Corporations are one of the oldest forms of legal entities. A significant body of case law and statutes exist defining the rights and liabilities of shareholders, officers, directors, and third parties dealing with the corporate entity. Certain states, like Delaware, have particularly favorable business corporation statues. As a result, many firms will strategically organize in those states in order to obtain the benefit of those advantageous laws.
Unlike a general partnership that can come into existence without filing anything affirmative, a corporation has a separate legal existence. The corporate structure serves to insulate most of the debts from the shareholders. A corporation is able to hold property in its own name and provide its shareholders with limited liability so long as the shareholders do not commingle funds or engage in other prohibited, self-serving activities.
By-laws are controlling documents enacted by the incorporator who organizes the entity. The by-laws govern the actions of the corporation and relationships of the shareholders, directors, officers and third-parties dealing with the entity. They set forth the framework within which the corporation must operate regarding important aspects, such as management, distributions and dissolution. The board of directors and officers of the corporation provide the management.
Some advantages of c-corporations are:
- a perpetual life
- no restrictions with regard to the participation in management
- the permissibility of any power structure
One particularly important benefit of utilizing the corporate form of ownership is the limitation of liability for officers and directors of the corporation. Unlike a limited partnership, the corporation’s shield of limited liability is not lost by the shareholder’s participating in the management of the corporation or its property.
Nevertheless, officers of corporations that own real estate must be aware of the potential for personal liability in certain circumstances. A court may decide to “pierce the corporate veil” whenever required by public convenience, fairness, or necessity.
For example, the corporate form may be disregarded by a court when there is such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist. In other words, the corporation must strictly observe the formalities associated with this form of ownership or else risk having personal liability.
Another example where personal liability could potentially be imposed in a real estate ownership context is for environmental hazards under statutes like the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), known also as “Superfund.”
Significant disadvantages exist when using the corporate form for real estate investment. First and foremost, the individual shareholders cannot obtain any of the tax benefits generated by the investment. Unlike a partnership, no pass-through of the corporation’s income tax deductions exists. The corporation’s profits are taxed twice at the corporate level through the payment of the corporate income tax and at the shareholder level by the shareholder’s payment of individual income taxes on the distributions they receive from the corporation. States also impose corporate income and franchise taxes which can materially and adversely affect the financial considerations of owning real estate in a corporation.
Subchapter-S corporations are c-corporations that have filed an election with the IRS using Form 2553. S-corps allow investors to avoid the double taxation of the corporation’s profit and the inability of the corporation to pass its income tax losses and credits onto the shareholders while still providing them with limited liability.
Nevertheless, certain limitations apply to Subchapter-S corporations such as:
- There can be no more than one class of stock.
- There can be no more than 75 stockholders.
- Essentially all investors must be individuals.
Profits and losses pass through to the shareholders without a corporate income tax. Shareholders of S-corps are taxed the same as partners, and the taxable income is treated as partnership income.
A disadvantage of S-corps is the difficulty in transferring real estate and other property held by the corporation caused by the limitation on the number of investors. Also, S-corps are subject to the IRS passive loss rules. Lastly, an additional problem imposed by Subchapter-S occurs in the event of liquidation of the corporation or the conveyance of its assets to an operating entity. The corporation could be required to pay corporate level capital gains tax.
In part four of our continuing series of blogs, we will discuss limited liability companies as a form of real estate ownership.