Formation, Operation and Dissolution of Business Organizations for REI

After we spoke about the benefits and downfalls of different business organizations for real estate investment, in this article we will go a little further in explaining the processes of formation, operation and dissolution of partnerships and corporations. We won’t be discussing sole proprietorship because generally, the processes involved are very simple and straightforward. However, if you need more information or assistance with this, please do contact us. This will give you an even clearer picture of what structure would be best for your unique scenario as a real estate investor.

Partnerships

Formation of a Partnership

In general, the law that governs partnerships is determined by the courts. The main acts ruling in almost all states are the Uniform Partnership Act (UPA) (except in Georgia and Louisiana) and Uniform Limited Partnership Act (ULPA) (except in Louisiana). According to those acts a partnership is an association between two or more individuals that have come together to carry on as joint owners of a business. Generally, an oral agreement of a partnership is acceptable under the law. However, we would always recommend that you craft a good written agreement that is signed by all partners. This helps significantly if any issues with taxation arise or if the partners want to distribute profits and losses according to the size of their investment and not equally as per presumption. A written agreement is necessary for:

• Compensations and distributions of capital contributions and interest
• Special allocations
• Partnership capital
• Partnership property
• Buy and sell provisions

Operation of a Partnership

How the partnership will operate in most cases is controlled by the (written) agreement, the law and UPA or ULPA (whichever is applicable). Here are the general principles, right and duties of partnerships:

• In general partnerships, partners have equal rights to management and decision making, even though the shares may not be equal.
• The majority can overrule the minority on small matters.
• Partners cannot get paid for the services they provide as part of the partnership, unless the written agreement allows it.
• No interest is distributed on capital investment.
• The distributions on investment are based on the profits/losses share and the cash flow.
• Each partner is allowed to inspect the books and make copies.
• A partner can request for an accounting suit upon dissolution of the partnership.
• Each partner has equal right to use the partnership property for any activities related to serving the firm and no right to use it for other purposes.
• Each partner can act as an agent of the partnership and sign deals on its behalf.

Dissolution of a Partnership

When partners stop doing business together they enter the first stage of ending the partnership as a business organization - dissolution. The next two phases are winding up and termination, where assets are converted to cash, creditors are paid off and all profits and losses are distributed to the partners.

For dissolution to occur if at least one of following events has happened:

• Consent of the partners
• Operation of the law
• When a partner leaves the partnership or a new one joins
• Violation of the agreement
• Court decree

In many cases partnerships are designed with a fixed lifetime (the length of a particular project). However, if not specifically outlined in the agreement, a partner can withdraw at their own will, which leads to dissolution.

When the partnership get to the next stage, named as winding up, liquidation of assets begins. After the firms has paid all that is owed to creditors, the assets are distributed to partners as follows:

• Individual loans including interests are repaid.
• Each partner receives their own contribution to the capital.
• The remaining profits are distributed equally or as per the written agreement.

In the case of a loss, the creditors still have to be paid first and the the loss is distributed to partners either equally or as per the agreement.

Partnership as a business organization can be very beneficial for real estate investment activities because of its tax shelter providing features. Limited partnerships in particular are even more attractive to real estate investors because they also provide a good level of asset protection.

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Corporations

Formation of a Corporation

The formation of a corporation is a much more complex. In its core it is a legal entity that has the right to sue and be sued, but is not liable for the debts of its shareholders, nor the shareholders are liable for the debts of the corporation. This business organization is created by the authority of the state with an approved charter and the rules and regulations for this vary with each state. Let’s present the procedure of formation of a corporation in a nutshell:

• File an application (a minimum of 3 people required to file)
• You need to provide:
  • The name of the agent
  • Location of the business
  • Purpose
  • Duration
  • Listing of capital stock
• Stockholders need to elect a board of directors
• Bylaws need to be created
• A Buy and Sell Agreement need to be put in place
• A formation fee has to be paid (amount varies by state)

Operation of a Corporation

The operation of a corporation is well structured. It is carried out by:

• The shareholders
• The board of directors
• The elected officers

There’s a hierarchy, which begins with the shareholders who elect the board of directors. They in turn create bylaws and elect officers who execute these bylaws. The shareholders are able to control what happens in the corporation usually by the annual meetings where voting occurs. Each shareholder has as many votes as shares in the corporation. They can vote on electing directors, mergers, major policy issues and dissolution. In addition, the shareholders have the right to:

• Inspect the books
• Share the profits with dividends
• Exercise the preemptive right (protect and maintain their control and interest in the corporation)
• Bring a derivative suit ( a suit of equity to prevent the officers from doing anything that can harm the assets of the corporation)

Directors on the other hand hold the following responsibilities:

• Hire key employees
• Plan and strategize for the future of the corporation
• Supervise the general business activities
• Hold meetings
• Maintain good faith by recommending policies with due care

They receive salaries as agreed and are liable for their decisions.

Dissolution of a Corporation

Usually corporations are chartered for continuous period of time, however, can be terminated if a specific date is stated in the charter. Also, if no business activity has occurred the corporation can be voluntarily dissolved. Otherwise, if the organization is already in business a written consent from all shareholders or action by the board of directors with the approval of the majority of the shareholders is required.

Dissolution of a corporation can also happen involuntarily, triggered by:

• The state
• The shareholders
• The creditors

The state has the right to cancel a charter for one or more of the following reasons:

• Failure to file an annual report
• Failure to appoint an agent for notices
• Failure to pay the franchise tax and license fees
• Failure to use authority appropriately
• Failure to attain charity legally
• Failure to perform the corporate function for a long period of time

Shareholders can force dissolution through the court of equity if they can prove that the corporation is acting illegally, fraudulently or oppressively (has deviated from fair play practices).

Creditors can sue the corporation in order to obtain payment of debts, often leading to the dissolution of the business organization.

Different investors have different opinions whether corporations are good structures for real estate investment. The reality is that they are neither right, nor wrong. Whether a corporation is a suitable solution for you as a real estate investor depends on your personal circumstances and investment goals. The lack of a smart tax planning and strategy would certainly help to weigh against operating through a corporation for a real estate investment, however, if you have a good tax advisor, you may enter a gold mine with such a structure.

We at FAS CPA & Consultants have years of experience helping real estate investors make the right moves to maximize their wealth. We want to help you too. Your free 30-minute consultation with one of our experts is just a call away. Alternatively, you can email us at [email protected].

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