Pitfalls of an Limited Liability Company - AKA 3 Horror Stories of LLC Ownership

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In California - the Limited Liability Company or LLC is the most common entity with which commercial real estate is owned. Individuals within an LLC are known as members. Members are governed by an operating agreement which outlines whom within the LLC are authorized to sell, buy, and borrow. Also, percentages of ownership are specified in the case of multiple members. Why an LLC? Because of a multitude tax advantages and liability protection - which are beyond the scope of this column. However, as commercial real estate practitioners we encounter some pretty hairy issues involving LLC ownership.

Waking a Grizzly. Annual fees must be paid to the Franchise Tax Board and tax returns must be filed each year with the state of California. If not, the LLC may be declared inactive. To re-activate an LLC is akin to awakening a hibernating Grizzly. We once experienced an LLC that was formed, owned a parcel of commercial real estate, and was allowed to lapse - for thirty three years! Now the owner wanted to sell but couldn’t. You see the individual - with whom we were dealing - was not the owner because title was vested as the LLC. Therefore - with an inactive LLC - the individual member couldn’t sign a listing engagement, execute a Purchase and Sale Agreement, or transact any business until the past returns were completed and overdue due fees paid. Fortunately, no income had been reported through the LLC - thus no taxes were owed. Therefore, it was a matter of preparing tax returns dating back to 1986 and forking over thirty-three years of filing fees - which now - with interest and penalties - were in the tens of thousands of dollars. Oy vey!

Who’s in the mirror. Frequently, we experience this challenge. An LLC owns a building which is occupied by a business. Even though the entities of ownership may vary - building LLC and business a corporation - the individuals of each entity are synonymous. In a recent case - over time this changed - two of the three members of the building ownership LLC died and the business corporation was sold to the employees. Created was a difference of objectives - the occupying company needed less space or a correspondingly cheap rent. Desired by the LLC - now comprised of four heirs and an original member - was maximum return from the investment. So now what? The LLC sold and the business relocated to a building half the size.

But we are divorced. Sure. But your real estate ownership may not be. In a particularly nasty situation - we were thrust between LLC members - an ex husband and wife. The only remaining joint asset was a piece of commercial real estate once occupied by a business they operated. While still married - the business was sold but the real estate retained - providing a nice cash flow for the couple. When the two divorced - now desired was a sale of the building. Problem was - the divorcees also wanted to defer the taxes which would inure from the sale. The solution was a risky tactic known as a “drop and swap”. Title was changed to tenants-in-common from the LLC. This change in ownership vesting allowed the individual members - divorced husband and wife - to go their own ways. Please seek legal counsel and tax advice before attempting this.

Allen C. Buchanan, SIOR, is a principal with Lee & Associates Commercial Real Estate Services in Orange. He can be reached at abuchanan@lee-associates.com or 714.564.7104. His website is allencbuchanan.com.