In 1994, when California adopted the Beverly-Killea Limited Liability Company Act, organizing limited liability companies in California became a reality.
Limited liability companies ("LLCs") gained immediate acceptance since they combined the flow-through tax treatment of partnerships with the limited liability of corporations. As a result, LLCs rapidly became the entity of choice for many real estate acquisitions in California. The use of LLCs increased when California authorized the use of single-member LLCs. In some situations, however, LLCs are not the most beneficial form of entity. The choice of LLCs instead of limited partnerships may come at a price as LLCs and limited partnerships are not subject to the same fees in California.
LLC Costs
In California, an LLC is subject to an $800 annual tax if it is formed under California law, qualified in California (i.e., registered with the Secretary of State as a foreign LLC) or otherwise doing business in California. Regardless of where the trade or business of an LLC is primarily conducted, an LLC is considered to be doing business in California if any of its members, managers or other agents is conducting business in California on behalf of the LLC.
Similarly, a limited partnership doing business in California is subject to an $800 annual tax.
In addition to the annual tax, however, every LLC must pay an annual fee based on its annual "total income." Total income is not apportioned or allocated based on the operations in California. Rather, total income of an LLC means its worldwide gross income (calculated without deducting the costs of goods sold that are paid or incurred in connection with the LLC's trade or business).
The annual fee schedule for taxable years beginning on or after January 1, 2001, is as follows:
| TOTAL INCOME | FEE AMOUNT |
| $0 - $249,000 | $0 |
| $250,000 - $499,000 | $900 |
| $500,000 - $999,999 | $2,500 |
| $1,000,000 - $4,999,999 | $6,000 |
| $5,000,000 or more | $11,790 |
The annual fee for an LLC has posed a particular problem for real estate developers that establish a special purpose entity for each real estate project. In some cases, a developer may voluntarily elect to use a special purpose entity to help isolate project risks. More often, however, the developer has no choice and is required to use a special purpose entity to satisfy the requirements imposed by the project lender. Real estate lenders increasingly require that the borrower qualify as a "bankruptcy-remote" special purpose entity to protect the lender and its collateral from the developer's other creditors and the developer's bankruptcy.
If the developer uses an LLC for each special purpose entity, the developer is faced with the prospect of paying a separate annual fee for each LLC. Even though the annual fee is less than $12,000 and caps at $5,000,000 of total income, each LLC will be charged separately and must climb the graduated scale separately before reaching the cap. Therefore, while the annual fee may not be large for a single LLC, it may become a significant annual expense if it must be paid on a number of separate LLCs.
Limited partnerships are not subject to a comparable annual fee.
Given the additional annual cost of maintaining an LLC, choosing an LLC should not be automatic. Rather, before deciding on which type of entity to use, careful consideration should be given to the costs and benefits of an LLC over a limited partnership or a structure that combines a limited partnership with an LLC.
Traditional Limited Partnership Structure
Prior to the advent of LLCs, a real estate project was frequently developed using a limited partnership. A limited partnership must have at least one general partner and one limited partner. The disadvantage of using a limited partnership structure is that the general partner is liable for the obligations of the limited partnership. The traditional approach to minimizing this problem is to establish a corporation with limited assets to act as a 1% general partner, with limited partners holding the remaining 99% interest in the limited partnership. By utilizing this approach, only the limited assets of the general partner are exposed to liability and only 1% of the limited partnership's income is subject to corporate income tax.
The use of the traditional limited partnership structure avoids the annual LLC fee. The other costs of forming and maintaining a limited partnership (e.g., the annual tax of $800, the formation costs, and tax return preparation and other accounting costs) should be virtually the same as for an LLC. However, the foregoing structure results in additional costs associated with using a corporation, including additional formation costs, federal corporate taxes, California franchise taxes (which will be a minimum of $800), and tax return preparation and other accounting costs. The costs of a limited partnership structure need to be compared with the potential annual LLC fee to determine whether the limited partnership structure is preferable.
Combination Structure
Some of the costs of the limited partnership structure may be reduced by substituting a single-member LLC as the 1% general partner in place of the corporation. The cost of setting up the LLC will still need to be incurred. However, at the option of the member, the existence of a single-member LLC can be ignored for federal tax purposes. Thus, the single-member LLC will not be required to file a federal tax or information return or pay any federal income tax. The LLC will still be required to pay the annual tax of $800 and the annual income-based LLC fee attributable to its share of the limited partnership's income (i.e., 1%). For some projects, this may be a more cost effective alternative.
Disregarded Limited Partnership
A further refinement on the combination structure, known as a "disregarded limited partnership," may be available in some situations. A disregarded limited partnership involves a limited partnership with a single-member LLC as the 1% general partner. The member of the LLC is also the 99% limited partner of the limited partnership. Although the limited partnership exists for corporate law purposes, it does not exist for federal income tax purposes. This is because the existence of the LLC is disregarded for federal income tax purposes, which means that the member owns 100% of the interests in the limited partnership. Therefore, the existence of the limited partnership will be completely disregarded for federal tax purposes and the member will be treated as the tax owner of the assets held by the limited partnership. Accordingly, neither the limited partnership nor the LLC will be required to file federal income tax returns. The limited partnership will also be exempt from filing any California state income tax returns. The LLC will be required to file an annual California state return and pay the $800 annual tax and the annual income-based fee on its 1% share of the limited partnership. Accordingly, if available, the use of a disregarded limited partnership structure will eliminate some of the additional administrative costs of using a combined limited partnership/LLC structure.
Restructuring of Existing LLCs
In addition to evaluating which entity to use for a new project, one should consider other possibilities for restructuring an existing LLC as a limited partnership. This may be accomplished a number of ways depending on a variety of facts, including whether the existing LLC has a single member. Along with several more traditional methods, California law now permits the "conversion" of an LLC to a limited partnership. To effect a conversion, a Certificate of Limited Partnership - Conversion (LP-1) must be filed with the California Secretary of State along with a $30 filing fee. Upon conversion, the LLC will become a limited partnership, while continuing its existence for all other purposes, including property ownership, contract rights, and obligations and relationships with debtors and creditors.
Before converting an LLC to a limited partnership, the LLC's existing contracts should be examined to determine whether consents from any third parties are required. For example, the LLC's existing loan documents must be reviewed to make sure that the proposed restructuring is permitted under the loan documents or that the LLC can obtain the consent of the lender. As the ability to convert an LLC into a limited partnership is a relatively new phenomenon, some loan documents do not include provisions prohibiting such a conversion.
Conclusion
Despite the current popularity of LLCs because of their limited liability and flow through tax treatment, LLCs may not always be the optimum choice of entity in California due to the California fee structure. Various hybrid structures that use a combination of partnerships, corporations and LLCs may limit the California fees while achieving the same limited liability and flow-through tax treatment. The costs of establishing and maintaining these hybrids should be compared with the costs of LLCs before deciding on the best choice of entity.
Dana P. Newman is a Partner in the Los Angeles office and may be contacted via e-mail at dnewman@pillsburywinthrop.com or by phone at (213) 488-7334.
Arsineh Voskanian is an associate in the Los Angeles office and may be contacted via e-mail at avoskanian@pillsburywinthrop.com or by phone at (213) 488-7456.
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