Chapter 9 – Business OrganizationsTABLE 9 – 1Comparison of Business OrganizationsAdvantages and Disadvantages1. Sole Proprietorships: The sole proprietorship is the simplest business organization, and can quiteliterally be formed by declaration at the moment an investment piece of real estate is acquired by aninvestor. It has the additional advantage of all income and expenses flowing directly through to thetaxpayer/proprietor. A major disadvantage is the exposure of the proprietor to individual liability for allthe debts or obligations of the “business.” The proprietorship terminates upon the death of the founder,and capital access is limited to the wherewithal of this founder. Ownership transfer, cash distribution andasset sales are at the discretion of the founder, subject to credit and mortgage requirements. 2. General and Limited Partnerships: The general partnership is a stepped-up version of the soleproprietorship in most states, and involves additional tax and administrative duties beyond those requiredof a sole proprietorship. Income and expenses flow through to partners, according to partnershipagreement, based typically upon the relative investment in the partnership by the partners. Partners aresubject to taxes and liabilities deriving from the partnership, independent of any cash distributions. Capitalaccess is limited to the partners, and the partnership may terminate upon the death of a partner.Partnership interests are not easily bought or sold. A limited partnership, used commonly in real estateinvestments in the early to mid 1980’s, limits the liability of the limited partners to the capital invested,but limits their income potential, as well. Limited partnerships were often employed to allow passiveinvestment by high-income investors in real estate deals whose primary appeal were the pass-throughs ofsubstantial tax write-offs against marginal tax rates at the time of 50% (or more, including state taxes).Many limited partnerships were disallowed by the IRS in the late 1980’s. The limited partnership hasbeen largely displaced by the LLC in obtaining the same or superior objectives in the late 1990’s and2000’s. 3. Limited Liability Company (LLC): The LLC is a hybrid between the corporate and partnershipforms of business organization. It is allowed in all 50 states, though modest administrative differencesexist. An LLC investor is a member, not a shareholder. The largest advantages include: the flow throughof income and losses; the allowance of members that are not individuals; the separation of the ownersfrom direct liability; and the easier transferability of ownership interests than a partnership, typicallyaccording to the by-laws of the LLC. Gains and losses flow through to investors based upon theirpercentage investment in the property acquired by the LLC. It is governed by a managing member,typically elected by a majority vote of membership interests. Its disadvantages include: capital accesslimited to the owners’ wealth; the frequent requirement for personal guarantees of LLC mortgagefunding; the potential ease of “piercing the corporate veil” of the LLC; and the misallocation of LLCresources by the managing director. 4. Real Estate Investment Trust (REIT): The REIT was created with federal legislation passed in 1960to allow the accumulation of capital to fund large-scale real estate investment. Founded and managedlargely like a typical public corporation, the REIT is afforded special tax treatment if: 75% of the assetsand income of the REIT are derived from real estate or mortgages; no less than five shareholders control50% of the REIT; and a specified portion of the REIT’s income or funds from operations is paid out in anon-qualifying dividend each year. The greatest advantages of the REIT are the non-payment of taxes atthe corporate level, the liquidity of the REIT shares traded on the stock exchanges, and the substantialavailability of capital. The clearest disadvantages are the agency costs suffered with any large company. 5. General or C-class Corporation: Large corporations, such as those traded on the organized stockexchanges, are often note well-suited for firms dedicated primarily towards real estate investment. Theprimary advantages of the general corporation is the liquidity of the ownership interests, as the shares canbe bought and sold with some ease, and the access of the firm to substantial capital though stock or bondsales. Real estate assets are not highly liquid, but publicly-traded common stock is. The majordisadvantages include the double-taxation of income, at the corporate and personal level as dividends aredistributed, and the agency costs arising with the separation of owners from management. 6. Subchapter S Corporation: Like the LLC, the Sub-S is a hybrid exhibiting features of bothpartnerships and corporations. The Sub-S has the primary advantages of a pass-through of income orlosses, and modest (though penetrable) protections against the liabilities of the business for theshareholders. Disadvantages include restrictions on ownership to individuals, the limited ease ofownership transfers and shareholder tax obligations independent of cash distributions by the Sub-S. Thisform has been largely supplanted by the LLC for most real estate investments that might previously beenpursued using the Sub-S form of business organization. Selected chapter 9 objective practice questions: 1. All of the following items might be considered disadvantages of a general partnership EXCEPT (A) the partnership itself pays no income tax (B) each partner has unlimited liability for partnership debt (C) partnership can be terminated by the death of a partner (D) an interest in a partnership is not easily sold 2. Perhaps the greatest advantage of an LLC over a Sub-S corporation is:(A) that a non-living entity like a trust or other corporation can be a member of an LLC, whereas only a living person can be a shareholder in a Sub-S. (B) the number of eligible investors in an LLC is unlimited, whereas it is limited to 35 for a Sub-S. (C) Sub-S ownership is restricted to shareholders in a single state, whereas LLC members can come from various states, or countries. (D) LLC bylaws are the same nationwide, whereas Sub-S rules