When are you purchasing and rehabilitating (i.e., flipping) residential properties with a Business Partner you typically are doing business either within a limited liability company (LLC) or a for-profit corporation which has made an “S” election with the IRS. Each choice has pros and cons, mostly from a tax perspective.
Taxation: The enterprise will be treated as a “trade or business” for tax purposes, rather than as a pure real estate investment company because it will purchase and “flip” residential “fixers” rather than buying and holding long term real estate. This means at least some of the gain will be treated as ordinary income paid to you and your Business Partner in exchange for your services to the company, and subject to self-employment tax (e.g., Social Security and Medicare).
Compensation: You will want to pay yourselves a reasonable level of compensation and tax it appropriately, and you can then distribute any remaining profits to yourselves as dividends (not subject to self-employment tax). An “S” corporation offers clearer guidance from the IRS on doing this.
- It is possible to do the same thing with an LLC, but it is less clear how the IRS will treat it.
- In either case, please consider having your Accountant run a cash scenario so you get an understanding of how much you’ll need to be paying out as compensation for services, and how it will affect your cash flow.
In-Kind Distributions: If you decide to dissolve the company in the future – perhaps because of a disagreement between you, an LLC would allow you to distribute any real estate assets between you “in kind” without immediate tax consequences. In an LLC, the owner receiving the in-kind distribution would have the same basis in the real estate as did the LLC. Tax on any gain would be deferred until the owner sold the real estate. In an S-Corporation, an in-kind distribution would be deemed a sale to the owner. The S-Corporation would owe income tax on the difference between the value at distribution and the company’s basis in the real estate (a capital gain). While this is a long term risk that may never happen, the tax savings from the LLC could be very substantial. If you go with an S-Corporation and later find a property you want to buy and hold, consider doing it within an LLC.
Formation Issues: In forming the S-Corporation, the IRS may consider that your Business Partner has received stock in return for a commitment to perform services for the company, and has received ordinary income for tax purposes equal to the value of his stock. This is because you will be contributing substantially more capital than your Business Partner. This risk is not present in an LLC. However, your Accountant may feel this risk can be managed in structuring your contributions to the company, either as loans or as a premium for a controlling interest, or as a combination of both.
- An S-Corporation must have a single class of stock, so any debt must be structured as straight debt, documented by a promissory note, and paid according to its terms. Depending on how the company does, this may mean you get paid on the debt before the company can pay either you or your Business Partner any dividends on your stock.
- With an LLC, unequal contributions of capital can all be treated as equity, and profits and losses can be shared in a different proportion than ownership.
- Another feature of the S-Corporation is that each stockholder must be a U.S. citizen (or a trust benefiting a US citizen), and you can have no more than 100 stockholders.
- If you go with an S-Corporation, you will need articles of incorporation, bylaws, and a shareholder’s agreement to deal with buy-sell issues. With an LLC you will have a one-page certificate of formation, and an “operating agreement” that will deal with all the issues. In either case, you can run the corporation with relative informality without losing your shield against personal liability, although it is probably more important to observe formalities with the S-Corporation. than with the LLC.
Capital Structure: Occasionally a partner will contribute more money to the initial capital of the company than their Business Partner. While an LLC offers greater flexibility in structuring an entity that reflects the agreement with your Business Partner, at this point it seems that we can work the “deal” in either an LLC or an S-Corporation.
- You should pay a bit more for your stock than your Business Partner so that you can purchase a controlling interest (51%). This will protect you in the management of the business. One can soften the impact of your control by requiring a higher threshold of owner approval for certain “fundamental” company decisions.
- Occasionally, if a female owner owns more than 50%, the business can be treated as “woman-owned” though this may not offer much benefit given the nature of the business.
- Consider investing at least some of your capital as debt. You will have interest income on the repayment of this, but no tax consequences on the return of the principal. You will also be entitled to get this money back in a liquidation scenario before money is paid to shareholders.
Management: This discussion assumes you have a 51% interest in the company. The management model will be a little different in a corporation or an LLC, but we can accomplish the same thing either way:
- Control (51%) can give you either the power to stop things, or the power to make things happen.
- If you want to make things happen, you need to have the ability to elect a majority of the corporate board in an S-Corporation. (and typically the agreement would also assure your Business Partner control of one seat on the board).
- Or you can be the “manager” in an LLC or “president” in a corporation with the authority to hire and fire, set salaries, etc., and be removable only with the approval of the owners, which could be just you and your Business Partner. This is pretty extreme from your Business Partner’s point of view.
- If you want to stop things, you can have a 2 person board that can only act on certain things with shareholder approval. It’s better to have a three person board because you reduce the chance of “deadlock” – but you need a 3rd person you can trust to follow your wishes in most cases, and that your Business Partner can trust to check you if you get completely out of control. Any takers?
- A Business Partner will want arequirement that owners approve certain events by margins of more than 51% – so the things can’t happen unless you both agree. Examples of these types of issues:
- Admission of a new shareholder or owner.
- Sale of shares.
- Transactions between the company and Business Partner, her relatives, or other companies she or they own.
- Borrowing money in excess of a certain amount.
- Requiring owners to contribute additional capital. (The agreement would normally have a consequence if the owner did not contribute the capital once the “capital call” was approved, for example, dilution of his or her ownership interest.)
- Sale, merger, or liquidation of the company.
- Approval of an annual operating budget that fixes expenses for office overhead, employee compensation, etc. Your agreement might provide, for example, that the company could not exceed this budget by more than ten percent without owner approval.
- Other, more “day to day” events that your Business Partner may want veto power on:
- Decision to buy a property
- Price and terms for sale of a property
- Termination of your Business Partner as an employee. I wouldn’t recommend giving a veto on this. There are other ways to protect him, one being to give him the right to force the company to buy him out if he is terminated as an employee. Since this is not to be his only source of income, you may not even need to do this. What should matter is that the company is being well served by its employees and is making money – that will benefit him as a shareholder.
Fiduciary Duties, Competition: You’d ordinarily agree that each owner has to bring real estate investment opportunities to the company before he or she can pursue them outside the company. Beyond that, would there be any restraints on competition with the business? For example, could your Business Partner take jobs managing other peoples’ real estate? Could you take a job as a realtor, or start a business making real estate loans? With the other person’s approval?
Buy-Sell Issues These would be handled in a shareholder’s agreement, or in your operating agreement for the LLC.
Sale of Ownership Interest: The buy-sell portion of your agreement would typically include one or more of these:
- An owner cannot sell his or her interest without approval of all owners? (not recommended)
- An owner can sell his or her interest to anyone without approval, but there is a right of first refusal for the other owners?
- An owner can transfer his or her interest to his or her heirs by gift or by will without any right of first refusal?
Death: On death of an owner, you would give the owner’s estate an option to require a buy-out, hopefully funded by life insurance as your cash flow allows. Terms might include a down payment of 25% or more (covered by the insurance) with the rest payable over time, secured by the real estate (but subordinate to any mortgages held by lenders).
Disability: How you treat this depends on your objectives. If this is to be your or your Business Partner’s major source of income from work, then you want to allow the disabled person the option to force a buy-out on terms, over time, similar to with death. If not, then I would give the company the option to force the buy-out, figuring the company’s operations would produce some income for the disabled person anyway, and that the company would only do a buy-out if the person’s inability to contribute ongoing services was too big a drag on operations.
Divorce: In a divorce, the divorcing spouse will have a claim to the Business Partner’s interest in the company unless they have agreed otherwise in an enforceable pre- or post-marital agreement. You won’t know for sure if the marital agreement is enforceable until the divorce court rules on it. So, in addition to whatever your Business Partner wants to do with that piece,
- I recommend the company have an option to buy any interest awarded to a non-owner spouse on payment terms stated in the agreement. The spouse will have to sign the buy-sell.
- You can also give your Business Partner a first option to purchase before the company does. This becomes a tool in the divorce proceeding to “buy” the shares of the company by giving the spouse other items of property.
- (The buy-sell agreement could also provided that the spouse disclaimed any interest in the company, but if the ownership interest turns out to be the only asset in the divorce, a court might order it to be sold anyway and the proceeds divided among the spouses.)
Termination / Retirement: You will sometimes see a provision giving the company the right to buy out an owner if the company terminates the owner as an employee for “cause” – with cause being defined in the agreement. You also sometimes see an owner being given the right to force a sale once they reach retirement age. I don’t recommend the latter provision.
Disagreement & Deadlock: You may come to a point where the company is unable to operate efficiently because the owners cannot agree on how to proceed. If you have 51% control, the deadlock is unlikely to interfere with day to day operation, but may keep the company from doing those things that require your Business Partner’s approval. A number of ways to address this:
- Mediation – a great first step, and if it results in an agreement, fine. If not, what is the next step?
- Arbitration – you are giving a third person the power to decide the outcome of the business. If you go this route, you want a qualified person (or 3 persons, though this is more expensive and can be much more time consuming).
- Dissolution and liquidation: either party always has the right to approach a court, prove there is a “deadlock” and request liquidation of the business. As noted, if properties are sold and cash distributed, there will be tax consequences. If done in-kind, there will be tax consequences in an S-Corporation in any event.
- Buyout: the agreement can give either owner (or both) the option to buy out the other for a value to be determined. I don’t typically see these types or provisions in a situation where one owner has control and the other is reasonably protected from minority “freeze-out” by measures requiring his consent to key decisions.
- Terms can be determined in the agreement or by a shotgun method. E.g., after an appraisal of value, either owner can offer terms to the other. The other has the option of buying or selling on those terms. The agreement could provide for minimum down payment and maximum length of time to pay off any balance, and fix the interest rate at prime or prime + x points.
- A buyout provision is going to work to the advantage of the owner who is in a stronger financial position when the buyout is triggered. Since you probably won’t know who that is until the time comes, it makes sense to craft provisions that are fair to both buyer and seller.
- Any right to force a buyout should expire before the owners reach retirement age. I’ve seen provisions giving either owner the right to propose buyout terms to the other (and the other must buy or sell on those terms) before they reach the age of 60.
Value: In any buyout scenario, value can be determined by agreement, or by appraisal. Appraisal is a well understood method for real estate. It may be expensive, though, and you might consider using appraisal only as a backup in cases where the two of you had not updated the agreed value for more than one year. I would suggest a method where you each pick an appraiser who, in turn, picks the appraiser who does the appraisal. You can also specify minimum qualifications for the appraiser, e.g., that he or she is a Realtor