There are two different kinds of decisions that we need to make in order to protect yourself from the very beginning from deals going sideways, or making a mistake by choosing the wrong kinds of investors.
The first decision that we have to make is about entity types. We’ll go over what the basic entity types are, and then we’ll also go through what the structure looks like. Once you have that in mind, you’ll know how to basically build that whole framework that lets you do syndications in a much safer way. And this really boils down to protecting you as the syndicator from anything going wrong and protecting you from liability.
The topic of entity selection and structures may only be interesting to lawyers. But you’d be surprised how important this is.
Let’s start with a little story. The Ghost Ship was an office building in Oakland, California which some tenants decided to convert to live-in lofts and a dance hall. Then there was a fire that broke out.
The Ghost Ship was owned by a trust, which was owned by one woman. But the trust didn’t only own the Ghost Ship, it owned something like 20 other buildings. When the fire broke out, 36 people died. Their families sued the trust, which was the owner of the building. When this one entity was sued, all of these other buildings were suddenly vulnerable to losing everything.
Setting up a trust for syndicating wasn’t a smart move for this woman.
If you chose to put everything under your own name, you will be basically acting as a sole proprietor. That is just you, with no liability protection.
Then there is a partnership. This is two or more people coming together for a common enterprise.
Next, there is the limited liability partnership.
Then, there is your limited liability company.
And finally, there are corporations.
Now, you may be asking, what about S corporations versus C corporations? S corporations and C corporations are not specific kinds of corporations. These labels are simply referring to their ways of being taxed.
As we go through these, start thinking about what makes most sense for you, in terms of number of people involved, asset protection, maintenance, governance, and taxes. At the end of the day, there’s probably one entity type that makes the most sense for you.
So when it comes to a sole proprietor, we’re talking about one person, and that’s you. Everything is under your name, your social security number, and there is no asset protection whatsoever. As a sole proprietor, in terms of maintenance and governments, it’s very, very simple. You may have to do a DBA, or “doing business as” filing with your local municipality. But that’s it. In terms of taxes, this all goes on your individual taxes – you don’t have a choice about that.
Now, let’s talk about partnerships. Partnerships are always two or more people. There is no asset protection for the general partner. The governance is actually pretty easy. There is not a lot that you need to do for a partnership, but check with your local state, if a partnership is something of interest to you. In terms of taxes, you probably are going to be paying as a partnership.
Then there is your LLP, which also requires two or more people. There’s some asset protections for the general partner, and good asset protection for the limited partners. So why would you choose a partnership over an LLP? Really, it comes down to the cost of filing. And then there is the difficulty of governing it. There can be a moderate amount of maintenance that needs to take place on the LLP in order to keep it valid, and you will be taxed as a partnership.
An LLC can have just one person. But in order for it to have the best level of asset protection, it should be two or more people, with one acting as a general partner, or your managing member of the LLC. An LLC has good asset protection and also easy to moderate governance. It’s not very difficult, but there is some work to be done. Again, check with your local state or where you’re going to be filing.
In terms of taxes, though, the LLC has a choice of either being taxed as a partnership, or an S Corp. To decide on how you want to be taxed, you should talk to your accountant, because those distributions can change radically based on your designation.
In terms of corporations, we can also just have one person. In most jurisdictions, there is good asset protection, though slightly different than in an LLC. But the maintenance of them tends to be fairly complex – you need to have a board of directors with officers and rules that need to take place. While an LLC will have an operating agreement, a corporation will have bylaws. Typically, there are more complex things that are required for a corporation to stay active and look like a real company in order to get that asset protection. Then taxes are either an S corp or a C Corp.
A member-managed LLC consists of a team of people who are all part of the same property LLC. Each person gets their own vote, and they all have control equal to the amount of shares or membership units that they own in the LLC.
This becomes very hard to manage, as you’re ceding control to all of your investors in order to get things done, making it hard for you to get paid. It’s generally defeatist in your business goals, except for one particular context, which is called the joint venture. We’ll talk through that soon.
A manager-managed LLC means that control over the LLC is held by one individual or entity, and investors have only the voting rights that are specified in the operating agreement.
When you form a syndication, you can opt to structure it as member-managed or manager-managed. About 95% of the time, you should opt for a manager-managed LLC.
Let’s say you’ve identified a terrific building, perfect for you and your investors. You put a down payment on it, call your other investors, and maybe three or four other people contribute money into the property. You smartly decide to create an LLC, which will own the property.
One of the decisions you make when setting this up is whether to be a manager-managed or member-managed LLC. After this discussion, you’ll understand why most of the time you should choose a manager-managed, because then you have some control over the property itself and over your actions. But in this case, we’ll say you choose to form a member-managed LLC.
Now let’s say that later, one of your investors isn’t thrilled with the property and wants to file a lawsuit against you and the property. He wants his money back, as well as punitive damages. The problem with the structure of the member-managed LLC is that everyone involved is now exposed to this lawsuit.
No doubt, there’s an indemnity clause for the LLC. But it’s not as effective as you probably would like, because ultimately you can’t just bankrupt this property LLC and all the other investors involved. You’re on the hook, subject to the claims of the property LLC itself.
Most small, unsophisticated syndications are put together this way, and you can see how it’s a big mistake.
Let’s look at another scenario. You find a great property and have two investors join you to invest in it. You set up a property LLC, but this time you’ve learned your lesson. You know that if you were just to put in your money and the deposit on that property, you’re being exposed.
So instead, you create another, separate entity for management. We’ll talk later about structure and choice of entity, but many times this will be a corporation or a separate LLC.
In this example, let’s say you contribute your deposit money into this management entity, you make the down payment on the property, and you start gathering up the investors’ funds. The property LLC then pays management fees and other fees to you through this separate entity.
If one of your investors decides to file a lawsuit, they can then sue you, the property LLC, and the separate management entity. But because you’ve conducted business through the management entity, you’re actually not liable. And the court will not recognize the lawsuit filed against you. The investor can still sue the property LLC and the management entity, but your assets are protected.
This way of doing things — a management company managing the property LLC itself — is the most common way of doing things.
There’s no reason to wait on getting started with filing that syndicator entity as soon as you know you’re going to be putting a deal together. There are a lot of costs that are associated with not only putting it together, but many jurisdictions have taxes that apply in the first year for the minimum maintenance of the entity. Starting with establishing the entity is taking massive action towards your future. So think carefully when you make that decision about what entity type makes the most sense for you.
Are you ready to get started with your own syndication and need a private placement memorandum? Moschetti Law Group is a real estate syndication law firm and we’d be happy to meet with you to put together your Reg D PPM from a syndication attorney and guide you through the process of launching your own offering.
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