Lawrence P. Frazer is counsel in the Corporate Department of the Boston office of Murtha Cullina Roche Carens & DeGiacomo.

A variety of entities are available for use in the business of real estate development. Because a host of potential liabilities, ranging from employee injuries to environmental concerns, can affect participants engaged in the development of real estate, doing business in individual, sole proprietor form is generally not an option. Finding a way to limit one’s liability through entity structure tends to be of paramount concern.

Other factors, such as the tax treatment of the entity or the need to structure for multiple investors of varying project involvement, also may play an important role in choosing a structure.

S corporations, limited liability companies and limited partnerships are the three forms of entity typically considered, as they provide both limited liability and also are “pass-through” entities for tax purposes. A “pass-through” entity is one where the entity itself is not subject to income tax liability, and the liability for income tax instead passes through to the entity’s stockholders, members or partners.

Pass-through tax treatment avoids the double taxation treatment found in other entities (especially C corporations, in which gains are taxed at both the entity level and again at the shareholder level upon a dividend distribution). Accordingly, each owner, stockholder, member or partner is taxed only once on his or her share of the company’s income, gain, loss, deduction or credit earned in the ordinary course of business.

S Corporations
Corporations are created under state statutes and must satisfy certain formal requirements and filings for legal recognition. Developers may already be familiar with this corporate form and its basic features of shareholders owning stock, and management by directors and officers.

The key advantage of the corporate form is the fact that corporations afford limited liability protection. The liability of a corporation’s shareholders is generally limited to the amount of their respective investments. Disadvantages of the corporate form include the costs of maintaining corporate formalities, such as holding annual shareholders’ and directors’ meetings, and recordation requirements. It is important that a corporation maintain such formalities, otherwise such corporations may be susceptible to courts’ “piercing the corporate veil” and disregarding the corporation’s limited liability protection.

An S corporation is a corporation for which an election has been filed with the Internal Revenue Service to be treated for income tax purposes as a pass-through entity. The rules for ownership of capital stock in an S corporation are restrictive. Generally, not more than 75 individuals who are either citizens or residents of the United States and certain trusts may own stock of S corporations. With some exceptions, corporations, partnerships, or other entities generally cannot own stock in an S corporation. S corporations may only authorize a single class of capital stock with parallel equitable rights. The stock can only be owned in proportion to the owner’s capital contribution to the company.

S corporations may have stock compensation programs for the benefit of their employees, including tax favored incentive stock options. Incentive stock options are not available for limited liability companies. The management of an S corporation will be under the control of the company’s board of directors, who serve at the pleasure and are elected by vote of the stockholders.

This entity may prove inflexible for accommodating certain investor arrangements and holding structures. Additionally, while for federal tax purposes, S corporations are treated as pass-through entities and bear no entity level tax, certain entity level excise taxes may apply at the state tax level.

Limited Liability Companies
On Jan. 1, 1996, Massachusetts enacted legislation allowing the formation of limited liability companies. An LLC is a hybrid entity that combines the advantages of the pass-through tax characteristics of a partnership (assuming the LLC does not elect to be taxed as a corporation), with the limited liability of a corporation.

Owners of the LLC, called members, are not liable for company debts by virtue of being members. Members may manage the company without forfeiting their liability protection. Under current Massachusetts law, an LLC must have two or more members. (However, single member LLCs may be formed in other jurisdictions [e.g. Delaware], and may register to do business in Massachusetts.)

LLCs are not as restrictive as corporations, and allow for much more flexibility in determining members’ management control as well as rights of assignment and termination. Members may structure management to be disproportionate to their percentage interest ownership. In addition, members may alternatively elect a manager or managers (who need not be members) to manage the company. Members should enter into detailed written operating agreements to establish such rights.

Unlike an S corporation, eligibility of ownership of a membership interest in an LLC is without restriction. Under Massachusetts’s law, any person or entity can own an equity membership interest in an LLC. An LLC can have multiple-classes of management and ownership interests. Separate profit sharing formulas, therefore, can be established amongst the members.

Limited Partnerships
Prior to the enactment of the LLC enabling statute, limited partnerships tended to be the most popular entity for multiple investor real estate development companies.

Limited partnerships have substantially the same legal form as a general partnership, except that, in addition to having one or more general partners, who manage and control the business and are subject to the liabilities of the partnership, a limited partnership will have one or more “limited partners” each of whose liability for partnership obligations is limited to his contribution amount and the amount of any recourse debt. Limited partners may not, however, participate in management of the business without risking loss of limited liability, and limited partners have more limited tax benefits than general partners.

A limited partnership is created in Massachusetts by the filing of a certificate with the Secretary of the Commonwealth. A written partnership agreement will generally also be entered into by the partners to govern management and tax issues, and may include other provisions such as restrictions on assignment of partnership interests. Frequently, where limited partnerships are used for real estate development, a multi-tier structure is utilized, where an LLC or S corporation will be formed to act as the general partner of the limited partnership, thereby providing limited liability to the owners of the general partner. The real estate developer will own the stock or membership interests in the general partner entity and will thus be able to control decisions of the partnership.

Of course, anyone considering formation of a corporate entity is urged to consult a lawyer or tax professional concerning one’s own situation and to address any specific legal questions that may arise.

This article is intended for informational purposes only, and should not be construed as legal advice or a legal opinion on any specific facts or circumstances.