This article examines the formation and taxation of a limited liability company (LLC), and the conversion of an existing limited partnership to an LLC.
A limited partnership vs. the LLC
A limited liability company (LLC) is a hybrid business entity. It combines state law, limited liability advantages of a corporation with the federal income tax treatment of a partnership. [Calif. Corporations Code §§17000 et seq.; Calif. Revenue and Taxation Code §§17941 et seq.]
Like a limited partnership, the LLC itself does not pay federal income taxes. Instead, all reportable income, profits and losses of the LLC are passed through to the members for individual tax reporting. The members, as individuals, pay federal and state income tax on their share of any LLC income and profits.
The LLC is an entity comparable to a limited partnership, but without a general (liability) partner. Limited liability in an LLC extends to all members, including the manager. Conversely, the managing general partner in a limited partnership is personally liable for the partnership’s debts.
The syndicator in a limited partnership sometimes seeks to limit his liability by forming a one-man corporation to act as general partner for the partnership, rather than naming himself as the general partner. A sole, corporate general partner in a limited partnership creates a liability limitation situation for the syndicator similar to the LLC, with its limited liability extended to all individual members and the manager.
Taxwise, however, a limited partnership with a sole, corporate general partner is a co-ownership structure that is more restrictive than an LLC. For instance, all partnerships with the same corporation as the sole general partner for each are taxed as corporations unless the corporate general partner owns assets with a net worth of at least 15% of the partners’ contributions to all the partnerships, limited to $250,000 for total contributions up to $2,500,000. When contributions exceed $2,500,000, the net worth of the corporate general partner must be at least 10% of total contributions by partners. [Revenue Procedure 72-13]
Also, a partnership with a corporate general partner is unable to take advantage of the exemption from tax reporting for small partnerships. Partnerships with 10 or fewer partners are exempt from filing the Internal Revenue Service (IRS) 1065 return, but only if all the partners are individuals. [Internal Revenue Code §6231(a)(1)(B)]
Taxwise, the LLC also resembles an S corporation. An LLC is essentially a small corporation (because of its state law corporate liability structure) that is treated as a partnership for income tax purposes. However, an LLC has fewer restrictions imposed on the participants and their investments than in an S corporation.
For example, the shareholders in an S corporation must be individuals (or estates, organizations or trusts in limited circumstances), and an S corporation may have no more than 100 shareholders. [IRC §1361(b)]
The members of an LLC, on the other hand, can be any kind of legal entity, including individuals, corporations, partnerships and other LLCs. Also, no limit is imposed on the number of members. [Corp C §17001(ae)]
For real estate syndication purposes, the LLC also resembles a real estate investment trust. Real estate investment trusts (REITs) are unincorporated organizations formed for the purpose of group investment primarily in real estate, and they provide limited liability for investors and pass-through of income for state and federal tax reporting. [Corp C §23000; IRC §856]
However, the REIT is not an appropriate syndication vehicle for group investments in local real estate. The LLC offers more management flexibility and the same tax results for the participants.
For example, to qualify for federal tax reporting as a real estate investment trust, the REIT must have at least 100 shareholders and 75% of the REIT’s business activities must be restricted to investments in real estate, trust deed notes, cash or government securities. [IRC §856(c)(4)]
No such restrictions apply to the LLC.
Further, a REIT must always qualify its investment program with the California Department of Corporations (DOC). Conversely, an LLC only needs to qualify its investment program if a securities risk exists for its members and no exemption applies. [Corp C §23000(b)]
The form for filing the articles of organization is the LLC-1 issued by the Secretary of State, the equivalent of the LP-1 for limited partnerships. The filing fee is $70. [Calif. Government Code §12190(b); see LLC-1, accompanying this chapter]
The $70 LLC-1 fee is for documents filed by mail. The Secretary of State charges an additional $15 counter fee for any LLC documents delivered in person.
The person signing the LLC-1 does not need to be a shareholding member of the LLC. In a typical real estate investment program, the LLC-1 will be signed by the syndicator acting alone. The syndicator then typically designates himself or an entity he controls as the managing member.
The LLC-1, when filed with the Secretary of State along with the $70 fee, establishes the LLC as a legal entity in the state of California. The filing provides limited liability for its members and manager. No further recording with the county is necessary. However, a certified copy of an LLC-1 and any other addenda or documents is typically recorded with the county recorder in the county where the LLC will hold to title to real estate. [Corp C §17052(f)]
When recorded, those dealing with the LLC, such as title companies, lenders, sellers, buyers, escrows, brokers and others, do not need to look any further than the LLC-1 in the county records to determine who to deal with — the manager, a group of managers or a majority in interest of members.
The LLC-1 form can be obtained from the Secretary of State’s Limited Liability Company Unit, from the branch offices of the Secretary of State or downloaded from the Secretary of State’s website at www.ca.ss.gov/business. [See Figure 1]
Editor’s note — Although LLC forms can be obtained from any branch office or downloaded from the Secretary of State’s website, only the Limited Liability Company Unit in the Secretary of State’s Sacramento office will accept LLC forms for filing.
The LLC-1 is a very limited and fairly simple document, intended mainly to:
· register the LLC with the state;
· establish it as a legal entity in order to provide limited liability to all managers
and members (and a minimum tax of $800 annually to the state); and
· notify the public of the individual with the authority to bind the LLC by entering into agreements on its behalf.
In an addendum to the LLC-1, the syndicator might include an alienation-restriction provision to assure the members that the real estate vested in the name of the LLC cannot be sold, encumbered or subjected to a long-term lease without the consent of a majority in interest of the members. The addendum serves to limit the manager’s activities to the designated purpose of the LLC — to own and operate the real estate for the benefit of the members.
An LLC is commonly thought of as having two or more members. However, a single person can form an LLC by filing articles of organization with the California Secretary of State. [Corp C §17050]
The liability limitation for members of an LLC is slightly less extensive in its protection from debts than it is for limited partners in a limited partnership. The limited liability protection for the members of an LLC is the same as for the shareholders in a corporation. [Corp C §17101(b)]
For example, the liability of a partner in a limited partnership is absolutely limited to the amount of their capital contribution. However, corporate shareholders — as well as members in an LLC — can be held generally liable for the debts of the corporation or LLC if it can be proven that the corporation or LLC exists solely to shield the shareholders from liability for their debts or actions.
In a limited partnership, the limited partners escape liability beyond the amount of their contributions. However, the general partner of the limited partnership is then personally liable for all partnership debts.
In a corporation or LLC, no member, officer or shareholder is generally liable for any of the entity’s debts. Without personal liability for debts incurred by the LLC, an individual can use a corporate or LLC business entity to shield themselves from liability in the conduct of the investment. Such individuals carry on their personal activities behind a corporation or LLC that is merely a facade, called an alter ego.
A corporation, and thus an LLC, is considered an alter ego of a controlling shareholder if:
· the corporation or LLC is entirely dominated by a single individual or by a small group of shareholders or members;
· the economic interests of the corporation or LLC are indistinguishable from the interests of the shareholders or members; and
· an injustice would result from treating the shareholders’ or members’ acts as the acts of the corporation or LLC and not as their own. [Stark v. Coker (1942) 20 C2d 839]
Also, a corporation that is undercapitalized to meet its reasonably anticipated demands for cash is often considered an alter ego of the shareholders. If a corporation is not funded with a sufficient amount of capital, it will not have sufficient assets to pay off the debts it incurs in the ordinary course of business.
Sufficient capitalization is rarely an issue in real estate transactions since all funds needed to own the property, in the form of cash and mortgage money, must be raised before the property can be acquired.
To be undercapitalized, a corporation or LLC is then regarded as existing in name only, created to shield the shareholders or members from liability for personal debts incurred in the entity’s name. [Automotriz del Golfo de California S. A. de C. V. v. Resnick (1957) 47 C2d 792]
Taxation by the FTB
To maintain the limited liability of its members as permitted by state law, the LLC must report and pay annual taxes and fees to the state.
Every LLC must pay an annual $800 minimum franchise tax, a tax also imposed on corporations and limited partnerships. [Rev & T C §§17941, 23153(d)(1)]
In addition to the minimum franchise tax, an LLC with over $250,000 in annual gross income (rents) is assessed an annual fee by the Franchise Tax Board (FTB) based on its gross income for that year. The fees are:
· $900 for a total gross income of $250,000 to $499,999;
· $2,500 for gross income of $500,000 to $999,999;
· $6,000 for gross income of $1,000,000 to $4,999,999; and
· $11,790 for gross income over $5 million. [Rev & T C §17942(a)]
An LLC formed solely for real estate syndication purposes that acquires income-producing property with a scheduled gross income of less than $250,000, will not be concerned with the additional tax. Thus, ownership of income property valued at roughly $1,500,000 and $2,000,000, based on the cost of operations and the gross income, would not be subject to the annual “rental tax.”
The LLC name
A syndicator selects a name for an LLC, which must end with the words “Limited Liability Company,” or the initials “LLC” or “L.L.C.” The words “Limited” and “Company” may be abbreviated to “Ltd.” and “Co.” [Corp C §17052(a)]
As a practical matter, the name selected for the LLC should reference the property purchased and operated by the LLC, such as the property’s name or street address. The name of the LLC should not include the name of the manager or any of the members, in order to avoid making their ownership interests in the LLC easily traceable.
Also, the name may not include the words “bank,” “insurance company,” “insurer,” “trust,” “trustee,” “incorporated,” “inc.,” “corporation” or “corp.” [Corp C §17052(d)]
For example, a typical LLC name, created from the property’s address, might be “Main Street Properties, a California Limited Liability Company”.
An LLC name may be reserved by applying to the Secretary of State with a Name Reservation Request Form. For a fee of $10, the name is reserved for 60 days. An additional $10 counter fee will be charged if the form is given in person to the Secretary of State’s public counter. [Corp C §17053; Gov C §12190(a); see Name Reservation Request Form, accompanying this chapter]
Alternatively, a syndicator can use a private filing service to reserve the LLC name or file the LLC forms. These companies charge a fee for these services. One such company is:
Corporation Service Company 2730 Gateway Oaks Dr. Ste. 100 Sacramento, CA 95833 (800) 927-9800 //www.incspot.com
Preparing the LLC-1 articles
The LLC-1 articles of organization includes a space for stating whether the LLC will be managed by all members or by one or more appointed managers. For real estate syndication purposes, the syndicator will, in most cases, check the box stating the LLC has one manager — the syndicator himself. Thus, he alone will be able to bind the LLC to buy, sell, encumber or lease real estate.
Also, the LLC syndicator must designate an agent for the service of process on the LLC with an address in California, as is required of any statutory entity. The agent may be an individual or an entity. [Corp C §17057(b)]
For real estate syndication, the agent for service of process is usually the syndicator or his attorney.
In addition to the appointed manager, the LLC’s operating agreement may provide for the appointment of officers such as president, secretary, treasurer, chief executive officer (CEO), chief financial officer (CFO), chief operating officer (COO) and so on. [Corp C §17154]
The officers do not need to be members or managers of the LLC. For example, an accountant or bookkeeper who is not a member of the LLC can be hired as treasurer or the CFO.
The LLC must have an office in the state of California where it maintains its records. LLC records include the names and addresses of all members and managers, copies of the articles of organization (LLC-1) and the operating agreement, copies of state and federal tax returns, financial statements and the books and records of the current and past four fiscal years. A true copy of business records relevant to the amount, cost and value of all property owned, claimed, possessed or controlled within the county must be made available upon the request of the county assessor. [Corp C §§17057, 17058]
The LLC-12 Statement of Information must first be filed within 90 days after filing the articles of organization for the LLC. It must state the name and address of the LLC, its manager, agent for service of process and the type of business it conducts. The statement is then filed every two years thereafter during the calendar month in which the articles of organization were first filed. A $20 filing fee is required each time the LLC-12 is filed. [Corp C §17060; Gov C §12190(k); see LLC-12, accompanying this chapter]
If the information required in the filing has not changed since the previous year, the LLC may simply file the form, stating no changes have been made. [Corp C §17060(b)]
LLCs are not currently permitted to be licensed as real estate brokers. The Limited Liability Company Act prohibits LLCs from offering professional services to others in the name of the LLC for a fee, which includes the services of accountants, attorneys, physicians and real estate brokers. Some professions may conduct business and provide services under a parallel entity called a limited liability partnership (LLP), but not real estate brokers.
However, an LLC manager who is licensed as a real estate broker may act as the real estate agent representing the LLC as its broker, and collect a brokerage fee on transactions handled on behalf of the LLC. Also, an LLC can act as a principal in any real estate- related transaction, with the same powers as a corporation, partnership or individual, to conduct any business, buy, sell, finance and lease property, sue or be sued, enter into agreements, etc. [Corp C §17003]
FTB annual tax reporting
Limited liability companies are considered partnerships for tax reporting purposes, except for the annual California franchise tax and tax on rental income. [Rev & T C §28.5]
An LLC is required, like a partnership, to submit a state information return annually to the FTB. The form for filing an LLC information return is FTB Form 568. [Rev & T C §18633.5]
An LLC reporting as a partnership for federal income tax purposes is required to file a 1065 return annually with the IRS, unless the LLC qualifies for the 10-or-fewer small partnership exemption.
Federal small partnership exemption
Although it does not pay income taxes, a partnership — including LLCs since they automatically qualify as partnerships — is required, unless exempt, to file an information return with the IRS, reporting the income and losses passed through to the partners. [IRC §6031]
The tax form for filing the LLC information return is the IRS Form 1065. The IRS 1065 return informs the IRS of the LLC’s income and losses and identifies each member along with his share of the income and losses.
An LLC automatically qualifies as a partnership for federal income tax purposes. Thus, an LLC can avoid filing an IRS 1065 return if it qualifies under the small partnership exemption. [IRC §7701, IRS Letter Ruling 9543017]
An LLC or partnership with 10 or fewer participants, all of whom are natural persons or estates (husband and wife are treated as one), is not required to file an IRS 1065 Form. [IRC §6231(a)(1)(B)]
The IRS has imposed further restrictions beyond the number of participants for the exemption. Even if the LLC has 10 or fewer members, the IRS has ruled it is not exempt from filing a 1065 return if:
· it has significant holdings;
· it is a “tier” entity, in which a parent entity holds interests in one or more sub-entities;
· each member’s interest in the capital and profits is not owned in the same proportion; or
· all items of income, deductions and credit are not allocated in proportion to the owner’s percentage of membership. [Revenue Procedure 81-11]
Generally, most small investment groups do not have significant holdings and do report income and losses based on their percentage of ownership. Despite the additional restrictions imposed by the IRS, an LLC formed for real estate syndication with 10 or fewer members can avoid filing the IRS 1065 return. Each member reports his share of income, expenses, interest and depreciation in a schedule attached to his 1040 return, such as a Schedule E for rental ownership reporting.
Converting a limited
partnership to an LLC
Many general partners who manage existing limited partnerships will convert their limited partnerships to LLCs. A syndicator, as manager in an LLC, has a limited liability that stands in dramatic contrast to his general liability for property operations and loans as the general partner in a limited partnership.
However, the process of conversion comes at a price. Filing the necessary forms requires fees of over $200.
Despite its cost, the advantage of limited liability gained for the syndicator ultimately outweighs the fees for converting to an LLC.
Conversion by merger
The simplest way to convert a limited partnership to an LLC is through a process called a merger. The LLC scheme allows a limited partnership to be merged into an LLC, which extinguishes the limited partnership. [Corp C §17550]
To complete a merger, the LLC is first created by filing an LLC-1 with the Secretary of State. Then the limited partnership is merged into the LLC by filing a certificate of merger form, the LLC-9. [Corp C §17552]
A merger agreement is also required, and must be approved by the limited partners. The agreement states the terms of the merger, the names of the surviving LLC and the merging partnership and the method for converting interests in the limited partnership into membership interests in the LLC. [Corp C §15678.2]
The merger agreement can simply be the operating agreement for the LLC. The syndicator can draw up an LLC operating agreement containing the same provisions as contained in the agreement for the merging limited partnership, and state in the purposes provision: “The LLC is the successor in interest to a limited partnership of the same name.”
When the merger is completed by filing the LLC-9, the limited partnership ceases to exist as a separate entity, and the LLC succeeds to all the property, debts and liabilities of the “disappearing” limited partnership. No further act or documentation is required to transfer the partnership’s real or personal property to the LLC. [Corp C §17554(a)]
However, if required by a title insurer, the change of ownership to the real estate can be documented by recording a copy of the LLC-9 and the LLC-1 with the county recorder of the county where the property is located.
A copy of the LLC-9, certified by the Secretary of State and recorded in the county recorder’s office, serves as a notice of the transfer of property ownership to the LLC. [Corp C §1109]
Also, the limited partnership is dissolved automatically on filing the LLC-9, without having to file a certificate of dissolution (LP-3) or certificate of cancellation (LP-4). [Corp C §15678.4(c)]
The syndication program itself remains identical after the merger. The investors retain the same proportional interests, rights and obligations in the LLC as in the limited partnership as long as the LLC operating agreement is a mirror image of the limited partnership agreement.
The conversion is little more than a change in the entity’s surname and the titles of co-owners of the entity. The limited partnership becomes an LLC, the limited partners become members and the general partner becomes the manager. Property operations and federal tax reporting remain the same.
The significant difference is the limited liability the former general partner gains as the syndicator of the newly-formed LLC. However, the syndicator’s liability limitation does not extend to his liability for debts existing before the limited partnership was merged into the LLC. [Corp C §17554(d)]
The drawbacks of conversion
The conversion from a limited partnership to an LLC does not qualify as a change of ownership that triggers reassessment of the partnership’s property, as long as all the members retain the same proportional interests in the LLC as in the extinguished partnership. [Rev & T C §62(a)(2)]
However, the conversion from a limited partnership to an LLC is a transfer of the limited partnership’s property that triggers the due-on-sale clause in any security device, such as a trust deed, encumbering the property. [12 United States Code §1701j-3(a)]
Although the due-on-sale clause is triggered by this technical, statutory transfer of the partnership’s property to the LLC, notice to the lender is avoided if the merger documents (LLC-1 and LLC-9) are not recorded with the county recorder.
No county recording is necessary to transfer the property to the LLC, since the LLC automatically succeeds to all rights and obligations of the partnership on filing the LLC-9 with the Secretary of State. Title to the real estate, tax billings and insurance policies can remain in the partnership’s name since the LLC, even though the LLC-1 is not recorded, is still the successor-in-interest to the partnership.
If the LLC-9 is not recorded, and since no grant deed to the LLC exists, nothing on record will indicate a transfer of the property has taken place.
Of course, in order to obtain title insurance for a refinance or sale of the property, the LLC-9 will have to be recorded with the county recorder. However, delaying the recording interferes with the lender’s ability to discover the transfer and call the loan due until the property is actually sold.
The Secretary of State will not file the LLC-9 until a tax clearance certificate is obtained from the FTB, stating the limited partnership has paid all taxes for which it is liable. [Corp C §17552(e); Rev & T C §23334]
Also, an LLC is not liable for the franchise tax if its tax year is 15 days or less and it does not do business during that tax year. Thus, the creation of an LLC and the merger should occur during the last 15 days of December. [Rev & T C §17946]
LLC-12 information statements
Within 90 days after recording an LLC-1 form with the state of California, called a filing, the LLC syndicator, as manager, must fill out an LLC-12 form Statement of Information and send it, along with a check for $20 payable to the Secretary of State, to:
Secretary of State, Statement of information Unit P.O. Box 944230 Sacramento, CA 94244-2300
Failure to file the LLC-12 within the 90-day period following the filing date of the LLC-1 results in a $250.00 penalty. The LLC-12 form is available online at www.ss.ca.gov/business. There, it can be viewed, filled out and printed from your computer for preparation prior to mailing to the state.
In addition, every two years after filing the LLC-1, an LLC-12R statement of information form must be mailed to the Secretary of State for filing, along with a payment for the $20.00 processing fee. The period for filing the LLC-12R is every two years during the month in which the LLC-1 was filed or the preceding five months. Filing the LLC-12R continues until the LLC files an LLC-4/8 form for cancellation of the LLC entity.
Preparing the statement of information
The following instructions are for the preparation and use of the LLC-12 statement of information. Each instruction corresponds to the provision in the form bearing the same number.
1. Enter the name of the limited liability company exactly as it is recorded with the Secretary of State.
2. Enter the file number issued by the Secretary of State.
3. Enter the state under whose laws the LLC was organized.
4. Enter the complete street address, city and zip code of the principal executive offices of the LLC. Do not enter a P.O. Box or abbreviate the name of the city.
5. Enter the complete street address, city and zip code of the office in California where the LLC’s physical records are maintained.
6. Enter the name and complete business or residential address of the chief executive officer, if one exists.
7. Enter the name and complete business or residential address of the manager identified in the LLC-1 articles or operating agreement.
8. Provides for identification of an additional, named manager.
9. Provides for identification of an additional, named manager.
10. Enter the name of the agent for service of process located in California. Typically, the manager is the agent for service of process. However, a member or an attorney who represents the LLC could be named as the agent for service.
11. Enter the business or residential address of the agent for service if he is an individual.
12. Enter a brief description of the business conducted by the LLC.
13. Enter the name and title of the person completing the LLC-12 form. Enter the date this form was prepared and obtain the signature of the person named.
Cancellation of the LLC-1
Within 12 months after creating an LLC by filing the LLC-1 with the Secretary of State, a syndicator may need to or want to cancel the LLC. Cancellation eliminates the LLC entirely and terminates any further assessment of the annual $800 franchise tax on the entity.
Frequently, an LLC entity is formed solely to hold title to real estate for an individual who is the true owner of the property. For federal tax reporting purposes, the LLC is considered a disregarded entity, which does not affect the individual’s personal tax handling of real estate vested in his “one-man” LLC. The individual creates his one-man LLC by preparing, signing and filing the LLC-1. He takes on no co- owner, acts as the sole owner of the LLC, which does not report to the IRS, but does report to the California FTB and pay the annual California LLC franchise tax.
While the individual vests his property in the name of the LLC, he may want to retain the LLC vesting but cancel the entity to eliminate the annual franchise tax (and of course end the right of the LLC to sue or be sued and his right to limited liability for obligations of the LLC). Since the LLC was formed only for the purpose of vesting title to the property in the name of the LLC in lieu of vesting title in the name of the individual so the property is owned by the individual and not the LLC, the limited liability shield serves no legal consequence.
A checking account is established in the name of the LLC and will be retained. Following the cancellation of the entity, title will remain in the LLC vesting.
If the individual needs to encumber or convey the property on a refinance or sale, the LLC-1 remains of record with the county recorder, authorizing the individual to encumber or convey real estate vested in the name of the LLC, even though it, as an entity, has been formally canceled with the state of California. Conveying is different from suing someone in the name of the LLC since maintaining a lawsuit is not permitted after cancellation of the LLC-1, but the individual is unaffected by the cancellation and is able to sue in his own name.
Occasionally, a syndicator files an LLC-1 in anticipation of acquiring a property by forming an investment group, but is unable to close escrow and take title in the name of the LLC. The syndicator may have encountered difficulty clearing contingencies and, as a result, canceled the purchase agreement and escrow instructions. It is more likely that he failed to solicit and obtain sufficient commitments from investors to fund the closing.
Either way, the LLC now exists as an entity and the LLC-12 must be filed within 90 days after filing the LLC-1 or a $250 penalty is incurred. The syndicator must pay ongoing annual $800 franchise tax as long as the LLC-1 remains uncancelled. Thus, within 12 months after filing the LLC-1, the syndicator who created an LLC and no longer needs it, can prepare and file an LLC-4/8 form to rid himself of further liability and the continued existence of the LLC as an entity. There is no charge for filing an LLC-4/8. Any filing by mail should be sent Certified Mail Return Receipt Requested.
Before filing the LLC-4/8 cancellation, a final tax return must be filed with the Franchise Tax Board. However, a return does not need to be filed with the IRS if a return has not previously been filed.
The following instructions are for the preparation and use of Form LLC-4/8 Certificate of Cancellation. Each instruction corresponds to the provision in the form bearing the same number. [See Form LLC-4/8, accompanying this chapter]
1. Enter the file number assigned to the LLC by the Secretary of State.
2. Enter the name of the LLC exactly as it is recorded with the Secretary of State.
3. Provide statements required by the person canceling the LLC-1 and which cannot be altered. The form cannot be used if any of the statements do not apply.
4. Check the appropriate box to indicate whether property or cash has been acquired by the LLC or if neither has been acquired.
5. Check the appropriate box to indicate whether a group of members organized under an operating agreement has voted to dissolve the LLC, or the organizer who signed the LLC-1 has decided to dissolve the LLC.
6. If an operating agreement has not been entered into and no members have been admitted into the LLC, the individual who signed the LLC-1 must sign the LLC-4/8 as the organizer. If there are members, then a majority of the members must sign.
7. Enter the name and address of the person to whom a copy of the filed LLC-12 is to be returned.