By: Michael Van Someren and Daniel A. Kaminsky
The limited liability company tends to be the entity of choice for commercial real estate owners due to limited liability protection, structure flexibility, and pass through income and taxation. A traditional ownership structure in which a sponsor assembles investors to acquire, develop, and manage a real estate project looks like this:
In the traditional structure, the real property company owns the real estate, and the investors and sponsor own membership interests in the real property company. The sponsor typically has the authority to make most decisions, while the investors are often “passive” investors with very limited decision making authority. The real property company provides the investors and sponsor with protection against liability that may arise from the underlying real estate (e.g., damages arising from accidents on the real estate, loan defaults (unless the loan is personally guaranteed by investors or sponsor)). Additionally, the investors receive pass-through income from the real property company, and also avoid the double-taxation of a c-corporation.
While the traditional structure is effective at providing liability protection, pass-through income, and tax benefits, it has certain limitations when the decision is made to sell. As noted in our team’s December 6, 2017 article, Purchasing LLC Membership Interests vs. Real Estate: Pros and Cons, a method of exiting real estate is to sell the membership interests in the company that owns the real estate. Membership interests are the personal property of each investor, and depending on the number and location of investors in the real property company, getting all of the investors to sell and convey their membership interests can be a burdensome process. Further, when an investor conveys their membership interest, he or she exposes himself or herself to potential personal liability arising out of that sale.
To allow for greater ease of selling membership interests in the real property company and continued liability protection, the following alternative structure should be considered:
Utilizing the alternative structure set forth above has a number of benefits. To begin with, it has all of the benefits of the traditional structure. There is liability protection. There is also pass-through income. The real property company is disregarded for tax purposes as is the holding company. The investors and sponsor have the same financial and tax outcomes as they would under the traditional structure. Finally, the decision making and management authority can reside with the sponsor in the alternative structure just the same as it does in the traditional structure.
The major benefits exclusive to the alternative structure are that the holding company, as the sole member of the real property company, can sell all of the membership interests in the real property company to a buyer without having to obtain signatures from each of the investors in the project, and such sale transaction does not expose the investors to potential individual liability arising out of the sale. It can also make the sale of membership interests more appealing to potential buyers by reducing the risk that an investor may have, intentionally or unintentionally, encumbered its membership interests in the real property company.
By utilizing the alternative structure above, a prospective buyer can rely on the fact that there is one member that owns all of the membership interests of the real property company and that a single assignment of those membership interests will give the prospective buyer total ownership and control of the real property company that owns the real estate. In addition, with the alternative structure, the original investors are not exposed to individual liability related to such a sale transaction because they are not conveying their membership interests and are not directly involved in the transaction (although the investors will receive the economic benefit of the transaction).
Exit strategies should be considered when structuring or analyzing entities for commercial real estate projects or investments. If you wish to discuss entity structure in connection with a real estate project or investment, please contact your Davis|Kuelthau, s.c. attorney, the authors linked above or the related practice group co-chairs linked here.
 It should be noted that the traditional structure may include provisions in the real property company’s operating agreement that grant the manager of the real property company the authority to unilaterally convey and sell the investors’ membership interests in the real estate company; however, that approach still comes with certain issues, including: (a) regardless of the authority granted to the manager in the operating agreement, risk averse buyers may insist on the investors executing an assignment of membership interest and providing certain representations (e.g., a representation that the membership interest has not been pledged as collateral for a personal loan); and (b) the investors would likely retain the risk of liability arising out of a sale of their membership interest.