Legal Structure Options for Commercial Real Estate Ownership: LLCs, Partnerships, and Corporations

California’s commercial real estate market offers diverse opportunities, from bustling urban centers to expanding suburban hubs. For those looking to invest in or develop commercial properties, one of the most important initial decisions is selecting the right legal structure for ownership. This choice has far-reaching implications, affecting everything from liability and taxation to management flexibility and future growth potential.

Navigating Commercial Property Ownership Structures

Commercial real estate ownership involves more than just acquiring a parcel of land or a building. It requires a thoughtful approach to legal organization. The structure you choose dictates how profits are taxed, how liabilities are managed, and how the property can be bought, sold, or transferred in the future.

For commercial property, common ownership structures include:

• Limited Liability Companies (LLCs): Often favored for their blend of liability protection and tax flexibility.
• Partnerships: Suitable for co-ownership, offering various forms to fit different levels of involvement and liability.
• Corporations (C-Corps and S-Corps): Provide strong liability protection and are well-suited for businesses planning significant growth or seeking external investment.

Each of these structures interacts differently with California’s legal and tax environment, necessitating careful consideration.

Limited Liability Companies (LLCs) in Commercial Real Estate

LLCs have become a highly popular choice for commercial real estate ownership in California due to their adaptability and protective features.

Liability Protection: One of the primary benefits of an LLC is the separation it creates between the owner’s personal assets and the business’s liabilities. If the commercial property faces a lawsuit (e.g., a slip-and-fall accident, a dispute with a tenant, or an environmental issue), the personal assets of the LLC members are generally shielded from the business’s debts and legal obligations. This “corporate veil” feature is a significant advantage over sole proprietorships or general partnerships.

Taxation Flexibility: LLCs offer flexibility in how they are taxed.

• Pass-Through Taxation: By default, an LLC with a single owner is taxed as a disregarded entity (like a sole proprietorship), and an LLC with multiple owners is taxed as a partnership. In both cases, profits and losses “pass through” directly to the owners’ personal tax returns, avoiding the double taxation often associated with C-Corporations (where the corporation is taxed on its profits, and then shareholders are taxed again on dividends).
• S-Corporation Election: An LLC can elect to be taxed as an S-Corporation, which can be beneficial for owners who want to reduce self-employment taxes. This election allows members to be paid a reasonable salary, with the remaining profits distributed as dividends, which are not subject to self-employment taxes.
• C-Corporation Election: Although less common for direct commercial real estate ownership, an LLC can also elect to be taxed as a C-Corporation if it aligns with specific business or investment strategies, such as attracting large-scale external investment.

Management Flexibility: LLCs offer considerable flexibility in their management structure. They can be member-managed (where all members participate in day-to-day operations) or manager-managed (where specific individuals, who may or may not be members, are appointed to manage the business). This allows owners to tailor the management structure to their operational preferences.

Operating Agreement: A well-drafted LLC Operating Agreement is a foundational document. It outlines the rights and responsibilities of each member, profit and loss distributions, decision-making processes, procedures for admitting new members, and protocols for resolving disputes or exiting the business. This agreement is critical for avoiding future conflicts, particularly in multi-member LLCs.

Partnerships in Commercial Real Estate

Partnerships represent another common ownership structure for commercial real estate, especially when multiple individuals or entities co-own a property. California law recognizes several types of partnerships, each with different liability implications.

General Partnership (GP): In a general partnership, all partners share equally in the management, profits, and liabilities of the business.

• Unlimited Personal Liability: The most significant drawback of a GP for commercial real estate is that each general partner is personally liable for the partnership’s debts and obligations. This means that a partner’s personal assets are at risk if the partnership faces financial difficulties or legal claims.
• Ease of Formation: GPs are relatively easy to form, often requiring only an oral agreement, though a comprehensive written partnership agreement is strongly recommended to define roles and responsibilities.

Limited Partnership (LP): An LP consists of at least one general partner and one or more limited partners.

• General Partner: The general partner manages the business and assumes unlimited personal liability for the partnership’s debts.
• Limited Partners: Limited partners contribute capital but do not participate in the day-to-day management. Their liability is limited to the amount of their investment in the partnership, protecting their personal assets. LPs are often used in syndications where investors want to limit their exposure while a general partner manages the project.

Limited Liability Partnership (LLP): LLPs are typically used by professionals (e.g., lawyers, accountants) and offer limited liability to all partners, protecting them from the liabilities arising from the negligence or misconduct of other partners. While less common for direct commercial real estate ownership, it might be relevant for firms investing in property for their own use.

Partnership Agreement: Similar to an LLC Operating Agreement, a detailed Partnership Agreement is essential. It defines profit-sharing, decision-making authority, dispute resolution mechanisms, capital contributions, and exit strategies for partners. Without a clear agreement, disputes can escalate, jeopardizing the commercial property investment.

Corporations for Commercial Real Estate Ownership

Corporations, specifically C-Corporations and S-Corporations, offer distinct advantages and are often considered for commercial real estate ownership, particularly for larger ventures or those seeking substantial external investment.

C-Corporation:

• Strong Liability Protection: A C-Corp provides robust liability protection for its shareholders, meaning their personal assets are shielded from the corporation’s debts and legal obligations.
• Double Taxation: The main disadvantage of a C-Corp is “double taxation.” The corporation’s profits are taxed at the corporate level, and then dividends distributed to shareholders are taxed again at the individual shareholder level.
• Investor Appeal: C-Corps are attractive to investors, especially venture capitalists, as they allow for different classes of stock and are structured to raise large amounts of capital.

S-Corporation:

• Pass-Through Taxation: An S-Corp avoids the double taxation of a C-Corp by passing profits and losses directly to the owners’ personal income without being subject to corporate tax rates.
• Liability Protection: Like a C-Corp, an S-Corp offers liability protection to its shareholders.
• Restrictions: S-Corps have certain restrictions, such as limits on the number of shareholders (currently 100) and who can be a shareholder (generally U.S. citizens or residents). This can make them less flexible for some commercial real estate ventures.

Key Considerations When Choosing a Structure

The decision among LLCs, partnerships, and corporations for your commercial real estate venture in California requires a thorough evaluation of several factors:

• Liability Exposure: Assess the level of risk associated with the property. Properties with high public access or environmental concerns may benefit more from structures offering stronger liability shields.
• Tax Implications: Analyze how each structure will affect your personal and business tax obligations, considering factors like pass-through taxation, self-employment taxes, and potential for double taxation.
• Number of Owners and Their Roles: If there are multiple owners, consider their desired level of involvement in management and their individual liability preferences.
• Capital Raising Needs: If you anticipate needing to raise significant capital from outside investors, certain structures (like C-Corps) may be more appealing to them.
• Management Control: Determine how you want management decisions to be made and who will be responsible for day-to-day operations.
• Exit Strategy: Plan for how the property or ownership interests might be sold or transferred in the future, as different structures facilitate these processes differently.
• Compliance and Administrative Burden: Corporations generally have more stringent compliance requirements (e.g., annual meetings, minutes, bylaws) compared to LLCs or partnerships.

The Mills Act Program and Commercial Properties

California’s Mills Act Program, while often associated with residential properties, can also offer significant financial incentives for owners of qualified historical commercial properties. This program allows for a reduction in property taxes in exchange for the owner’s commitment to preserving and maintaining the historical character of the property.

• Eligibility: To be eligible, the commercial property must be a “qualified historical property” as defined by state law and must be located in a city or county that has adopted a Mills Act program. Designation on national, state, or local historical registers is typically a prerequisite.
• Tax Savings: The tax savings can be substantial, as the assessed value of the property for tax purposes is recalculated based on the income it generates, rather than its market value. This can lead to a significant reduction in annual property tax payments.
• Preservation Requirements: In return for the tax benefits, owners must sign a contract with the local government agreeing to maintain, preserve, and, where necessary, restore the historical features of the property in accordance with specific preservation standards. These standards are typically based on the Secretary of the Interior’s Standards for the Treatment of Historic Properties.
• Long-Term Commitment: Mills Act contracts are generally for a 10-year term and automatically renew annually unless either party gives notice of non-renewal. This represents a long-term commitment to preservation.

For owners of designated historical commercial properties, exploring the Mills Act can be a vital financial strategy, offsetting the potentially higher maintenance and preservation costs associated with these unique assets.

Due Diligence in Commercial Real Estate Transactions

Regardless of the chosen legal structure, thorough due diligence is paramount in any commercial real estate acquisition. This comprehensive investigation helps uncover potential risks and ensures the property aligns with your investment goals.

Key areas of due diligence include:

• Financial Due Diligence: Reviewing income and expense statements, leases, tenant creditworthiness, operating costs, and potential for future revenue.
• Physical Due Diligence: Conducting inspections of the property’s structural integrity, HVAC, plumbing, electrical systems, roof, and other physical components. This may involve engaging engineers, environmental consultants, and other specialists.
• Environmental Due Diligence: Assessing potential environmental hazards, such as contamination from past uses (e.g., underground storage tanks, hazardous waste), and ensuring compliance with environmental regulations. Phase I and Phase II Environmental Site Assessments are common.
• Legal Due Diligence: Examining the property’s title for any liens, encumbrances, easements, or restrictions; reviewing zoning and land use regulations; verifying permits and certificates of occupancy; and scrutinizing all existing contracts related to the property (e.g., leases, service agreements).
• Tenant Due Diligence: For income-producing properties, a detailed review of all existing leases, tenant estoppel certificates, and rent rolls is essential to confirm income streams and tenant obligations.

Navigating Commercial Lease Agreements

Once a commercial property is acquired, the lease agreement becomes a critical document, especially for landlords. A well-drafted commercial lease protects the landlord’s interests while clearly defining the rights and responsibilities of both parties.

Important aspects of commercial lease agreements include:

• Lease Term and Renewal Options: Clearly specify the duration of the lease and any provisions for renewal.
• Rent and Rent Escalations: Detailing the base rent, methods for calculating rent increases (e.g., fixed increases, CPI adjustments), and additional rent components (e.g., operating expenses, property taxes, insurance in triple net leases).
• Operating Expenses (CAM): Defining what constitutes common area maintenance (CAM) charges and how they are allocated among tenants.
• Tenant Improvements: Outlining who is responsible for tenant build-outs, the approval process for modifications, and whether fixtures become part of the property at lease end.
• Maintenance and Repair Responsibilities: Clearly delineate responsibilities for structural repairs, routine maintenance, and specific systems.
• Use Clauses: Specifying the permitted use of the leased premises and any restrictions.
• Assignment and Subletting: Setting conditions under which a tenant can assign their lease or sublet the premises.
• Default and Remedies: Establishing conditions that constitute a default and the remedies available to the landlord in such events.

Zoning and Land Use Regulations

Commercial real estate ownership in California is heavily influenced by local zoning and land use regulations. These regulations dictate how a property can be used, its permitted density, height restrictions, parking requirements, and other development standards.

• Zoning Ordinances: Local zoning ordinances divide a city or county into different zones (e.g., commercial, industrial, residential) and specify the types of activities allowed within each zone.
• Conditional Use Permits (CUPs): Some uses may require a Conditional Use Permit, which allows a specific use that is not automatically permitted in a zone but may be allowed if certain conditions are met.
• General Plans and Specific Plans: Municipalities also have long-range general plans and more detailed specific plans that guide future development and land use.
• Building Codes: Commercial properties must comply with state and local building codes, including those related to safety, accessibility (e.g., ADA compliance), and seismic standards in California.
• Environmental Regulations: Projects may also be subject to environmental reviews under the California Environmental Quality Act (CEQA) or other environmental protection laws.

Thorough investigation of these regulations is essential during due diligence to ensure the intended use of the property is permissible and to avoid costly delays or non-compliance issues.

Property Tax Considerations for Commercial Owners

Property taxes are a significant ongoing cost for commercial real estate owners in California. These taxes are assessed based on the property’s value and are subject to the provisions of Proposition 13, which generally limits annual increases in assessed value to no more than 2% unless there is a change of ownership.

• Proposition 13 Reassessment: A “change of ownership” (e.g., sale, transfer of more than 50% of the ownership interests in a legal entity) can trigger a reassessment of the property to its current market value, potentially leading to a substantial increase in property taxes.
• Base Year Value: Under Proposition 13, a property’s assessed value is generally its 1975 value plus limited annual adjustments, or its purchase price after a change in ownership, whichever is more recent.
• Property Tax Appeals: Commercial property owners have the right to appeal their property tax assessment if they believe it exceeds the fair market value or if a reassessment was improperly triggered.
• Mills Act Impact: As discussed, for eligible historical properties, the Mills Act can significantly alter property tax assessments by basing them on income rather than market value.

Understanding California’s complex property tax system is essential for accurate financial forecasting and effective management of commercial real estate.

California Commercial Real Estate Ownership: Structure Your Success.

The decision of how to legally structure your commercial real estate ownership in California is a foundational one that impacts liability, taxation, management, and future flexibility. Each option—LLC, partnership, or corporation—offers distinct advantages and disadvantages that must be carefully weighed against your specific investment goals, risk tolerance, and long-term vision.

Whether you are acquiring your first commercial property, expanding your portfolio, or considering the best way to manage existing assets, securing knowledgeable legal guidance is a key component of a successful strategy. Our attorneys at Garmo & Garmo are prepared to help you evaluate these options, draft the necessary agreements, and navigate the intricate legal landscape of commercial real estate ownership in California.

Contact us for a consultation to discuss your specific needs and ensure your commercial real estate ventures are structured for lasting success.