This article examines the formation and taxation of a limited liability company (LLC), including 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 the limited liability advantages of a corporation with the 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 are passed through to the members for individual tax reporting. The members pay federal income tax on their share of any LLC income or profits.

The LLC is like a limited partnership without a general (liability) partner, as limited liability in an LLC extends to all members, including the manager. Conversely, the general partner in a limited partnership is generally 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. Having a sole, corporate general partner in a limited partnership creates a situation for the syndicator similar to the LLC, with its limited liability for all individual members and the manager.

Taxwise, a limited partnership with a corporate general partner has a more restrictive structure than an LLC. For instance, a partnership with a corporate general partner is taxed as a corporation unless the corporate general partner owns assets worth at least 15% of the partners’ contributions. [Revenue Procedure 72-13]

Also, a partnership with a corporate general partner is unable to take advantage of the small partnership exemption from tax reporting. 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, since the LLC is essentially a small corporation (because of its corporate liability structure) treated as a partnership for income tax purposes. However, there are fewer restrictions imposed on the participants and investments in an LLC than in an S corporation.

For example, the shareholders in an S corporation must be individuals (or estates or trusts in certain cases), and an S corporation may have no more than 75 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 in real estate, providing limited liability for investors and pass-through of income for state and federal tax reporting. [Corp C §23000; IRC §856]

However, the REIT is obsolete as a syndication vehicle for local real estate investment groups. The LLC allows more management flexibility and the same tax results.

For example, to qualify for federal tax reporting as a real estate investment trust, the REIT must have at least 100 shareholders, and the REIT’s business activities are restricted to investments in real estate. [IRC §856]

No such restrictions apply to the LLC.

Further, an REIT must always qualify its investment program with the California Department of Corporations (DOC). Conversely, the LLC need only qualify if a securities risk exists and no exemption applies.

Formation

An LLC is defined as having two or more members. However, only one person is required to form and commence the existence of an LLC by filing articles of organization with the California Secretary of State. [Corp C §17050]

The form for filing the articles of organization is the LLC-1 issued by the Secretary of State, analogous to the LP-1 for a limited partnership. 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 need not even 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 will then become the managing officer. He typically holds a Class B membership in the LLC for having packaged the investment program.

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 and secures the limited liability of 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 may be recorded with the county recorder in any county of California. [Corp C §17052(f)]

Thus, those dealing with the LLC, such as title companies, lenders, sellers, buyers, escrows, brokers and others, need only look to the recorded LLC-1, and no further, to determine who to deal with – the manager, group of managers or majority 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 Fig. 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 fairly simple document, intended mainly to register the LLC with the state and establish it as a legal entity in order to provide limited liability to all managers and members (and $800 annually to the state).

As an addendum to the LLC-1, the members may wish to include a clause stating the LLC’s real estate may not be sold or encumbered without the consent of a majority in interest of the members. The addendum will serve to hold the manager to the purpose of the LLC – to own and operate the real estate for the benefit of the members.

Limited liability

The liability limitation for the members of an LLC is slightly less extensive than for the 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/LLC if it can be proven the corporation/LLC exists solely to shield the shareholders from liability for their debts or actions, called piercing the corporate veil.

In a limited partnership, the limited partners escape liability beyond the amount of their contributions. Conversely, the general partner is generally liable for all partnership debts.

Conversely, in a corporation or LLC, no member, officer or shareholder is generally liable for any of the entity’s debts. Thus, the possibility of the abuse of a corporate or LLC business entity by individuals seeking to shield themselves from liability arises. Such individuals carry on their personal business activities behind a corporation or LLC which is merely a facade, called an alter ego.

A corporation, and thus an LLC, is considered an alter ego 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 which is undercapitalized is often considered an alter ego of the shareholders. If a corporation is not funded with a significant amount of capital, it will not have sufficient assets with which to pay debts it incurs in the ordinary course of business.

Thus, a corporation or LLC may be regarded as existing in name only, 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]

Sufficient capitalization occurs in real estate transactions since all funds needed to own the property must be raised before the property can be acquired.

Taxation by the FTB

To secure the limited liability of its members, the LLC must pay annual taxes and fees to the state.

Every LLC must pay the annual $800 minimum franchise tax which is also imposed on corporations and limited partnerships. [Rev & T C §17941; §23153(d)]

In addition to the minimum franchise tax, an LLC with over $250,000 in annual gross 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)]

Thus, an LLC formed solely for real estate syndication purposes, which acquires income-producing property with a scheduled gross income less than $250,000, will not be concerned with the additional tax.

The LLC name

The syndicator selects a name for the LLC, which must end with the words “Limited Liability Company,” 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 should not include the name of the manager or any of the members, 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, gleaned from the property’s address, might be “Main Street Properties, LLC, a California Limited Liability Company”.

An LLC name may be reserved by applying to the Secretary of State. For a fee of $10, the name will be reserved for 60 days. [Corp C §17053; Gov C §12190(a)]

The Secretary of State does not have a specific form for LLC name reservations. A name can be reserved by simply sending a letter stating the name to be reserved to the Limited Liability Company Unit, along with the $10 fee. An additional $10 counter fee will be charged if the request is made in person at the Secretary of State’s public counter.

Alternatively, use a private filing service to reserve your name or file your LLC forms. These companies charge a fee for these services. One such company is:

• CSC, 2730 Gate Way Oaks Drive, Suite 100, Sacramento, CA 95833, (916) 649-9916/(800) 222-2122 http://www.inc.spot.com

The LLC-1 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.

Also, the LLC syndicator must designate an agent for the service of process with an address in California, as is required of any statutory entity. The agent may be an individual or a corporation. [Corp C §17057(b)]

For real estate syndication, the agent for service is usually the syndicator or his attorney.

In addition to the agent for service, the LLC’s operating agreement may provide for the appointment of officers such as president, secretary, treasurer, and so on. [Corp C §17154]

The officers need not be members or managers of the LLC. For example, an accountant or bookkeeper who is not a member of the LLC could be hired as treasurer.

The LLC must have an office in the state of California where it maintains its records, including 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, and financial statements. [Corp C §17058]

Finally, each LLC must file a statement every two years with the Secretary of State, stating the name and address of the LLC, its manager and agent for service, and the type of business it conducts.

The form for filing the biennial statement is the LLC-12, “Statement of Information.” A $20 filing fee is required. [Gov C §12190(k); See LLC-12, accompanying this chapter]

The LLC-12 must first be filed within 90 days after the articles of organization for the LLC are filed, and every two years thereafter during the calendar month in which the articles of organization were first filed. [Corp C §17060]

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)]

Once registered, the LLC commences its existence as a legal entity and has the same powers as a corporation, partnership or individual to conduct any business, buy, sell and lease property, sue or be sued, enter into agreements, and so on. [Corp C §17003]

However, LLCs, like limited partnerships, may not engage in the business of banking, issuing policies of insurance and assuming insurance risks, or the business of trust companies. [Corp C §17002]

Also, LLCs are not currently permitted to be licensed as real estate brokers. The Limited Liability Company Act prohibits LLCs from offering professional services in the name of the LLC for a fee, which includes the services of accountants, attorneys, physicians, and real estate brokers.

However, nothing prevents the manager from acting as an individual and representing the LLC as its broker, and collecting a brokerage fee on transactions handled for the LLC. Also, an LLC can act as a principal in any real estate-related transaction.

Tax reporting

Limited liability companies are considered partnerships for tax reporting purposes, except for the annual California franchise tax and income-based fees. [Rev & T C §28.5]

The 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]

Also, LLCs reporting as partnerships for federal income tax purposes will file a 1065 return annually with the IRS, unless the LLC qualifies for the 10-or-fewer small partnership exemption.

The small “partnership” exemption

Although a partnership does not pay income taxes, each partnership – including LLCs which automatically qualify as partnerships – is required 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, a kind of “snitch sheet”, informs the IRS of the LLC’s income and losses and identifies each member and his share of the income and losses.

However, an LLC or partnership with 10 or fewer participants, all of whom are natural persons or estates, is not required to file an IRS 1065 Form. [IRC §6231(a)(1)(B)]

Since an LLC automatically qualifies as a partnership for federal income tax purposes, an LLC is also able to avoid filing an IRS 1065 return if it further qualifies under the small partnership exemption.

No regulation or ruling exists stating an LLC may qualify for the small partnership exemption. However, for federal taxes, “partnership” is defined broadly as any business entity which is not a corporation, trust or estate. [IRC §761; Rev. Regs. §301.7701-3]

Thus, an LLC is automatically classified as a partnership and can take full advantage of partnership tax treatment, including the small partnership exemption from filing the IRS 1065 return.

However, the IRS has imposed restrictions other than 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, where 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 84-35]

Most small investment groups do not have significant holdings and thus report income and losses based on their percentage of ownership. Despite the restrictions imposed by the IRS, an LLC formed for real estate syndication with 10 or fewer members is able to avoid filing the IRS 1065 return. Each member reports its share of income, expenses, interest and depreciation in a schedule attached to their 1040 return, such as Schedule E for rental ownership reporting.

Converting a limited partnership to an LLC

Many general partners managing existing limited partnerships will convert their limited partnerships to LLCs. The limited liability for the syndicator as manager in an LLC stands in dramatic contrast to his general liability as the general partner in a limited partnership.

However, the process of conversion comes at a price. The filing of the necessary forms requires fees of over $200.

Ultimately, however, the advantage of limited liability gained for the syndicator 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 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, or LLC-9. [Corp C §17552; See LLC-9, accompanying this chapter]

Also required is a merger agreement, to be approved by the limited partners. The agreement states the terms of the merger, the name of the LLC into which the partnership is being merged 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 terms as the agreement for the limited partnership being converted, and stating 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, the change of ownership to the real estate can be documented, if required by a title insurer, by recording a copy of the certificate of merger (LLC-9) and the LLC-1 with the county recorder of the county where the property is located.

A copy of the certificate of merger (LLC-9), certified by the Secretary of State and recorded in the county recorder’s office, serves as notice of the transfer 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, the investors retaining the same proportional interests, rights and obligations in the LLC as in the limited partnership, so 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 surname and references to participants. The limited partnership becomes an LLC, the limited partners become members, and the general partner becomes the manager. Property operations and tax reporting remain the same.

The significant difference is the limited liability gained by the former general partner as the managing member of the newly-formed successor LLC. However, the liability limitation for the manager 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 triggering 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 triggering the due-on-sale clause in any security devices (trust deeds) 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 can be 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 is the successor-in-interest to the partnership.

If the certificate of merger (LLC-9) is not recorded, and no grant deed to the LLC exists, nothing on record title will indicate a transfer of the property has taken place.

Of course, in order to obtain title insurance, the certificate of merger (LLC-9) will have to be recorded with the county recorder before the LLC can refinance or deed out the property to a subsequent buyer. 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.

Editor’s note — If the lender later discovers the change of ownership has taken place, its only remedy against the LLC is to call the loan due.

However, if a third party, such as a broker or attorney, advises the syndicator to conceal the change of ownership from the lender to avoid due-on enforcement, the third party advisor can be held liable for any retroactive interest differential (RID) for interfering with the contract (due-on provision) between the lender and the syndication group – a tort. [J'Aire Corporation v. Gregory (1979) 24 C3d 799]

The Secretary of State will not file the certificate of merger (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 the tax year. [Rev & T C §17946]

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