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Single Purpose Entities in US Real Estate Transactions, Briefings in Real Estate Finance, P.J. Javaheri (contributing author)
Best practices in commercial real estate financing

Joshua Stein, Section Editor is a real estate and finance partner in the New York office of the international law firm of Latham & Watkins LLP. He has pubtished extensively on commerciat lending and commercial leasing, including a number of papers in Briefings in Real Estate Finance, and four books.

Single-purpose entities in Us real estate transactions: Are they worth the hassle?

William C. Seligman is a partner in the Rea[ Estate department of Winston & Strawn LLP. He practised law in New York for 15 years, and relocated to Los Angeles in 2003. Mr. Seligman notes with appreciation the research assistance of Hilary Fey, an associate in Winston & Strawn's Los Angetes Real Estate department, and Pejman Javaheri, a 2004 summer associate in Winston & Strawn's Los Angeles office,

Abstract Single-purpose entities are commonly required by lenders in commercial real estate financings in the USA. This paper will review the risks against which protection is sought through the single-purpose entity structure, the elements of a 'single-purpose entity' and a'bankruptcy-remote' entity, common objections of owners and investors to using these structures, and some key holdings of US courts in this area.

Keywords: single-purpose entity (SPE), bankruptcy-remote entity, independent director, substantive consideration

INTRODUCTION

Single-purpose entities (SPEs), also referred to interchangeably as single-asset entities or special-purpose entities, are much maligned modern real estate transactions. In financing, lenders require SPEs, seeming to hold out the presence of an SPE as a talisrnan that will ward off all future evil, while borrowers complain about the upfront and long-term costs of complying with the lender's requirements. In a purchase and sale agreement, a buyer struggles to obtain representations and warranties that survive the closing, and then must face the added challenge of negotiating for recourse to an entity that will not have any assets once the property is sold and the cash distributed. Yet, that same buyer, wearing the hat of the landlord in a lease, willingly accepts the benefits of holding title to a building in an SPE while seeking guaranties from would-be tenants who fail to bring the proverbial 'deep pocket' to the table. But all of them - landlord, tenant and lender alike - will welcome the protections of SPE ownership when a 'slip and fall' plaintiff commences litigation against anyone and everyone imaginable.

The reputation of the SPE was not helped by the association of SPEs with many of the abuses attributed to certain transaction structures now eternally linked to Enron. Yet, Enron and its advisors did not invent the SPE; SPEs have long played myriad roles in real estate transactions in the USA. This paper aims to provide a brief overview of some primary advantages and disadvantages of using SPEs in US real estate transactions.

A note on terminology

As noted above, the SPE goes by many names. It is also sometimes linked to the (misleading) term 'bankruptcy proof' or the less overreaching'bankruptcy remote', although it should be noted that not every SPE is'bankruptcy remote'. In this paper. the term 'SPE' will refer to a corporation, a limited partnership or a limited liability company (LLC), formed under the laws of one of the jurisdictions of the USA and organised for the express purpose of holding a single real estate asset. Other types of organisations. such as general partnerships or trusts of various types, are regularly used to hold title to commercial real estate, often based on state law or practice; these structures are beyond the scope of this paper.

Why do lenders require SPEs?

The rationale for requiring an owner of commercial real estate - and the borrower of a commercial mortgage loan - to be an SPE is perhaps best stated in Standard & Poor's (S&P) definition of an SPE as an entity 'that is unlikely to become insolvent as a result of its own activities and that is adequately insulated from the consequences of any related party's insolvency'. Of course, most poperty owners would argue -- perhaps not tongue-in-cheek that the rationale for requiring an owner of commercial real estate to be an SPE is that the rating agencies want it that way.

Mitigating risks from the bonower's own acts

The risks from a borrower's own acts are broadly grouped by S&P into three categories: risks related to owning and operating the subject property; risks related to entity action that impairs the continued existence of the borrower as an entity; and risks related to a borrower seeking bankruptcy protection on its own volition.
Risks related to ownership and operation
As every real estate owner knows all too well, owning real estate requires a seemingly constant series of expenses. This is as true for the owner of the smallest house as it is for the owner of the largest mixed-use development. The SPE structure is not the only way by which a lender seeks to control the cash flows of a property owner; just as SPEs are a nearly ubiquitous requirement in commercial real estate financing, so too are lender-mandated reserve accounts -- impounds for taxes and insurance premiums, reserves for capital expenditures and, for certain asset classes, reserves for costs incurred in leasing space. But the SPE structure plays a role here too, through the limitations on debt, discussed below under 'Restrictions on actions'.
Risks related to entity action
This category of risk consists of actions that are unlikely to occur absenl direct and specific action by the borrowing entity. Acts such as consolidation, liquidation or merger will not occur in the ordinary course of business; it is those provisions designed to protect against this type of risk where the typical SPE restrictions are often least problematic.
Risks related to a borrower seeking voluntary bankruptcy protection
SPE structures, as their primary purpose, create obstacles in the path that an entity would be likely to take towards bankruptcy. The other risks described above are factors that are likely to lead to bankruptcy - either voluntary or involuntary; here, the risk is voluntary bankruptcy itself. As more fully discussed in the last section of this paper, while courts have long held that an outright prohibition on voluntary bankruptcy filings is not enforceable against an entity by its creditors once a bankruptcy filing has occurred, lesser limitations on seeking thc protections of bankruptcy have lound more success in court.

Mitieating risks of a related partfs insolvency

This category of risk can be described as the risk that financial difficulties of a beneficial owner of a borrower entity will result in the borrower seeking - or becoming involved in - a bankruptcy. There is a certain degree of protection against voluntary bankruptcy in the customary SPE provisions, which are discussed in this paper; this protection is enhanced if a borrowing entity is 'bankruptcy remote'. But what protects the lender against risks from actions - or liabilities - of the equity owners? Commercial lenders rely on the knowledge and experience of a borrower's controlling principles in operating property; if those principles are in financialjeopardy for other reasons, they could lose their ownership interests in the SPE borrower - taking away the link to those essehtial skills. Whether through amezzanine lender realising on indirect equity interests that served as collateral for mezzanine financing, or through judgment creditors acquiring beneficial ownership of a property in satisfaction of other debts, these are risks against which commercial lenders seek protection.
In this regard, it is appropriate to discuss the topic of substantive consolidation. Substantive consolidation is an equitable remedy available in a bankruptcy court; a court ordering substantive consolidation of one or more separate. but related, legal entities or persons will combine their assets and liabilities into a single pool, treating them as the assets and liabilities of a single entity, available to all creditors of the combined group. For a real estate lender, the risk of substantive consolidation should be obvious: the property underwritten as security for the mortgage loan instead would be security for other debts -- of not just the property owner, but of other related entities as well.

WHAT MAKES AN ENTITY AN 'SPE'?

By its literal meaning, a 'single-purpose entity' is an entity that exists for only onc purpose - in the context of this paper, for the ownership and operation of a parcel of property. But, of course, it cannot be that easy. Lenders and owners - or, more likely, counsel for lenders and owners - will debate both the content of a set of restrictive provisions and whether they are set forth in loan documents, in the documents that control the governance of the SPE, or in the publicly available documents that lorm an SPE.
The purpose clause
Most basic to an SPE is the purpose clause. The document that is filed to form an entity can have either a broad purpose clause, allowing the entity to exercise all rights and powers available to an entity under the law of the state, or a purpose clause that is limited to some subset of those rights and powers. The purpose clause in the Articles of Organisation of a typical SPE - in this example, for an LLC - will read substantially as follows:

'The sole purpose of the Company is to acquire, own, hold, maintain, and operate - (the "Property"), together with such other actvities as may be necessary or advisable in connection with the ownership of the Property'. Ihe Company shall not engage in any business, and it shall have no purpose, unrelated to the Property and shall not acguire any real property or own assets other than those related to the Property and/or otherwlse in furtherance of the limited purposes of the Company. For funher details regarding the restrictions applicable to the Company, including restrictions on amending these Artictes of Organisation, refer to the Operating Agreement of the Company.'

For a purpose clause to have the desired effect - putting on notice the existence of restrictions on the rights of the SPE to engage in conduct that would otherwise be permitted by a legal entity - it must be included in a document that is available to the public. Customarily, this would mean including the purpose clause in the formation document that is filed in the public records, so that it can be located by any party (such as, for example, another lender) conducting due diligence investigations into the entity.

The'separateness' covenants

The purpose clause, by itself, does not satisfy the requirements of most lenders for a borrowing entity to be an SPE. Lenders also customarily require a series of covenants designed to further the distinction between the SPE and related entities or alfiliates. including some or all of the following

  • To maintain books and records separate from any other person or entity;
  • Typical separateness o To maintain its accounts separate from any other person or provisions entityl
  • Not to commingle its assets with those of any other person or entityl
  • To conduct its business in its own name;
  • To maintain separate financial statements;
  • To pay its own liabilities, out of its own funds;
  • To observe all legal formalities appropriate to an entity of its type;
  • To maintain an arm's-length relationship with any affiliates;
  • To maintain a sufficient number of employees in light of its contemplated business dealings, and pay their salaries out of its funds:
  • Not to guarantee, or become obligated for, the debts of any other entity, or make loans or advances;
  • Not to hold out its credit as being available to satisfy the obligations of others;
  • Not to acquire debt or equity securities of those who hold beneficial interests in the entity;
  • To allocate fairly and reasonably, by written agreement, any overhead for shared office space;
  • To use separate stationery, invoices and cheques;
  • To hold itself out as a separate entity;
  • To correct any known misunderstanding regarding its separate identity; and
  • To maintain adequate capital in light of its contemplated business operations.

Individual lenders, and their counsel, may vary these covenants from time to time, based on the size of the transaction; the foregoing are meant simply to be representative.

Restrictions on actions

Another element of satisfying a lender's SpE requirements is that the entity's formation documents include clauses that restrict thc right of the entity to undertake certain actions while the loan remains unpaid. These covenants, broadly stated, limit the SpE's ability to incur debt and attempt to restrict its right voluntarily to seek bankruptcy protection.

Typical covenants limit 'debt' to that necessary in the ordinary course of owning and operating the property that is the collateral for the loan, and further provide that this 'debt' not be evidenced by a note and that the 'debt' be paid within a relatively brief period - often 60 days -- of when it is incurred. Moreover, these covenants commonly provide that the amount of these trade debts should not exceed 2 per cent of the amount of the loan; it should be noted that these limits are not always acceptable to hotel owners, where the combination of lower levels of first-mortgage leverage (especially in the hotel financing market as it has evolved in the post-9/11 era) and higher levels of operating expenses may necessitate higher debt limits.

In the area of bankruptcy rights, it is customary for an SpE to agree that it will not seek bankruptcy protection (under either the bankruptcy laws of the USA or any of the lesser-known State laws allowing protection from creditors), nor will it consent to any such proceedings being instituted against it or take certain other actions that would facilitate a bankruptcy or similar filing against the SpE by its creditors (such as admitting its inability to pay debts as tlrey come due, or consenting to appointment of a receiver or trustee), in each case without the unanimous consent of its owners.

WHAT MAKES AN SPE'BANKRUPTCY REMOTE'?

An SPE can have additional structural features that offer further protections against voluntary bankruptcy, and thus SpEs bound by these restrictions are called 'bankruptcy remote'. As used in this paper, a 'bankruptcy remote' entity is one in which the entity, in order to have sufficient authority to nake a bankruptcy filing, is required to have the affirmative approval of an 'independent' party. This 'independent' party can either be a director of a corporate SPE or the manager of an LLC. In the case of a limited partnership, for the limited partnership to be considered bankruptcy remote, each general partner of the limited partnership must be an SPE with an independent director; as a result, the authority ol the partnership, acting by its general partner(s), is similarly constricted.

To qualify as 'independent' according to S&P's definition, the director or manager must not (either at any time during his or her service, or for a period of five years prior to appointment to such position) have been, directly or indirectly, a legal or beneficial owner of any interest in the relevant entity or any affiliate; a creditor, supplier, employee, officer, director, partner, member, manager or contractor of such an entity, or a relative of any such person; or a person who controls (whether directly, indirectly or otherwise) such an entity or any person described in the previous clause. S&P's standard does not require an investor to use a total stranger as an independent director, nor does it require the investor to pay a commercial services firm to provide an 'independent' person (together with appropriate directors' liability insurance) for an annual fee; there is no prohibition against the investor recruiting her best friend from childhood, or his regular tennis or golf partner, to serve as the independent director. provided that the objective criteria described above are satisfied.

WHY WOULD AN OWNER OR INVESTOR OBfECT TO FORi,llNG AND USING AN SPE?

It is indisputable that there are costs to complying with a lender's SPE requirements. SPE structuring guidelines olten require more than one newly formed entity in connection with a financing; this can result in both upfront transactional fees as well as annual franchise taxcs. entity filings and similar charges. Often, these costs by themselves are a sulficient incentive for some owners and investors to resist -'- or seek waivers of -- the requirements of an SPE or a bankruptcy-remote entity.

Bankruptcy remoteness, with an independent director or manager, is particularly troubling for many real estate owners. The need to involve an unrelated third party in any element ol one's business -- even under the rarest circumstances - is anathema to a significant segment of the real estate community. Even the most cursory review of so-called 'pre-sale' reports of commercial mortgage-backed securities (CMBS) ratings (summaries by a rating agency describing the transaction it is rating, and the features of the underlying loans), however, shows that the vast majority of mortgage loans of $20m and higher include bankruptcy remoteness with an independent director; clearly, the sophisticated real estate investor comnrunity has evaluated the merits of an independent director and concluded that the tangible benefits of lower interest rates exceed the risk of interference with a potential future bankruptcy filing.

Some property owners object to the minutiae of the separateness covenants. They fear the risk of what to them would be a minor and inadvertent default that, in a difficult situation, could give a lender leverage disproportionate to the risk or harm the lender bore. For example, a property owner's attorney might ask a lender's counsel (or, more accurately stated, a property owner's attorney ftas asked the lender's counsel) why a default should exist if a property owner fails 'to correct any known misunderstanding regarding its separate identity' by not returning a letter addressed to the SpE's parent entity.

Until recently, a major cause of objections to spE requirements was the potential for adverse im_pact on tax-deferred exchanges _ the so-called '1031' transaction.6 This concern, however, was largely ameliorated in2002, through the Internal Revenue Service.s issuance of Revenue Procedure 2a02-22, which explicitly stated that an entity could utilise a wholly owned subsidiary (such as a singlemember LLC or a corporation in which the entity was the sole stockholder) to hold title to the newly acquired property without losing the benefits available under 1031.

Perhaps the most lasting, and, to a lender, the most persuasive, argument against strict compliance with the SpE guidelines promulgated by the rating agencies is the immediate economic impact of state and local real property transfer taxes. Although there is no federal tax payable solely based on the value of real property that is bought or sold, many states and municipalities do impose such transfer taxes. In some states, it may be possible to avoid the transfer tax by purchasing the stock, partnership interest or membership interests in the entity that holds title to the property; however, by doing so, the purchaser is subject to the risk of the entity's pre-existing liabilities. sometimes, in situations where the existing owner of the properry involved is, itself an SpE. it will be possible to 'recycle' the SPE under new beneficial ownership.

DOES THE AMERICAN LEGAT SYSTEM RESPECT THE SPE FORMATITIES?

Nobody .- especially a lawyer - can give a definitive answer to this question. US law, being a combination of lederal law in some areas, and the laws of the several states in others, is an amalgam of often contradictory case rulings. The quest for legal certainty is further hampered by the simple fact that the strong economics of owning commercial real estate (other than hotels, if one considers a hotel to be real estate rather than a business) in recent years has meant that fewer properties wound up in litigation, and thus the validity of these structures was often not presented to courts, or if the cases arose, they often settled prior to judgment. Instead, set forth below is a brief overview of the status of the validity of the SpE structures discussed in this paper, with a particular focus on what may be the single most significant case in this area in the past two years. As always, parties to any transaction should consult competent legal counsel for advice as to the current status ol law in any area.

Prohibitions on filing bankruptcy

courts have long held that an outright prohibition on voluntarily seeking bankruptcy protection is not enforceable against the debtor by its creditors once a bankruptcy filing has occurred. since the act of filing bankruptcy is still an action that requires the requisite corporate, partnership or LLC authority to make the filing, however, creditors often seek to challenge the validity of a voluntary bankruptcy by alleging that this authority was lacking. Unfortunately for the creditor, any such challenge (such as that brought to the voluntary bankruptcy filings of two SPE subsidiaries of notorious healthcare financier National Century Financial Enterprises) will take place during the early stages of a bankruptcy proceeding, placing the creditors at a procedural disadvantage

Independent director restrictions

Lenders have attempted to use the 'independent director' feature as an element of making an SPE 'bankruptcy remote' for over a decade. It has, however, evolved over time, owing, in significanl part, to an early, adverse court ruling. While refusing to directly address the enforceability of the independent director structure, the 1997 ruling by a federal bankruptcy court, in a case entitled.In re Kingston Square Associates, cast signilicant doubt on the viability of the independent director restrictions when the so-called independent director was, in fact, appointed by the lender' The court specifically found that even the lender-selected 'independent' director had a fiduciary duty to the other creditors, and to the equity holders. More than any other case, Kingslon Square led lenders to usc the objective criteria described above for selecting independent directors. rather than appointing a lender's employee or reliable ally to the role.

Substantive consolidation

A 2003 bankruptcy court decision, In re Central Ettropean Industrial Development Compau'LLC dlbla CEIDCO, has attracted much attention in the real estate finance community - both for the outcome of the case and perhaps equally importantly' for the unambiguous statements contained in the order. Central European Industrial Development Company (CEIDCO) was set up as an SPE. CEIDCO owned 99 per cent of an entity, TKG, which owned two entities, each of which owned real estate in Poland. CEIDCO was owned by two partners' one named TKG Europe, LP, in equal percentages (although TKG Europe was in control of CEIDCO). Lehman Brothers made loans to CEIDCO and TKG, secured by pledges of TKG Europe's equity interests in CEIDCO and CEIDCO's equity interests in TKG' and by second mortgages on the Polish properties. The loans defaulted, and the inevitable disputes - and litigation - began, cuiminating in voluntary bankruptcy filings by TKG Europe' TKG and CEIDCO'8 (Of interest is that the independent manager of CEIDCO did' in fact, vote to authorise the bankruptcy filing.) At the time of the filing, Lehman Brothers was CEIDCO's only creditor. The three affiliatect debtors jointly moved for substantive consolidation, hoping to avoid the situation where the sole creditor can block a plan of reorganisation where its claim is impaired' Lehman, however, moved to dismiss the bankruptcy proceeding TKG Europe; hoping that by gaining control of TKG Europe's (controlling) ownership interest in CEIDCO, Lehman could end both the CEIDCO and TKG bankruptcies. The Court, in its decision, writes that:

'Debtors contend that since Lehman caused the corporate structure to be created and dealt with the Debtors as a single economic unit, substantive consolidation ls exactly what it bargained for. But that is totalty conbary to the inescapable fact that Debtors and Lehman a$eed to the structure and further, that plainty Lehman relied on the sepantlon of the entities, notwithstanding their relationships with one another.'

But that was not all. The Court went on to say'even if one or more Debtors or their affiliates is "bankruptcy-remote" --.or at least "US bankruptcy remote" - Debtors have cited no law that would be violated by such a corporate structure'. More fundamentally, the Court noted in unambiguous (and rather unjudicial) language that substantive consolidation is an equitable remedy, and the Court saw no reason that equity would be served by ordering it.

The CEIDCO situation presented several facts not customarily found in commercial real estate transactions. It is unusual for a real estate owner to have only one creditor, as Lehman was the only creditor of CEIDCO; it is possible that the fact that Lehman's financing was mezzanine debt rather than mortgage debt was relevant to the Court's rationale. The Court gave particular weight to the ownership interest of non-bankrupt parties in refusing to order consolidation. Yet, the bankruptcies of CEIDCO and TKG were both allowed to continue, forcing the lender into the delays and restrictions itrherent in the US bankruptcy process.

Conclusion

Are SPEs worth the hassle? To a senior lender, the answer is undoubtedly 'yes'. While the protections and benefits that an SPE structure, or, more particularly a bankruptcy-remote SPE structure, can provide are not iron clad, the case law has evolved to a point where lenders have a substantial degree of comfort that some significant protections are created. Moreover, of course, most of the cost and record-keeping burden of these requirements does not fall on the lender's shoulders.

Generally, a property owner is more directly aware of the costs of bankruptcy-remote entities and SPEs: the costs to form entities. conforming the organisational and governing documents to the various requirements of lenders; the ongoing pcriodic expenses of compliance; and the accounting and legal costs of annual filings. Most property owners would acknowledge receiving only two benefits from SPE structures: the advantages of limited liability as a protection against other creditors, and the availability of the loan on more favourable terms than would otherwise be available. But this final benefit is the most readily quantifiable in cost savings to the owner. In the end, the cost-benefit analysis is provided by the market, through the prevalence of SPE structures in US commercial real estate.

Notes
  1. See US CMBS bgul und Stuctured F'inancc Criteria, by Standard & Poor's Ratings Services, a division ol'The McGraw-Hill Companies, Inc., published on lst May,2003. It should be noted that the other major nationally recognised statistical rating agencies with long records of active participation in the US commercial mortgage-backed securities nrarket -- Fitch, lnc. and Moody's Investors Service, Inc. - have issued substantially similar written pieces, setting fbrth their expectations in the area ofSPE structure: the author has chosen to refer only to a single work, for ease olrelerence [or the reader.
  2. For a corporation, this would be the charter, the Certificate of Incorporation or the Articles of Incorporation. depending on the preferred lerm in the related state. For an LLC. this would be the Articles of Organisation or Certificate of Organisation. depending on the preferred term in the related state. For a limited partnership. this would be the Certificate of Limited Partnership.
  3. Note 1 rbove. p. 95.
  4. For ease ol-luture reltrence, all further reltrences in this paper to 'independent director' should be viewed as a collective reference to an independent director of a corporation or an independent nanager of an LLC. as appropriate in the context.
  5. Note I above. p, 94.
  6. A full description of the bencfils. and restrictions, of Sectjon I 03 I of the Internal Revenue Code is beyond the scope of this paper.
  7. Thc desire to evade the reach of transfer taxes in this way arises so frequently thal S&P has guidelines dealing with these'recycled SPBs'and the steps that must be followed to gain the benelits ol an SPE structure going fbrward in a rated transaction. See note I above. p. 239.
  8. The remaining I per cent interest in TKC was owned by a non-debtor, as was the other -50 per cent interest in CEIDCO.
  9. The Court wrote that TKG [iurope's request to stay the effectiveness of its order pending appeal was 'premised on the familiar notion that substantial harm will fbllow if [TKG Europel is not allowed to remain in bankruptcy because ofa parade ofhorribles that will lollow . . .'.

 

Briefings in Real Estate Finance - Single Purpose Entities in Real Estate Transactions.pdf
 

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  • MONDAY, OCTOBER 5, 2009
    Federal Trade Commission Issues Tough New Rules for Bloggers and Social Media Endorsements

    For the last year or so, I've been warning my clients that the Federal Trade Commission is becoming more involved in regulating online commerce, specifically in terms of disclosures relating to online content. In particular, I've been telling companies that the FTC is likely to implement new guidelines that will bring blogs, Internet forums, message boards, word-of-mouth marketing, social media marketing, social commerce, and other forms of electronic and viral marketing in line with fair advertising practices that have not been updated in more than 25 years.

    Well, earlier today, in a highly anticipated move, the FTC did just that. By a vote of 4-0, the Commission has approved new rules requiring bloggers and social media users to disclose payments they receive from companies for reviewing their products. The rules, which go into effect Dec. 1, give clear guidance to advertisers on how to keep their endorsement and testimonial ads in line with the FTC Act (warning: link takes you to a pdf file, not a Web page).

    Under the revised rules, advertisements that feature a consumer and convey his or her experience with a product or service as "typical" when that is clearly not the case, will be required to disclose the results that consumers can generally expect. In contrast to the 1980 version of these same rules--which allowed advertisers to describe unusual results in a testimonial, as long as they included a disclaimer such as "results not typical"--the revised rules no longer contain a safe harbor around that issue.

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    "Companies that sponsor blogs or pay bloggers to cover events -- an emerging trend in branded entertainment -- could face increased legal risk when held accountable for the statements of their bloggers," says Anthony DiResta, general counsel for the Word of Mouth Marketing Association. "A compliance program for brands that outlines policies and practices for selecting, hiring, and monitoring of agents or representatives is essential."

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    Posted by Entrepreneur.com

     

    WEDNESDAY, SEPTEMBER 30, 2009
    Sometimes it Takes a Village to Fund a Company - Entrepreneurs Get Creative with Sourcing Funds

    Plenty of entrepreneurs are turning to their communities for support in these tricky times. As the recession wreaks havoc on America's economy, finding the money to launch, expand or even just sustain a small business is often a struggle. In the second quarter of 2009, venture capital funds raised the smallest amount since the third quarter of 2003, according to the National Venture Capital Association in Arlington, Va. Banks continue to pull credit lines and credit cards from many small businesses. Even proprietors who are willing to extract capital from their homes -- often their biggest personal asset - can't always do so, because the declining housing market has left so many homeowners underwater.
    But entrepreneurs are resourceful, and as the economic crisis forces them to seek new sources of capital, a growing number appear to be finding money in their own backyards. After all, local customers have a personal incentive to invest in their favorite businesses. And while no one is officially tracking the trend, anecdotal evidence suggests that the practice is growing.

    John Halko was halfway through renovating an expanded space for Comfort, his mostly organic eatery in Hastings-on-Hudson, N.Y., when the credit crisis hit. His source of funding -- a home-equity line -- ran out, so he applied for a loan at a local bank. He was turned down. Halko wasn't ready to throw in the dish towel. His solution? The modern equivalent of an old-fashioned barn raising. Instead of soliciting neighbors to lift timbers, he asked them to open their wallets. For every $500 they purchased in "Comfort Dollars," his patrons received a $600 credit toward meals at the restaurant. As the community rallied around Comfort, Halko says, "it gave us hope." He raised $25,000 in six months, and the new, larger space - now called Comfort Lounge -- opened for business in May.

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    TUESDAY, SEPTEMBER 29, 2009
    What is your Idea Worth? -- Matchmaking for Companies

    A federally funded online service helps small manufacturers find inventors with new technologies - and estimate their worth.

    Process Equipment Co. had a fine history of innovation. Founded in 1946 by Emmert Studebaker, a member of the famous car-making family, PECo sold laser welders and other specialized equipment to GM and other manufacturers. That brought in dependable revenues of $40 million a year.

    But demand for PECo's products dropped as GM declined, and last year the Tipp City, Ohio-based firm was forced to lay off a third of its employees. More cuts would come unless PECo could figure out how to adapt its machines to other industries.

    Hiring a research firm to do the job would cost $100,000 -- way out of PECo's price range. Now, for just $2,000, PECo can turn to the USA National Innovation Marketplace. In May the Department of Commerce's Manufacturing Extension Partnership teamed up with entrepreneur Doug Hall to offer the service to small businesses. Hosted at Hall's Web site, Planet Eureka, the marketplace matches inventors with manufacturers.

    It's too soon to say whether such matchmaking will work in the small company world. But the National Innovation Marketplace has no shortage of ideas waiting to be picked up. Among them: a food packaging film made from edible soy protein, said to help protect ready-to-eat food from dangerous bacteria; a drug designed to prevent and cure osteoporosis in a single dose (the research predicts that commercialization will take up to 10 years); and a "supersaver dream sander" that eliminates dust when sanding drywall.

    Visit http://money.cnn.com/2009/09/09/smallbusiness/innovation_marketplace.fsb/index.htm?postversion=2009091013 for the full story.
    POSTED BY P. J. JAVAHERI, ESQ. AT 5:29 PM

     

    WEDNESDAY, AUGUST 19, 2009
    Wells Fargo Sued Over Home Equity Lines of Credit

    Hopefully this will give back some breathing room to some well-deserved entrepreneurs.

    NEW YORK (AP) - The banking unit of Wells Fargo & Co. is facing a lawsuit claiming it illegally reduced the size of customers' home equity lines of credit.

    The suit, which was filed in Illinois, claims Wells Fargo failed to accurately assess the value of customers' houses before deciding to cut the size of their credit lines. San Francisco-based Wells Fargo is being accused of using unreliable computer models that wrongly valued home prices too low to justify cutting the size of customers' loans.

    Home equity lines of credit are similar to credit cards in that a customer has a credit limit and can continue to borrow money until the limit is reached. Once a portion is paid off, it again becomes accessible to borrow. But, home equity lines of credit are backed by a borrower's property, whereas credit cares are unsecured.

    Michael Hickman, who filed the lawsuit on behalf of himself and is seeking class action status for it, claims Wells Fargo also did not provide proper notice that the bank was reducing the size of the credit lines.

    The bank's notice for reducing the lines also did not specifically provide a new estimated value for the property or the method used to determine the houses value. Hickman's lawsuit said that information was needed so a customer could challenge the change in the credit limit and try and reinstate the previous limit.

    Wells Fargo responded in a statement, "we are confident in our fair and responsible lending practices, including how we determine home equity credit limits available to customers depending on the amount of equity in their home. Our controls are based on contractual and regulatory guidelines and include a fair appeals process.

    "While we are beginning to review the lawsuit, from what we have read so far, it appears to mischaracterize credit controls designed to sustain homeownership."

    Hickman is being represented by KamberEdelson LLC, a Chicago-based law firm, which is also representing clients that have filed similar suits against JPMorgan Chase & Co. and Citigroup Inc.

    Nearly all banks have been hit hard by mounting loan losses tied to residential real estate over the past two years. Reducing lines of credit can limit exposure to the struggling sector.
    Wells Fargo set aside $5.09 billion to cover loan losses, which includes potential losses on home equity lines of credit, during the second quarter. It set aside $3.01 billion during the same quarter last year.

    The bank was one of hundreds of financial firms that received bailout money from the government last fall amid the mushrooming credit crisis. Wells Fargo received $25 billion as part of the Troubled Asset Relief Program, and has yet to repay the loan.

    Jay Edelson, a managing partner at KamberEdelson, said systematically cutting home equity lines of credit runs opposite of the goals of the bailout program, which was supposed to improve consumers' access to credit.

    Wells Fargo's had average total loans of $833.9 billion during the second quarter, compared with $855.6 billion in the first quarter. When it announced second-quarter earnings last month, Wells Fargo said the decline in total loans was a reflection of actions taken to reduce the size of high-risk loan portfolios and came amid moderating demand for new loans.

    However, Wells Fargo did ramp up lending in certain areas. It originated $129 billion in mortgages in the second quarter, compared with $101 billion during the previous quarter.

    By STEPHEN BERNARD
    POSTED BY P. J. JAVAHERI, ESQ. AT 9:07 PM

     

    MONDAY, AUGUST 3, 2009
    ARTICLE: SUGGESTED REVISIONS TO THE AIR STANDARD LEASE FORM

    Anyone involved in commercial real estate in California is undoubtedly familiar with the American Industrial Real Estate Association (“AIR”) standard lease forms. The ease and affordability of the AIR lease forms have garnered them immense popularity in California for both landlords and tenants alike. Generally, however, the parties merely fill in and sign the standard form while making little, if any, changes to the language of the lease.

    So long as everything runs smoothly, landlords and tenants are perfectly happy with this arrangement. However, those parties that have engaged in lease disputes have quickly realized that the standardized lease form often fails to favorably address many of their specific needs. This is why, prior to using a standard AIR lease form, all parties to a lease should thoughtfully assess their interests and attempt to negotiate appropriate revisions.

    Although other articles have offered suggestions regarding items to negotiate in the AIR lease, we have attempted to present our own suggested revisions in a clear and concise format with special attention paid to the individual needs of the landlord and tenant.

    PROVISION ONE- COMMENCEMENT DATE:

    One of the first potential problem areas in the standard lease form is the “commencement date” section. Specifically, Paragraph 3.3, “Delay in Possession,” states that there is no penalty for the landlord for late delivery of the premises as long as the landlord delivers the premises to the tenant within 60 days from the agreed upon commencement date. The tenant’s only remedy is to terminate the lease within the 60-day period. The section also states that if the premises are not delivered within 120 days of the commencement date, the remedy is automatic termination of the lease.

    The commencement date paragraphs can pose many problems for both parties. One problem may occur if a dispute arises about construction delays for tenant improvements to the premises. These problems are intensified if the landlord is responsible for the work because the landlord has complete control of the situation.

    One more point of interest is how the commencement date is defined. Many times, it is defined as the time at which the landlord reaches “substantial completion” of the tenant improvements. This simply means that the landlord has finished sufficient work so that the tenant may move in and conduct business.

    If you are the Tenant:

    The situation is further exacerbated because tenants are often in a precarious situation when moving into new premises. They may be moving out of an old rental on a specific date, or have time sensitive arrangements for purchasing and moving furniture or hiring employees. Because of this vulnerable position, a significant delay can pose huge problems for tenants.

    Thus, it is important for the tenant to negotiate the commencement date and 60-day delay provision. The tenant may attempt to negotiate for no delay, however most landlords will insist on some delay, even if less than 60 days. Actively negotiating the 60-day period will encourage the landlord to provide the tenant with timely access because the landlord does not want to spend time and money adapting the premises to the tenant’s requests only to eventually lose the tenant.

    The tenant should also attempt to require the landlord to pay the tenant’s damages if the landlord delays delivery of the premises. Such revisions might include the landlord agreeing to pay damages for any holdover rent paid by the tenant as a result of the delay.

    When the commencement date is defined as “substantial completion,” the tenant must insist that paragraph 3.3 be modified. Without revision, paragraph 3.3 only gives the tenant the right to terminate if the landlord fails to deliver possession of the premises within 60 days of substantial completion. With no modification to paragraph 3.3, the landlord could indefinitely delay completion of the work without any repercussions because the tenant’s 60-day right to terminate only begins after substantial completion. Thus, the landlord will only violate paragraph 3.3 if the landlord substantially completes the work and then fails to deliver possession. Thus, to protect itself, a tenant should negotiate a fixed date by which the landlord must deliver the premises or give the tenant the right to terminate.

    If you are the Landlord:

    The commencement date paragraphs may also pose problems for landlords. If the commencement date is based on substantial completion, and the tenant is responsible for completion of the work, the same problems may apply. To avoid this, the landlord might insist on shifting the construction delay risks to the tenant. A landlord could attempt to assign the commencement date to either a fixed date or the date the tenant opens for business, whichever comes first, whether or not the tenant completes the construction. This might prevent the tenant from continually delaying commencement of the lease.

    PROVISION TWO - COMPLYING WITH APPLICABLE LAWS:

    From a simple reading of the lease, it is often difficult to ascertain which party is responsible for complying with applicable laws (or “requirements”). The lease contains a maze of confusing disclaimers that may or may not be relevant in determining responsibility. Ultimately, the decision of who is responsible for complying with applicable laws may only be determined after examining two cases decided by the California Supreme Court in 1994. These cases, Brown v. Green, 8 Cal. 4th 812 (1994), and Hadian v. Schwartz, 8 Cal. 4th 836 (1994), outline the relevant factors that a court will consider in making such a decision.

    In Brown and Hadian, the California Supreme Court held that despite the language in the AIR lease specifically placing the responsibility of complying with applicable laws on the tenant, a landlord may still be responsible for repair costs. In both cases, the court disregarded the clear and unambiguous language in the AIR lease form. Instead, the court applied a six-factor test for the tenant’s obligation to repair. The factors are as follows: 1) the relationship of the cost of the curative action to the rent reserved, 2) the length of the term and the time for the cost to be amortized 3) the relationship of the benefit to the tenant to that of the reversioner (i.e., the landlord), 4) whether the curative action is structural or nonstructural, 5) the degree to which the tenant’s enjoyment of the premises will be interfered with while the curative action is being undertaken, and 6) the likelihood that the parties contemplated the application of particular law or order involved.

    The reasoning in Hadian suggests that if the lease is a net lease, then it may be held that the parties intended for the tenant to share in such repair costs. However, neither landlords nor tenants should assume that merely allocating the risk to one party in the lease will control which party will bear the risk. This will only be determined after examining the facts in light of the six-factor test.

    If you are the Tenant:

    Although the six-factor test is ultimately determinative, the language in the lease may be a relevant factor in determining the outcome. Thus, the parties should make sure the terms of the lease meet their desires and expectations.

    A tenant should attempt to revise any language stating that the tenant bear the cost to repair or comply with laws if compliance is mandated after the landlord’s six-month warranty period expires. This is especially true in shorter leases where the majority of the benefit of compliance will go to the landlord. Additionally, a tenant should reject language that gives the landlord the right to terminate the lease if compliance is caused by factors outside the tenant’s use.

    The tenant should also protect against language stating that the tenant will lose its lease for something that the landlord will be required to fix even after the tenant leaves. The tenant may want to revise the amortization period to cover the “useful life” of the item rather than the AIR form’s 12-year period. Finally, tenants should try to delete paragraph 49 or at least modify it to state that the landlord must warrant that the premises currently complies with disability laws or will comply by the commencement date.

    PROVSION THREE - AUDIT RIGHTS:

    Paragraph 4.2 of the AIR office lease form should also be examined closely. This paragraph includes a nonexclusive list of operating expenses that the landlord may charge the tenant and also lays out a few exclusions. Most parties assume that since the list is nonexclusive, further items may be charged to the tenant.

    The AIR standard lease does not grant the tenant a right to audit the landlord’s books and records regarding operating expenses. However, while California case law does not give a tenant an implied right to audit, it is generally believed that a tenant may compel an audit during discovery after commencement of a lawsuit.

    If you are the Tenant:

    Many attorneys for tenants choose to include a list of exclusions from operating expenses in an attempt to clarify what expenses the tenant is paying. The tenant should examine this paragraph closely to make sure that the landlord does not use operating expenses as a source of profit.

    If you are the Landlord:

    The landlord should make sure that it keeps the inclusions and exclusions consistent in its leases. This way the landlord can avoid accounting confusion from differing leases. The attorney for the landlord should also be aware of any substantive exclusions added to the lease by the tenant that were not part of the original deal.

    For Landlords and Tenants:

    Because the AIR lease does not grant the tenant a right to audit the landlord’s books, it is beneficial for both the tenant and landlord to include some language about the tenant’s audit rights in the lease. Such additions should include the time and means of requesting and performing the audit, the qualifications of the individual performing the audit, the party that pays for the audit and if the tenant shall be reimbursed for audit costs if there is an error, and issues of confidentiality.

    PROVISION FOUR - ASSIGNMENTS AND SUBLETTING:

    Assignment and subletting are addressed in paragraph 12, Assignment and Subletting, and paragraph 36, Consent. As is, these sections state that the tenant has the right to assign or sublet to a third party as long as it receives the landlord’s reasonable consent. Although these sections are rather equal, each party may raise certain objections.

    If you are the Tenant:

    The tenant may notice that the standard lease does not allow the tenant to transfer to an affiliate without the landlord’s consent. If an assignment or sublet results in profits for the tenant, tenants will want to exclude transfer costs such as broker commissions, improvement allowances, downtime, legal fees, etc.

    If you are the Landlord:

    The landlord may notice that the standard lease does not address recapture rights that give the landlord the right to terminate the lease if the tenant attempts to assign or sublet. However, there is a separate addendum that addresses limited recapture rights. Most landlords will attempt to revise this section to make it unlimited. There is no issue of unreasonableness here, as the California Supreme Court has held that a recapture clause in a commercial lease is enforceable and is not subject to a reasonableness requirement. Carma Developers, Inc. v. Marathon Development California, Inc., 2 Cal. 4th 374 (1992).

    If the landlord does not add the recapture addendum, the AIR standard lease will not address situations where the tenant transfers for a profit or how the profit is treated. How profits are split should absolutely be defined by the parties.

    The landlord should make sure that the tenant is not attempting to define profit in a manner that avoids paying the landlord its fair share.

    The landlord should also address the situation in which the tenant accuses the landlord of improperly withholding consent to a transfer. Paragraph 12.1(e) states that a tenant may recover compensatory damages from the landlord in addition to obtaining injunctive relief. The landlord should include language stating that the tenant must seek a court injunction requiring the landlord to consent rather than sue for damages. Also, the landlord will want to delete the portion of paragraph 12.1(e) regarding compensatory damages.

    PROVISION FIVE - SECURITY DEPOSIT: If you are the Landlord:

    Paragraph 5 outlines the situations in which the security deposit may be used by the landlord. This section must be revised by the landlord. In 250 L.L.C. v. PhotoPoint Corp., 131 Cal.App.4th 703 (2005), a California court held that under Civil Code §1950.7, the landlord may not retain the security deposit to cover damages for future rent owed under the lease. However, the court did state that in commercial leases, a tenant can waive §1950.7. Such a waiver would allow the landlord to apply the security deposits toward future rent. Thus, the landlord should add an express waiver of §1950.7 or any similar provision of law.

    PROVISION SIX - REMOVAL AND SURRENDER:

    Paragraph 7.5(b) of the standard form lease states that the landlord may require the tenant to remove alterations and utility installations so long as the landlord gives notice between 30 and 90 days before the end of the lease.

    If you are the Tenant:

    In response, tenants may want to add language forcing the landlord to give tenants notice of the need for removal of alterations and utility installations before the tenant makes them. The benefit of such language is that, before construction, the tenant can determine the costs of removal at the end of the lease and decide whether the improvements are worthwhile.

    PROVISION SEVEN - DAMAGE OR DESTRUCTION: For Landlords and Tenants:

    Paragraph 9 of the standard lease gives the landlord the right to terminate the lease if damage costs exceed six months’ rent. This number is not based on any tangible factors and is not traditionally found in other leases. Therefore, depending on the specifics of the lease, the parties may want to alter this section to better suit their specific agreement.

    PROVISION EIGHT - LIMITATION OF LIABILITY: If you are the Tenant:

    Paragraph 20 states that the tenant must only look to the project for fulfillment of any liability of the landlord regarding the lease. A tenant should attempt to eliminate this provision. However, if the landlord is not willing to delete this language, the tenant and its attorney should attempt to revise the section. The tenant should attempt to include language clarifying that the tenant can also look to the rents, issues, profits, proceeds, and other income from the project regardless if the receiver is the landlord or other. The tenant should also clarify that paragraph 20 has no effect on the tenant’s rights to withhold or offset rents.

    PROVISION NINE - NONDISTURBANCE AND ATTORNMENT:

    Under paragraph 30.3, the tenant’s subordination of the lease is subject to the receipt of a nondisturbance agreement regarding security devices that the landlord becomes a party to after the lease is executed. The lease however, does not cover security devices that the landlord enters into before the execution of the lease.

    Furthermore, paragraph 30.2 of the lease states that a party that takes over the interest of the landlord after a foreclosure will not be liable to the tenant for the previous landlord’s acts or omissions. Additionally, the new landlord will not be subject to any offsets or defenses which the tenant might have against the old landlord. Even though this is a standard provision in most leases, it puts the tenant in a difficult situation if the landlord fails to pay the tenant improvement allowance or construct the tenant improvements.

    If you are the Tenant:

    The tenant should request that the landlord get a nondisturbance agreement from a lender to protect against termination of the lease upon foreclosure. This may be hard for the landlord to get, but the tenant should request it anyway.

    PROVISION TEN - WAIVER OF JURY TRIAL:

    Paragraph 47 of the AIR lease requires both the tenant and landlord to waive their rights to a jury trial in any action or proceeding concerning the property or arising out of the lease. This provision may be irrelevant however, because in Grafton Partners LP v. Superior Court, 36 Cal. 4th 944 (2005), the California Supreme Court held that predispute contractual waivers are not enforceable in California.

    For Landlords and Tenants:

    Because such agreements may not be enforceable in California, a landlord or tenant who wants to avoid a jury trial should include a separate provision in the lease requiring either judicial reference or arbitration.

    PROVISION ELEVEN - ELIMINATE BROKER BENEFITS:

    One interesting aspect of the AIR standard lease form is the information pertaining to brokers. Because the AIR lease form was drafted and funded by brokers, there is language in the lease that specifically benefits brokers but provides nothing for landlords or tenants. These provisions include Paragraphs 2.4, Acknowledgments; 15.1 – 15.2, Broker Fees; and 25, Disclosures Regarding the Nature of Real Estate Agency Relationship. Most of these provisions have nothing to do with the relationship of the landlord and tenant and should not be included in the lease. Such arrangements should be handled in a separate agreement between the landlord and the broker. Most attorneys will simply advise their clients to erase these provisions. Although the AIR Standard Lease Form is an effective tool in facilitating efficient and straightforward real estate transactions, it often does not adequately address one or both parties’ specific needs. We hope that this article will serve as a valuable asset in assisting both landlords and tenants in negotiating a more appropriate and beneficial use of the AIR Standard Lease Form.

    For more information, please contact the author directly at pjavaheri@jurislawgroup.com, or visit the Juris Law Group at www.jurislawgroup.com

    The purpose of this article is to assist in dissemination of information that may be helpful to real property investors, and no representation is made about the accuracy of the information. By reading this article, you understand that this information is not provided in the course of an attorney-client relationship and is not intended to constitute legal advice. This publication should not be used as a substitute for competent legal advice from a licensed attorney in your state. IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, any tax information contained in this site was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed on this site.

    POSTED BY P. J. JAVAHERI, ESQ. AT 6:12 PM

     

    TUESDAY, JUNE 30, 2009
    HOLDING REAL ESTATE IN CALIFORNIA: Benefits of a LLC and a Trust

    Owning investment properties can produce big rewards, but also big problems. This is why it is important to hold title to your property in the most beneficial way. A smart investor should consider using both a LLC and a trust to adequately protect himself and his property.

    Countless individuals invest in real estate every day. Some dream of becoming the next real estate mogul, while others simply wish to supplement their salary with additional income. Whatever your motivations, owning investment properties can produce big rewards, but also big problems. This is why it is important to hold title to your property in the most beneficial way. The internet is saturated with various posts and articles touting the most effective techniques to manage your property. It can often be a daunting task weeding through the mass of information in an attempt to discern what advice is reliable and what advice can get you into trouble. Our goal here is to provide a succinct and clear summary of the safest and most important strategies for holding investment property in California. We hope the result will be a valuable starting point in considering the best ways to both protect you as the owner/landlord from liability and also guarantee the best treatment of your assets.

    The Risks of Owning Real Estate

    As stated above, while property can be a valuable investment, there are also significant risks. One of the biggest risks is lawsuits. From common slip and falls, to environmental contamination, landlords and owners are easily exposed to legal judgments. Landlords have also been successfully sued by victims of crimes -- such as robberies, rape, and even murder -- that occur on their property on the theory that the landlord provided inadequate security.

    Options for Holding Real Estate

    Faced with the risk of lawsuits, it is crucial that you do not own investment real property in your own name. (The only real property you should hold in your own name is your primary residence.) Thankfully, there are several ways in which an individual can hold property other than in his/her own name. These include as a corporation, limited partnership, limited liability company (“LLC”), trust, and many others.
    While there are many options, when it comes to real estate investment, LLCs are the preferred entity by most investors, attorneys and accountants.

    For many reasons, few investors hold investment real estate in C corporations. A corporation protects the shareholders from personal liability, but the double taxation of dividends and the inability to have "paper losses" from depreciation flow through to owners make a C corporation inappropriate for real estate investments.

    In the past, partnerships and limited partnerships were the entities of choice for real estate investors. Limited partners were protected from personal liability while also being able to take passed through tax losses (subject to IRS rules--you'll need an accountant or attorney to sort out the issues of at-risk limitations and so on) from the property. However, the biggest downfall with limited partnerships was that someone had to be the general partner and expose himself to unlimited personal liability.

    Many small real estate investors also hold property in a trust. While a living trust is important for protecting the owner’s privacy and provides valuable estate planning treatment, the trust provides nothing in the area of protection from liability. However, although a trust provides no liability protection, it should not be overlooked, as it can easily be paired with an LLC.

    Benefits of a LLC

    LLCs appear to be the best of all worlds for holding investment real estate. Unlike limited partnerships, LLCs do not require a general partner who is exposed to liability. Instead, all LLC owners -- called members -- have complete limited liability protection. LLCs are also superior to C corporations because LLCs avoid the double taxation of corporations, yet retain complete limited liability for all members. Furthermore, LLC’s are rather cheap and easy to form.

    One LLC or Multiple LLCs?

    For owners of multiple properties, the question arises whether to hold all properties under one LLC, or to create a new LLC for each additional property. For several reasons, it is generally advisable to have one LLC for each property.First, having a separate LLC own each separate property prevents "spillover" liability from one property to another. Suppose you have two properties worth $500,000 and they're held in the same LLC. If a tenant is injured at property 1, and wins a $750,000 judgment, he will be able to put a lien on both properties for the entire $750,000 even though property 2 had nothing to do with the plaintiff's injury.
    On the other hand, if each property had its own LLC, then the creditor could only put a lien on the property where the plaintiff was injured (assuming that they cannot pierce the corporate veil).

    Additionally, many banks and lenders require separate LLCs for each property. They want the property they're lending against to be "bankruptcy remote". This means that the lender doesn't want a problem at a separate property to jeopardize their security interest in the property that they're lending on.

    Benefits of a Trust

    As stated above, an LLC may be used concurrently with a trust to provide the best protection and estate treatment for your property. There are many types of trusts, but the revocable living trust is probably the most common and useful for holding title to real estate. The major benefit from holding property in a trust is that the property avoids probate after your death. As many are aware, probate is a court-supervised process for transferring assets to the beneficiaries listed in one's will. The advantages of avoiding probate are numerous. Distribution of property held in a living trust can be much faster than probate, assets in a living trust can be more easily accessible to the beneficiaries of the trust, and the cost of distributing assets held in a living trust is often less than going through probate. [Note: One should also be aware of other ways to avoid probate. For instance, property held in joint tenancy w/ a right of survivorship automatically avoids probate whether or not the property is in the living trust. Consult an estate planning attorney for more advice regarding probate matters.]

    Use Both an LLC and a Trust

    Because an LLC and a trust both provide significant benefits to the owner of real property, a smart investor should consider using both a LLC and a trust to adequately protect himself and his property. Utilizing both a trust and a LLC creates the best combination of liability protection and favorable estate planning. To accomplish this, the owner should hold the investment property in a single member LLC, with the living trust as the sole member of the LLC. Here, the trust is the owner of the company and holds all of the interests of the LLC. This form of ownership gives you an added layer of protection from the LLC as well as the additional estate planning benefits of a trust.

    Costs

    For the most part, the costs of forming and maintaining an LLC and trust are rather minimal. For an average LLC, the costs are simply nominal filing fees and an $800 per/yr fee to the state of CA. While simple incorporations may be done on your own, it is strongly advised that you seek the advice of a knowledgeable attorney so that no mistakes are made. The same may be said for forming a trust. A little money now is worth the price of avoiding big problems in the future.

    The CA LLC Fee

    While the costs of forming a LLC are generally small, there are additional fees that may be imposed on LLCs in California depending on gross profits. The California Revenue and Taxation Code Section 17942(a) includes an additional fee on LLCs if total gross income (i.e. rent) exceeds $250,000. “Total gross income” refers to gross revenues (not profits). Under this Tax Code Section, the amount of the fee is determined as follows:

    1. $0 for LLCs with total gross income of less than $250,000;
    2. $900 for LLCs with total gross income of at least $250,000 but less than $500,000;
    3. $2,500 for LLCs with total gross income of at least $500,000 but less than $1,000,000;
    4. $6,000 for LLCs with total gross income of at least $1,000,000 but less than $5,000,000;
    5. $11,790 for LLCs with total gross income of $5,000,000 or more.

    Although the fee is relatively small, one must consider that the fee is assessed against gross revenues, not profits. This means that the fee is due whether or not your property is profitable. For a property with high revenues but narrow profit margins, the fee would reflect a higher portion of the property’s profitability than it would on a property that is highly profitable. For example, a company that owns an office building with revenues from rent totaling $1 mil, but a mortgage of $995,000, would actually operate at a loss after the $6,000 fee was imposed. Furthermore, the fee would be particularly irksome for those companies that foresee incurring losses in their early stages of development.

    A Possible Strategy if Gross Receipts Exceed $250,000

    For the vast majority of investors, the CA LLC fee should not dissuade you from forming an LLC. If, however, the impact is severely detrimental, there are several potential solutions that may be explored. A competent attorney or accountant may be able to work with you to avoid this fee. One method may be to form a Limited Partnership. The partnership should be set up with an LLC as the General Partner (assuming liability) and the owner(s) of the property as the limited partner(s). By forming a limited partnership with an LLC acting as the general partner, the landlord can likely avoid the higher fee imposed on an LLC while still protecting his/her personal liability. While this may be a possible solution, it is strongly recommended that you consult with an attorney or accountant regarding the best course of action.

    While there are indeed risks associated with real estate, with intelligent decision-making and thoughtful preparation, real property can be a valuable investment. The first step though, is to make sure that you have adequately protected yourself and your property. We hope that this article helps property owners begin to discover the various ways in which one may hold investment property, as well as the protections and benefits provided by such ownership.
    For more information, please contact the author directly at zshine@jurislawgroup.com, or visit the Juris Law Group at www.jurislawgroup.com

    The purpose of this article is to assist in dissemination of information that may be helpful to real property investors, and no representation is made about the accuracy of the information.
    By reading this article, you understand that this information is not provided in the course of an attorney-client relationship and is not intended to constitute legal advice. This publication should not be used as a substitute for competent legal advice from a licensed attorney in your state.

    IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, any tax information contained in this site was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under federal, state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed on this site.

    POSTED BY P. J. JAVAHERI, ESQ. AT 3:58 PM
  • The attorneys at Juris Law Group, whether handling our complex litigation matters or just one of our spontaneous corporate questions, are consistently thorough, insightful and provide personalized counsel and advice – all while keeping in mind our budgets and timelines.