Look before you leap: are LLCs right for you?

The new Limited Liability Company Law in New York offers numerous advantages to owners of real estate, but it may not be the right vehicle for every owner. In particular, individuals and corporations which already own and operate real estate have numerous issues to consider and resolve before transferring presently owned real property to a new LLC.

This article will briefly describe the prime benefits of LLC status. We then provide a checklist of some key issues to consider-from legal, tax and accounting points of view-before transferring assets.

Benefits of LLC

The four most common forms of ownership of real estate in New York are: individual ownership, including ownership by two or more individuals as tenants-in-common; general partnerships composed of individuals; limited partnerships, often with the sole general partner being a corporation; and corporations which have elected Subchapter S tax status.

Each form of ownership traditionally offered certain benefits and other drawbacks. For example, individual ownership and general partnerships expose owners to personal liability. Limited partnerships are cumbersome to create and maintain, and the IRS requires that the corporate general partner be capitalized at certain minimum levels, and allocations to partners must follow certain rules. Subchapte S corporations require that all shareholders be persons who are U.S. citizens or resident aliens, and do not offer shareholders the opportunity to use depreciation allocable to mortgage debt on the property. Thus, persons seeking to acquire property often had been forced to choose among several ownership options which were less than ideal.

The LLC form of ownership appears to offer the best of all possible worlds-the limited liability of a corporation, with the tax benefits and flexibility of a partnership, while eliminating numerous stringent requirements that are imposed on limited partnerships.

As news spread of the enactment of the New York Limited Liability Company Law, numerous owners have asked us whether they should convert to LLC status. Our response requires that we look at each entity separately, on a case-by-case basis.

Conversion Procedures

First, conversion to LLC status is easiest for general and limited partnerships. The New York statute allows a partnership to "convert" to LLC status simply by filing a statement of conversion with the Department of State. Upon this conversion, the partnership transforms into an LLC by operation of law, and without any further acts being required to transfer ownership of assets to the LLC; although for income tax purposes, a new entity has been created. Although all previous obligations and debts that were personal obligations of partners will remain their personal obligations, any obligations incurred after the conversion will be subject to the limited liability provisions of the new law.

However, individuals (including tenants-in-common) and corporations are not permitted simply to convert their status. Instead, they must form a new LLC, then transfer the assets of the existing ownership to the new entity, by deed (or if the transferor is a corporation or other entity, the transfer also can be accomplished by merger).

Issues to Consider

These transfers give rise to a number of issues to consider. Here are some of them:

Transfer taxes and transfer gains taxes: Recently, the law was amended to eliminate New York City transfer taxes on transactions that involve no change in beneficial interest. New York State has never taxed such transfers. However, the transferor and transferee must be owned in exactly the same proportions by the same persons. If beneficial ownership interests have changed without a transfer of record in the ownership entity, consider correcting your records to reflect the current ownership.

Prohibitions in mortgages, leases and other indentures and agreements against transfers of assets: Consider whether written consents of lenders, landlords and others are required, even in the case of a merger or consolidation.

Continuation of title insurance in new entity: Title insurance companies are now considering how to deal with such transfers, and whether a special endorsement to the existing insurance policy should be issued.

Income tax consequences: As a general rule, a partnership or individual may transfer assets to an LLC without income tax consequences. However, a transfer by a corporation will result in taxable gain if the value of the property on the transfer date is greater than its tax basis.

In addition, the transfer of assets to a limited liability company will not affect the liability of individuals for existing debt. However, new debt, a refinancing or modification of existing debt may result in recourse debt becoming non-recourse debt as to one or more owners, which may have income tax consequences.

Eligibility for [section] 1031 exchange. If the property is now owned by an individual, or by tenants-in-common, the owner may defer income tax on a sale by means of [section] 1031 exchange. This cannot be done with respect to interests in a partnership or LLC.

Transactional Costs: Substantial filing, advertising, legal and other costs will be incurred in these transactions, including a conversion from partnership to LLC status. These may include: filing fees; advertising costs; preparation of legal documents, including the Articles of Organization and the Operating Agreement, deeds, merger documents, transfer tax returns, and obtaining necessary consents from lenders and others; Transfers of bank accounts; and accounting costs.

Effect on ongoing litigation: Consider whether parties must be substituted in existing litigation and whether the change in the form of ownership alters your rights (i.e. "owner occupancy" proceedings may be affected).

Dissolution of existing entity: Existing entities which cease to do business should be dissolved of record, and appropriate tax returns should be submitted to tax authorities.

Multi-state issues: If the new LLC will do business outside of New York State, consider whether its status will be recognized in all states where it will do business, with respect to: (a) limited liability, and (b) partnership tax treatment.

The above is a brief list of some of the initial issues that owners should consider at this time. As the law develops, and various procedures are instituted by title companies, the Department of State and others, some of the above issues may become easy, while other issues may develop.