If you’re new to commercial real estate investing, you need to know how to protect yourself and your assets should your project go belly up. In this article, you’ll learn how and why you should consider an LLC vs general partnerships.
What’s the Difference Between a General Partnership and LLC?
When two or more people create a profit-oriented business, even if there’s no written plan or even the intent to be a partnership, that’s what it is. It’s a partnership. There is no registration requirement or formal filing that needs to be completed to form a partnership. It’s that easy.
But, in a society filled with lawsuits, where half of all marriages end in divorce, a written partnership agreement and/or Articles of Partnership should be created to, at the very least, establish each partner’s responsibilities, duties and rights.
While the advantage of the general partnership is its instant no-effort ease of creation, its drawback is the unlimited liability of the partners, exposing each partner’s personal assets to creditors and judgments. One way around this risk is to form a limited liability company, or LLC, which limits the exposure of each partner’s personal assets.
General partners can have any percentage share of ownership, and typically share management, profit and loss equally and/or in agreed-upon proportions relative to their investment in the venture. Passive partners usually only bring capital to the table.
Another business structure option to consider is the limited liability partnership (LLP), which is a blend between a corporation and a partnership and is typically registered in the state where it is formed.
How Are LLCs Formed? Everything You Need to Know
LLCs are usually easier to form than a corporation. Wyoming was the first state to permit LLCs to be formed, in 1977. Since then, every state has adopted an LLC statute. There’s wide variance among the states regarding LLC details, and uniformity between states is slowly happening in concert with the Revised Uniform Limited Liability Company Act (RULLCA). Along with the District of Columbia, these states have adopted the RULLCA:
- New Jersey
- North Dakota
- South Dakota
What Information Is Asked for When Articles of Organization Are Filed?
Usually, you are expected to provide:
- The name of the LLC
- The address of the registered office
- Statements on management and liability
And any other provisions, including whether there are members at all, or if this is a “shelf” LLC, which is allowable only in certain states:
Once again, a written operating agreement is not required, but it is strongly encouraged so each member’s responsibilities, duties and rights are clearly spelled out.
Personal Liability, Fees and Taxes
An LLC differs from a general partnership because of its personal liability limitations, and the option of pass-through taxation to the individual members. While the default taxation mode of an LLC is to be taxed as a partnership, members can also flexibly elect to be taxed as an individual sole proprietor, or C or S corporation. If a general partnership fails, the GP is responsible for the debts.
Speaking of taxes, it’s important to be aware that several states, including California, New York, Texas and Pennsylvania, levy a franchise tax on LLCs, an amount based on revenue, an amount based on profits or an amount based on the number of owners or the amount of capital employed in the state, or some combination of those factors.
In the example of California, an LLC, including a single-member LLC, is required to file a tax return and pay an annual fee based on gross revenue. The fee, which is at least $800 — even if the venture makes zero net income — can go as high as $11,790.
In most states, an LLC may have an unlimited number of members, including non-citizens of the U.S. On the other hand, there are caps on the number of members of an S corporation, and all S-corp shareholders must be U.S. citizens.
In most states, an LLC doesn’t need to have an annual meeting, and the LLC isn’t required to have a board of directors. Plus, there’s less paperwork and recordkeeping required compared to a corporation.
What Are the Benefits of an LLC in Commercial Real Estate?
First of all, they’re flexible. LLC members can be individuals, partnerships, trusts, estates, organizations or other business entities.
On top of that, in a commercial real estate venture, each individual property can be owned by a separate LLC, which shields the owners and their other properties from cross-liability. Many real estate owners and managers form a new LLC for each individual property that’s acquired.
If you have five properties, and one of them becomes embroiled in a problem or lawsuit, the other four properties are not at risk. You can work on solving the problem property without worrying that it will involve the others.
Speaking of shielding, Delaware happens to be one of the easiest places in the world to set up an anonymous company, making it a great place to establish an LLC. Similar to whois domain name protection, an LLC registered in Delaware would pay a nominal sum to a registered agent, who would become the official contact point of the LLC, leaving the true owners to be anonymous.
New Mexico, Wyoming and Nevada also don’t require public disclosure of a company’s owners. As in Delaware, however, courts may compel the release of more information through subpoena. Check out LLC laws in your state.
According to the Census Bureau and the Department of Housing and Urban Development estimates, in 2015, about 15% of all rental properties in the U.S. were owned by LLCs, limited liability partnerships or limited partnerships. That figure represented one-third of all rental units, and that can include single-family houses or apartment buildings. In that same year, about 9% of single-family home sales last year were sold to LLCs.
Generally, courts will pierce the veil of an LLC and impose personal liability upon its members in cases of fraud or other inequity, such as the forming of an LLC to avoid existing personal obligations.
But in most cases, personal assets such as cars, homes and bank accounts are protected from creditors, and members of an LLC are only liable to the degree of their personal investment for the business’ debts. In a limited partnership, the general partner is liable for the debts.
Here are 5 situations where LLC members can be held personally liable:
- When there is a commingling of funds between the business and the individual.
- When an LLC member personally guarantees a business loan and/or personally signs for an LLC’s debts.
- In cases of fraud or other illegal activities.
- In cases of gross negligence.
- In cases of unpaid taxes.
Capital Contributions and Distribution of Profit and Loss
All states allow a member’s capital contributions to be in cash, property or services already performed, and may also permit promissory notes and other binding obligations. In most states, members share LLC profit and loss according to the value of their contributions.
General Partnership vs LLC: Terms of Termination
In terms of termination, a general partnership and LLC operate differently.
In a general partnership, the entity cannot exist separately from the owners. In the event of a partner’s death, withdrawal from the company or the inability to operate the business, that partnership must end.
The remaining partners may keep the entity running by formulating a new partnership. However, an LLC is regarded as a separate entity from its partners. At risk of sounding morbid, an LLC survives the removal or death of a member. To terminate an LLC, official documents must specify a reason to end the company or establish an end date.
Which Level of Protection Is Right for Your Business?
At the end of the day, LLCs provide more protection than general partnerships, but less than corporations. LLCs are a popular and common way to protect your investments. Be sure to learn the difference between a sole proprietorship vs general partnership, as well.