s license in California.  As a result, real estate developers often had to form affiliate corporations or limited partnerships with corporate general partners to hold contractor’s licenses issued by California’s Contractor’s State License Board. The formation of these entities and the related flow through accounting and legal issues were an administrative burden for some developers. 

This year the Contractor’s State License Board is required to begin processing applications by LLCs for a contractor’s license.  The law does add some additional requirements for those seeking to license an LLC.  For example, applicants must procure a $100,000 surety bond in addition to the $12,500 contractor bond.  LLC’s wishing to be licensed must also secure liability insurance with a minimum limit of $1 million and an aggregate limit as high as $5 million, depending on the number of employees of record.  Satisfying these additional requirements makes business sense for most sophisticated real estate developers anyway. 

Now that LLCs may hold contractor licenses, real estate developers that typically purchased land or brownfields for development with the LLC form of entity may now consolidate their land ownership and construction activity into the same entity.  It is important to consult with an attorney knowledgeable with your situation to determine whether this consolidation effort is best for you.