Issues to Consider When Choosing a Holding Entity

1. Introduction

The property owner today faces many challenges including those of wealth creation, management, preservation and disposition. These challenges are made more difficult by current economic, legal and tax uncertainties which are increasingly more difficult to anticipate, comprehend and control.

Nevertheless, in developing a property acquisition, ownership and disposition plan, the “choice of entity” question is one of the most significant decisions that the owner of investment property has to make and thus demands careful review and analysis.

The choices of entities available to the property owner today are numerous. A list may be as follows.

Under individual ownership, one may select from:

Separate Property
Tenants in Common
Joint Tenants (WROS)
Community Property

For those considering a partnership form, the choices may include:

General Partnership
Limited Partnership
Family Limited Partnership
Limited Liability Company.

Those who are attracted to the corporate form of ownership should consider:

Subchapter S-Corporation
C-Corporation
Real Estate Investment Trust (REIT).

On the other hand, those of you who are attracted to a trust form may be considering:

Living Trust
Land Trust
Business Trust
Bypass Trust
Q-TIP Trust
Disclaimer Trust
Grantor Retained Income Trust (GRAT, GRUT or QPRT)
Private Annuity Trust
Foreign Trust
Charitable Lead Trust
Charitable Remainder Trust.

The factors involved in the choice of entity decision are even more numerous. The following is a somewhat complete list and explanation of those factors that should be considered.

2. Decision Factors

a. New Acquisition or Existing Property

It is much easier and typically less costly to make the choice of entity decision at the beginning of the investment cycle. More often than not it can be as simple as specifying and/or negotiating the deal based on a specific entity taking title. Once you are invested, it often takes more money and the agreement by multiple persons (ex: lenders; investors; partners; spouse; etc.) to effectuate a change in ownership.

b. Simplicity

Remember the old K.I.S.S. (i.e. Keep It Simple Stupid) principle? Believe it or not, that is still by far the most governing factor in making the choice of entity decision. People are more often driven by:

Set Up: How easy is it to set up? If it requires an attorney, it's too hard!
Dissolution: How easy is it to dissolve? If it requires an attorney, it's too hard!
Accounting: How easy is it to account for? If it requires maintaining a separate set of books or filing a separate tax return, then it is too hard!
Operating Costs: How much does it cost to operate? If there are extra filing fees or accounting fees or other entity related fees, then it's not worth it!

c. Duration of Ownership

How long do you plan on owning the property? If it's “short term” then it is most likely not worth creating a special holding entity! However, if you plan on owning the asset a long time, especially if you plan on retaining ownership for several generations, then it's very worthwhile to set up a permanent holding entity!

d. Limited Liability

How much personal liability do you expose yourself to from owning the property? Can you be sued due to the property and potentially lose everything else? Can you afford to lose the property because you are being sued somewhere else? Can you become an anonymous owner to prospective creditors?

e. Location of the Property

Is the location of the property a limiting factor due to your domicile or residency? Are you limited by your State (ex: California) of residency and your State (ex: California) of investment from choosing a specific entity (ex: a Nevada Corporation or a one member LLC)?

f. Source of Venture Capital

Where is the money coming from to pay for the investment? If it's a sizable loan financed by an institutional lender, are they insisting on a single-asset, bankruptcy proof entity like an LLC? If it's a passive investor, are they desirous of a Limited Partnership arrangement?

g. Number of Owners

Your choices are also very much constrained by the number and qualifications of the owners. If it's only you investing, then some of the myriad of choices are not available to you! If you have foreign investors, then some of the other choices will not be available to you.

Centralized Management: If you, and you alone, want to make all the decisions, then a General Partnership will not do.
Form of Compensation: If you want a preferred distribution of income but do not want that to be classified as earned income but only as passive income, then a C-Corporation won ’t do.

h. Income Tax Consequences

The income tax treatment of earnings, profits and losses may differ significantly from one entity to another depending on the choice of entity. The scrutiny given by various taxing authorities differ somewhat as well.

Lower Audit Profile: A Limited Partnership with multiple real estate assets worth millions of dollars which is generating hundreds of thousands of dollars of losses may be less prone to audit than a small apartment building generating a loss of tens of thousands of dollars.
Double Taxation: Some choices of entity (ex: a C-Corporation) will obligate you to two layers of taxation. You are taxed once at the entity level, and once again at the individual level.
Projected Income or Loss: Losses from certain entities (ex: Trusts) will not be available to you as an offset to income from other sources irrespective of the similarity in the quality of the income (ex: passive income).
Special Allocation: Certain entities (ex: Partnerships) may allow you to differentiate the nature and amount of income and losses and preferences as they pertain and are allocated to the various owners/investors.
Income Shifting: Investment in income producing assets, such as real estate, under certain entity forms (ex: Family Limited Partnership) will allow a family to successfully implement an income shifting strategy which will pass taxable income from high tax bracket family members to those in lower marginal tax brackets.

i. Estate Tax Consequences

Transfer of ownership and wealth during life (inter-vivos) or after death (testamentary) can be facilitated or hampered by the choice of entity made.

Net Worth of the Owner(s): The net worth of the owner should be a determining factor. If there is not much equity or wealth then there is no need to set up complex structures. However, if there is a lot to protect then the entities are very important. After all, the amount included in a decedent’s taxable estate can be controlled and reduced (if not eliminated) by making the right choice of entity.
Family Status of Owner(s): Husband and wife inheritance issues; inheriting off springs from multiple marriage issues; and constraints on heirs with “bad habits” can all be taken into consideration within certain forms of entities (ex: Trusts).
Discount Valuation Potential: Discounting (i.e. Leveraging) of $10,000 annual exclusion gifts and minority interests can be leveraged to their fullest under certain forms of ownership.
Ease of Transfer: Assignment of a fractional interest versus recording of deeds!

j. Property Tax Consequences

Protecting low property tax assessments as assets are partially or fully transferred can have a significant monetary reward or cost!

k. Other Considerations

Other considerations such as restricted transfers; related party transactions; fiscal or calendar year allowances; 100% deductible fringe benefits; step-up in basis at death; and the existence of reliable case law are but a handful of other factors that one can and perhaps should consider.

RealTax professionals have the knowledge and expertise to help you evaluate the issues when choosing a holding entity. We specialize in real estate oriented accounting, tax planning, tax preparation and related services. We invite you to contact us with regard to your specific needs.