Jurisdiction Selection and Entity Formation Considerations in a Real Estate Syndication

The two primary entities involved in a real estate syndication are the “issuer” entity and the “GP” entity. The issuer sells equity interests to investors in exchange for their capital contributions, which are in turn typically utilized at least in part to acquire the target real estate. The GP is the entity whose equity owner(s) comprise of the sponsor group. The sponsor entity may be appointed as the “manager” or “GP” of the issuer, or a third-party management vehicle may be utilized.

Under the terms of the issuer operating agreement, the manager is granted exclusive managerial authority over the operations and decision making of the issuer. It is common for the issuer to have two “classes” of members: one class reserved for the investor group, typically entitling them to preferred economic treatment (i.e., preferred distributions) but with minimal voting rights, and the other reserved for the sponsor, entitling it to subordinated economic treatment (i.e., only receiving distributions once certain economic milestones are met).

As mentioned, and most often found in a “multi-asset” real estate syndication structure, sometimes additional entities, referred to as special purpose entities (“SPEs”), are formed for the sole purpose of taking title to the real estate syndication’s target properties. In other words, each SPE acquires one target property with the issuer entity owning 100% of the equity interests of each SPE. This middle layer of ownership provides an added layer of protection to the issuer entity in the event there is a dispute arising from operation and/or ownership of one of the properties.

Moreover, while most real estate syndication sponsors are experienced real estate professionals who may even have other operating entities that can provide certain services to the real estate syndication and its underlying property/properties, it is common for real estate syndication sponsors to hire third-parties to provide certain property-related services, such as property-management, leasing, construction/renovations, and other services.

There are two limited liability entity types that are best suited for a real estate syndication: the limited partnership and the limited liability company.

Generally, the equity owners of a limited partnership consist of limited partners (i.e., “LPs”), who are the investor group who contribute capital in exchange for limited partnership interests, and a general partner (i.e., the “GP”), who is the sponsor group that manages the limited partnership on behalf of the LPs. The GP (which is generally another limited liability entity) has unlimited liability, and its earnings may be taxed as ordinary income or as capital gains. The LPs have limited liability up to the amount of their interest in the limited partnership and enjoy passive investment tax benefits. LPs are prohibited from making decisions or participating in the decision-making process on behalf of the limited partnership, or else they risk being reclassified as a GP. A limited partnership is a pass-through entity for tax purposes, which means that the earnings of the LPs are passed through to its partners, each of whom reports the proportionate share of the LP’s earnings on his or her own tax returns. Notably, however, LP interests are considered personal property and are thus ineligible for a 1031 exchange.

In contrast, a limited liability company (i.e., an “LLC”) is a hybrid entity that combines the benefits of a corporation with the benefits of a limited partnership without the formalities of a corporation. Like a limited partnership, the LLC is considered a pass-through entity for tax purposes. The investors in an LLC are called “members” and acquire “units” or “membership interest” in the LLC. Akin to a limited partnership LP interest, LLC interests are considered personal property and as such are ineligible for a 1031 exchange.

An LLC can be member-managed or manager-managed, while still providing limited liability protection to all of its members and the manager. In a member-managed LLC, scrutiny under securities laws may be avoided as long as each major decision is determined by unanimous or supermajority vote of all members, which is why member-managed LLCs are most commonly used by joint ventures. In a manager-managed LLC, however, the members are considered passive investors and may have limited or no voting rights, while the manager generally makes decisions on behalf of the LLC members.

In 1996, Delaware made history by becoming the first state to authorize the establishment of limited liability companies (LLCs) capable of having multiple series, each with distinct members, managers, LLC interests, or assets. These specialized entities, known as Series LLCs, have since gained traction in various states across the nation.

While Series LLCs are typically associated with mutual funds and investment ventures, they offer versatility for diverse business types seeking to compartmentalize their operations into units with segregated assets and liabilities. Each series within a Series LLC can possess unique attributes akin to separate LLCs, including distinct rights, powers, and duties concerning specified property or obligations. Moreover, each series may pursue its own distinct business objectives or investment goals.

Furthermore, should a Series LLC adhere to specific additional requirements mandated by state law, individual series within the LLC are shielded from the debts, liabilities, and obligations incurred by the Series LLC as a whole or any other series within the organization. This variation of Series LLC is aptly referred to in this context as a “Protected Series” LLC. Additionally, Delaware allows for the creation of a specific series known as a “Registered Series,” which shares many characteristics with a Protected Series, along with additional features that can be advantageous in secured lending transactions involving a series as a borrower, and for other purposes.

To initiate the formation of a Series LLC in Delaware, you first submit a certificate of formation to the Delaware Secretary of State (SOS). Notably, the individual series need not be in existence at the time of this formation. In accordance with Section 18-215 of the Delaware Limited Liability Company Act (LLC Act) (6 Del. C. § 18-215), the LLC agreement for the Series LLC can define one or more series of members, managers, LLC interests, or assets within the structure.

Just like with standard LLCs, it is advisable to have a written LLC agreement for a Series LLC, even though Delaware does not mandate it. Regardless, any series within the Series LLC is legally bound by its LLC agreement, irrespective of whether the series itself actively executes that agreement (6 Del. C. § 18-101(9)).

Nevertheless, the Series LLC entity form is only available in sixteen states and Washington DC and Puerto Rico, and therefore, this entity form many not be suitable depending on where the real estate syndication and its sponsors intend to operate and acquire property. In addition, tax treatment and reporting requirements for Series LLCs varies by state, with some states adopting some not-so-clear rules. Therefore, while it is certainly worth considering a Series LLC structure for a real estate syndication, these distinguishing factors should be taken into account when structuring the transaction.

There are various considerations to take into account when deciding on jurisdiction. One central jurisdictional consideration is where the entities intend to operate, which in the context of a real estate syndication is the state or states where the target property or properties are located, or in the context of the GP, where the management team resides. Additionally, one should consider the anticipated domiciles of investors in the transaction. Delaware is often an optimal state in which to form a real estate syndication vehicle for issuers expecting to receive investments from various states, due to its well-established legal system and strong body of corporate law, its business-friendly and flexible regulatory environment, and its tax benefits for businesses. Nevertheless, this entity would likely need to register as a foreign entity in each state where it owns and operates a property in order to do business there, which typically involves filing a “certificate of authority” or similarly titled document with and paying the relevant fees to each respective state’s secretary of state along with engaging a registered agent in such state. Please refer to the next FAQ for more information on foreign entity qualification.

Cost considerations can also vary by state, as some states may have higher formation fees, including filing fees and annual taxes. Furthermore, LLCs and limited partnerships are subject to annual reporting requirements, under which such entities may be required to provide basic information about the business and its management to the applicable state authority. The annual reporting requirements for LLCs and limited partnerships and the costs associated with them can vary widely depending on the state at issue. Some states may charge a flat fee for annual reports, while others charge a fee based on the size of the business or the amount of revenue generated. Moreover, there may also be legal and accounting costs associated with preparing and filing such annual reports. There are also other costs to consider when forming an entity, such as registered agent fees, annual taxes, internal accounting costs, and third-party professional services providers such as attorneys and accountants.

Whether or not your entity must qualify as a foreign entity depends on whether it is “transacting business” in a state beyond where it is domiciled. Activities that constitute transacting business vary from state to state. For example, in Florida and Colorado, “owning, without more, real or personal property” in-state would not constitute “transacting business” and would, therefore, not require foreign entity qualification. In California, however, that activity is not listed among the exceptions and would require foreign entity qualification. Other activities, like holding a bank account or holding meetings concerning internal affairs, would not constitute transacting business in all of those states and would not require foreign entity qualification. Therefore, it all depends on the nature of your entity’s activities and the laws of the states in which it operates. You should consult with corporate counsel to determine the requirements appliable to your venture on a state by state basis.

A registered agent is a person or business entity designated to receive service of process on behalf of a company, including a real estate syndication vehicle. A registered agent has a physical address within the state in which the company is formed and is available during business hours to receive legal and tax documents. Having a registered agent helps ensure compliance with reporting and tax obligations, and that important documents are properly and promptly received and routed to the appropriate parties within a company. Each state has its own laws pertaining to specific requirements for registered agents. In most cases, a registered agent may be a natural person residing in the state, a domestic entity, or a foreign entity with a usual place of business in the state. Furthermore, in most cases, the registered agent and its mailing address must be named in the entity’s formation documents. Some states have additional requirements. For example, in Wyoming, the articles of organization for an LLC must also include a written consent to appointment signed by the registered agent.

All states require a registered agent but hiring a third-party registered agent is not required. An individual associated with the company or the company’s attorney may be designated as the registered agent of the company, provided such person meets that state’s requirements. Many companies, however, choose to hire a third-party registered agent service provider for an annual fee for the sake of convenience.

The reporting requirements for LLCs and limited partnerships vary from state to state, but most require some sort of regular reporting to remain in good standing and doing business in the state of formation and any states where they are qualified as foreign entities. Many states require information on a company’s members/partners, addresses, business activity, and financials, as well as the payment of a franchise tax or fee. For example, aside from some exceptions, Wyoming requires all domestic and foreign LLCs to file an annual report by the first day of the month of its organization, prepared by the company’s treasurer or fiscal agent, (1) detailing the LLC’s capital, property, and assets located and utilized within Wyoming, (2) providing the address of its principal office, and (3) paying a license fee in addition to other statutory taxes and fees. California, however, requires every domestic and foreign LLC to file a statement of information within 90 days after filing their original articles of organization or registering to conduct business in California, and then biennially thereafter, detailing the company’s name, agent for service of process, principal office address, mailing address, names and addresses of managers or members, and the type of business activity conducted. If there has been no change since the last filing, a California LLC may instead file a form stating that no changes have occurred.