§1.3 - Advantages and Disadvantages of Organization Type

• Jurisdiction: Washington

§1.3 ADVANTAGES AND DISADVANTAGES OF ORGANIZATION TYPE

This section discusses and compares the advantages and disadvantages of each form of entity with respect to liability for obligations, tax considerations, transferability of interests, flexibility of organization, and record-keeping requirements.

(1) Personal liability

The personal liability of a principal for obligations of each type of entity are compared below.

(a) General partnerships and limited liability partnerships (LLPs)

A principal disadvantage of using general partnerships in real estate transactions is that each partner has personal liability for all obligations of the partnership. Such obligations include not only indebtedness of the partnership (e.g., promissory notes and related deeds of trust), but also other contractual obligations of the partnership (e.g., obligations under construction contracts, leases with tenants, etc.), tort liabilities of the partnership (e.g., "slip and fall" liabilities), and statutory liabilities (e.g., environmental damage, nondiscrimination, etc.).

However, if the general partnership registers under RCW 25.05.500 as a limited liability partnership, then, under RCW 25.05.125, the general partners are not personally liable for the actions of the partnership. For a further discussion of personal liability and general and limited liability partnerships, see WASHINGTON PARTNERSHIP AND LIMITED LIABILITY COMPANY DESKBOOK Chapters 12 & 13 (Wash. St. Bar Assoc. 2d ed. 2010).

(b) Limited partnerships

A principal advantage of the limited partnership is the general rule that limited partners have no personal liability for the obligations of the partnership. The general partners have joint and several personal liability, just as in a general partnership. RCW 25.10.401(1).

In the real estate context, some of the advantage of limited liability of limited partners can be eroded if the partnership's lenders require personal guarantees from limited partners. This frequently will be the case with respect to new entities or limited partnerships with modest capitalization. However, even in this case, the limited partners would continue to enjoy limited liability with respect to tort liability and other nonguaranteed contractual claims.

Under prior law, the limited liability of a limited partner could be lost if the limited partner participated in the control of the business. Under current law, a limited partner is not personally liable for obligations of the limited partnership solely by reason of being a limited partner, even if the limited partner participates in the management and control of the limited partnership. RCW 25.10.321.

Because the limited partnership statute requires that there be at least one general partner, the limited partnership form of organization cannot be used to extend limited liability to all owners. One solution to this problem is to designate a corporation (or other limited liability entity) as the general partner.

(c) Corporations (including S corporations)

Generally, shareholders of a corporation do not have personal liability for the obligations of the corporation. This is often the key advantage of using the corporate form of organization.

The principal exception to this general rule is the doctrine of "piercing the corporate veil." Under this doctrine, courts have disregarded the corporate form to impose personal liability on shareholders. Washington courts have followed a restrictive rule requiring proof that (1) the corporate form has been intentionally used to violate or evade a duty owed to another and (2) disregard of the corporate form is necessary to prevent unjustified loss to the injured party. Wash. Water Jet Workers Ass'n v. Yarbrough, 151 Wn.2d 470, 90 P.3d 42 (2004), cert. denied, 543 U.S. 1120 (2005).

As in the case of limited partnerships, the advantage of limited liability can be reduced if the corporation's lenders, or other parties with which it contracts, require the personal guarantees of shareholders.

(d) Limited liability companies (LLCs)

One of the principal attractions of the limited liability company (LLC) is that it affords limited liability to all owners (called "members") in the same manner as a corporation. The Washington Limited Liability Companies Act, Chapter 25.15 RCW, provides that LLC liabilities, whether arising in contract, tort, or otherwise, shall be solely the debts, obligations, and liabilities of the limited liability company. However, the concept of "piercing the corporate veil" is made expressly applicable to limited liability companies by RCW 25.15.060, which allows the court to consider the factors and policies set forth in case law with regard to "piercing the veil."

Again, the advantage of limited liability can be reduced if lenders or other parties require the personal guarantees of LLC members.

(e) Summary and comparison

Corporations and LLCs offer the greatest advantages in limiting the liability of owners. General partnerships afford no protection to owners. Limited partnerships also offer the advantage of limited liability to limited partners, but the advantages of this entity form are reduced by the necessity of having at least one general partner with unlimited liability and the risk that a limited partner will become a general partner by participating in the control of the partnership's business.

(2) Tax considerations

The tax advantages and disadvantages of each type of entity are compared below.

(a) Federal income tax classification

Principals in real estate transactions typically prefer the "pass-through" of tax consequences applicable to partnerships, LLCs, and S corporations rather than the taxation at the entity level applicable to C corporations. However, under federal tax law, the classification of an entity as a partnership (general or limited) for state law purposes is not sufficient to ensure classification of the entity as a partnership for federal income tax purposes. Generally, federal tax regulations permit unincorporated entities to elect their tax status for federal income tax purposes. See Treas. Reg.§301.7701-3.

Under these "check-the-box" regulations, an "eligible entity," i.e., a business entity that is not explicitly classified by the regulations as a corporation, can elect its tax classification. Eligible entities include general partnerships, limited partnerships, LLPs, and LLCs. An eligible entity with two or more members can elect to be classified as an association (and thus taxed as a corporation) or as a partnership (in which event profits and losses "pass through" to the members). An eligible entity with one member can elect to be classified as an association or to be disregarded as an entity separate from its owners, in which case the activities of the entity will be treated, for tax purposes, as the activities of its sole owner. Treas. Reg. §301.7701-3.

The "check-the-box" regulations provide default rules for entities in the absence of an election. A domestic eligible entity with two or more members is treated as a partnership for federal income tax purposes unless it elects otherwise. A domestic eligible entity with one owner is disregarded as an entity separate from its owner unless it elects to be taxed as a corporation. Treas. Reg. § 301.7701-3(b)(1). As mentioned above, a business entity that is taxed as a partnership or disregarded for tax purposes will not be subject to tax. Instead, the income, gains, and losses of the entity will be taxed to its members.

An eligible entity desiring to make an election to be treated for tax purposes in a manner different from that set forth above under the default rules may make an election to be so taxed on I.R.S. Form 8832.

Caveat: Be aware of the I.R.S. deadlines for filing taxable entity elections and S corp. elections. The consequences of missing these deadlines can be significant. Make sure the client is aware of filing deadlines and establish who will be responsible for filing.

(b) Other tax considerations

Aside from classification as a partnership for federal income tax purposes, a number of other tax issues may be significant in choice of entity. These include the following:

(i) Distributions

The tax treatment of distributions of cash or other property can be important to principals in real estate transactions. Obviously, owners would prefer such distributions to be nontaxable.

(ii) Basis in entity debt

Owners desire to include in their tax basis in the entity their share of the debt of the entity. Whether this is permissible depends on the entity and the nature of the debt (i.e., recourse or nonrecourse).

(iii) At-risk limitations

Generally, I.R.C. § 465 limits the losses that may be taken from certain specified activities to the amounts the taxpayer has "at risk." At-risk amounts include the money and adjusted basis of property contributed to the entity, the net fair market value of property (other than property used in the activity) pledged for the benefit of the entity, indebtedness of the entity for which the taxpayer is personally liable, and "qualified nonrecourse financing" (generally, financing relating to the real property activity, for which no person is personally liable, not convertible into equity, borrowed from an unrelated party engaged in the business of lending and secured by real property used in the business). The at-risk limitations apply to individuals and closely held C corporations, including, as applicable, their pass-through shares of partnership, LLC, or S corporation losses.

(iv) Passive activity limitations

Generally, deductions from "passive activities" are limited to the income from such activities, and excess passive losses cannot be taken until the taxpayer has passive income or the taxpayer disposes of his or her interest. A passive activity is one involving the conduct of a trade or...