Whether you are a new real estate developer or a seasoned property developer with years of experience in the real estate market, it is important to choose the correct business entity for your real estate projects.

When embarking on a real estate development endeavor in California, one of the key decisions a real estate developer has to make in the real estate development process is the selection of the business entity used by the real estate developer. This decision impacts the potential tax obligations, personal liability, and the ability to raise capital for the real estate developer.

In this article, we will guide real estate developers and real estate industry professionals through the process of choosing the most suitable business entity for their real estate development enterprises, considering various options including LLCs, C-Corps, S-Corps, General Partnerships, and Limited Partnerships for use in real estate markets.

We will delve into the benefits and drawbacks of these structures for real estate developers, providing a comprehensive guide to aid the choice of entity for future projects developing real estate.

Selecting the Right Business Entity for Your California Real Estate Company

While there are several business entity options for real estate developers for real estate development companies in California, two structures often emerge as the most viable: LLCs and Limited Partnerships.

These options are frequently preferred due to their unique attributes that cater specifically to the needs and sophisticated dynamics of real estate development. In the following sections, we will delve into a detailed examination of not only LLCs and LPs, shedding light on why they may serve as the most suitable choices for developing real estate but also the other types of business entities and why they are less suitable.

California General Partnerships for Real Estate Development in California

A California General Partnership is a feasible option for real estate development if there is more than one business owner involved.

Benefits of California General Partnerships for Real Estate Development

California General Partnerships offer several benefits for real estate development.

Simplicity of Formation

One of the primary advantages is the simplicity of its formation. It generally does not require any formal state filing, but filing with the California Secretary of State is required if a California General Partnership will hold real property.

No Limit on Number of Owners

California General Partnerships allow for unlimited partners, providing ample opportunities for attracting investors and raising capital.

Partnership Taxation

A California General Partnership is taxed as a partnership under federal and California tax laws, which provides for pass-through taxation where profits and losses are reported on the personal tax returns of each partner, potentially reducing the overall tax burden as compared to corporate taxation.

Capital Gains Tax Treatment in California General Partnerships

Capital gains tax treatment is available under partnership taxation. In partnerships, the share of the profit or loss is considered the personal income of each partner and is taxed accordingly.

If the partnership sells an asset that has appreciated in value, the profit from that sale is generally treated as a capital gain, which can be taxed at a lower rate than ordinary income, depending on the individual tax situation of each partner and the duration of time the asset was held.

Detriments of California General Partnerships for Real Estate Development

While the benefits of developing real estate as a General Partnership seem appealing, the detriments of operating a real estate development company as a California General Partnership outweigh those benefits.

Unlimited Liability

One of the significant drawbacks of a General Partnership in California for real estate development is the unlimited liability faced by the partners. Each partner can be held personally liable for the debts and obligations of the business. This could mean that the personal assets of the partners are at risk if the business faces any financial difficulties or legal issues.

This kind of arrangement might discourage potential investors who would provide capital but are unwilling to have unlimited liability when making that real estate investment.

All Partners Participate in Management

In a California General Partnership, all partners participate in the management of the business. This structure does not provide an opportunity to have a passive real estate investor, as it implies active involvement in decision-making and running the business.

Such an arrangement may deter potential investors who prefer to contribute capital without being involved in the day-to-day operations of the real estate development enterprise.

Potential for Conflict

Another detriment is the potential for conflicts among partners. As there are no official roles or hierarchies in a general partnership, disagreements on business decisions can arise, affecting the smooth functioning of the business.

The potential for a real estate professional leading the real estate development process, but having a partner who would otherwise be a passive real estate investor but instead has an equal say in the day-to-day operations of the real estate development company.

Self-Employment Taxes

Another notable disadvantage of a California General Partnership for real estate development concerns self-employment taxes. This tax obligation can significantly increase the financial burden on partners, as they are responsible for both the employer and employee portions of Social Security and Medicare taxes on their share of the partnership earnings.

Conclusion for California General Partnerships for Real Estate Development

About the only thing a California General Partnership has going for it is partnership taxation, but the unlimited liability, inability to separate real estate professionals from passive real estate investors, and imposition of self-employment taxes make the California General Partnership a poor choice for real estate development in California.

California Corporations for Real Estate Development in California

A California Corporation is not a feasible option for real estate development despite the many advantages of the corporate form.

Benefits of California Corporations for Real Estate Development

California Corporations offer several advantages for real estate development, which make them appealing to certain businesses.

Limited Liability

One of the primary benefits of a corporation is the limited liability provided to its owners. Shareholders are generally not personally responsible for the debts, liabilities, obligations, and legal judgments against a corporation. This separation of personal and business assets can be particularly important in industries like real estate development, which can involve substantial financial risks.

Compared to California General Partnerships, which have unlimited liability for each partner, the corporation comes out ahead of California General Partnerships on limited liability.

Ability to Raise Capital

Corporations can potentially raise significant capital through the sale of shares, which can be beneficial for large-scale real estate developments that require substantial investments.

Structured Management

Corporations have a well-defined management structure, with clear roles and responsibilities for directors, officers, and shareholders. This structure can provide clarity and efficiency in decision-making and operations, allowing real estate professionals to hold the seats of the board of directors and officer positions, while passive real estate investors only take on the role of shareholders.

Detriments of California Corporations for Real Estate Development

Double Taxation

One of the significant detriments of California Corporations for real estate development is the double taxation. The corporation is taxed on its earnings, and then shareholders are also taxed on any dividends they receive. This double layer of taxation can decrease the overall returns from a real estate development project, making the corporation less appealing to investors.

No Access to Capital Gains Taxation

Corporations, unlike general partnerships, do not have direct access to capital gains taxation. In a corporate structure, capital gains are first subjected to corporate income tax. After this, if profits are distributed to shareholders in the form of dividends, they will be taxed again at the personal income tax level.

This absence of access to capital gains taxation is another disadvantage that corporations face when it comes to real estate development, as it can significantly impact the potential returns on investment.

Conclusion for California Corporations for Real Estate Development

While the California Corporation form offers attractive benefits for real estate development such as limited liability, its ability to raise substantial capital, and a well-structured management system, these advantages are overshadowed by significant drawbacks of double taxation and lack of access to capital gains taxation.

California S Corporations for Real Estate Development in California

California S Corporations are potentially better for real estate developers than California Corporations subject to double taxation but still have significant deficiencies compared to the ideal options.

Benefits of California S Corporations for Real Estate Development

Pass-through Taxation

One of the major benefits of a California S Corporation for real estate development is the pass-through taxation feature similar to partnership taxation.

Like partnership taxation, this means that the corporation itself does not pay any federal income taxes, and instead, the income or loss is divided among and passed through to its shareholders. The shareholders then report the income or loss on their individual tax returns. This avoids the problem of double taxation that is characteristic of standard California Corporations.

Limited Liability

Similar to standard California Corporations, California S Corporations also provide the benefit of limited liability to its shareholders. This means that shareholders are typically not personally responsible for the corporation’s debts and liabilities. This feature can protect personal assets in risky ventures such as real estate development.

Ability to Raise Capital

While S Corporations have certain restrictions on the number and kind of shareholders they can have, they still maintain the ability to raise capital through the sale of stock. This can be advantageous for large-scale real estate projects that require significant funding.

Detriments of California S Corporations for Real Estate Development

Inflexibility in Ownership and Stock

One of the primary drawbacks of California S Corporations in the context of real estate development is the rigid nature of their ownership structure.

S Corporations are strictly limited to a maximum of 100 shareholders, and these shareholders must be U.S. citizens or permanent residents, which restricts the potential for foreign investment in real estate development projects. Furthermore, all shareholders have to make pro rata contributions and distributions must also be paid on a pro rata basis, forcing real estate professionals to contribute the same amount per share as passive investors, and also eliminating the possibility of creating preferred shares or preferential returns for passive real estate investors.

No Access to Capital Gains Taxation

California S Corporations, similar to standard California Corporations, lack direct access to capital gains taxation, which can impact the potential returns on investment in real estate development. Profits are distributed to shareholders as dividends and are subject to personal income tax rates, not capital gains rates, as are events like selling properties that have appreciated in value.

Conclusion for California S Corporations for Real Estate Development

While California S Corporations do address some of the taxation issues found in standard Corporations, and maintain the benefit of limited liability, their drawbacks including inflexible ownership rules and lack of access to capital gains taxation can make them less than ideal for real estate development in California.

California LLCs for Real Estate Development in California

California LLCs are a potentially viable choice for conducting real estate development in California.

Benefits of California LLCs for Real Estate Development

Pass-through Taxation

By default, a California LLC with two or more members is taxed as a partnership, identical to the tax structure of a California General Partnership. This means that the LLC itself is not subject to federal income tax. Instead, the profits or losses are passed on to the members who report them on their individual tax returns, which avoids the problem of double taxation.

Flexibility in Ownership and Management

California LLCs provide a high degree of flexibility in terms of ownership and management. There are no restrictions on the number of members, and members can be individuals, corporations, or other LLCs. Moreover, LLCs can either be member-managed or manager-managed, offering more options for decision-making and control of the company to allow real estate professionals to manage the day-to-day operations while passive real estate investors may be passive, without a say in the day-to-day operations.

Limited Liability

Just like California Corporations and California S Corporations, California LLCs also provide limited liability protection. Members of the LLC are not personally responsible for the debts, liabilities, obligations, or legal judgments against the LLC. This is a crucial factor for high-risk ventures such as real estate development where potential liabilities can be substantial.

Access to Capital Gains Taxation

In contrast to California Corporations and California S Corporations, California LLCs taxed as partnerships have direct access to capital gains taxation. This means that the sale of property that has appreciated in value is taxed at capital gains rates, which are usually lower than personal income tax rates. This can significantly increase the potential returns on investment in real estate development.

Detriments of California LLCs for Real Estate Development

Self-Employment Taxes

One of the potential drawbacks of California LLCs for real estate development is the burden of self-employment taxes. Unlike corporations, where only salaries (and not profits) are subject to self-employment taxes, for LLCs, all profits are subject to this taxation. This could significantly increase the tax burden for members of the LLC.

California LLC Fee

Another potential downside of California LLCs for real estate development is the California LLC Fee. The State of California requires all California LLCs, California Corporations, California S Corporations, and California Limited Partnerships to pay an annual minimum franchise tax of $800, regardless of their income level.

Additionally, LLCs in California with income over $250,000 are subject to an extra fee. This additional fee ranges from $900 to $11,790, depending on the LLC’s total income. Hence, this tax structure can significantly increase the operational costs of an LLC, particularly for those generating substantial income.

Conclusion for California LLCs for Real Estate Development

California LLCs offer an attractive solution for real estate developers in California, particularly if the maximum anticipated gross revenues are not expected to exceed $250,000 annually. For smaller-scale projects with more modest revenue expectations, California LLCs present an appealing structure that balances taxation benefits, operational flexibility, and limited liability protections, but the California LLC Fee can be sizeable for larger projects with revenues exceeding $250,000 annually.

California Limited Partnerships for Real Estate Development in California

For real estate developers starting a real estate development company in California, a California Limited Partnership is likely the most beneficial choice.

Benefits of California Limited Partnerships for Real Estate Development

Flexibility in Management and Investment

General partners and limited partners play distinct roles in a California Limited Partnership. General partners are typically responsible for managing the day-to-day operations of the partnership. They make key decisions, manage the investment, and take on the risk of potential liabilities. The real estate professionals involved in real estate development in a California Limited Partnership would take the role of general partner.

Limited partners in a California Limited Partnership are essentially investors who contribute capital but do not participate in management or daily operations, which makes it an attractive business entity for those seeking to invest in real estate development passively, without a role in management. It is also attractive to real estate developers who do not want passive real estate investors involved in the management and operation of daily real estate development activities.

Limited Liability for Limited Partners

In a California Limited Partnership, limited partners enjoy limited liability. This means that they are not personally liable for the debts and obligations of the partnership beyond their investment in the partnership. This is a significant benefit in the context of real estate development, where potential liabilities can be quite substantial.

Pass-through Taxation

Similar to California LLCs and California General Partnerships, California Limited Partnerships enjoy the benefit of pass-through taxation because they are taxed as partnerships. The partnership itself does not pay taxes on its profits. Instead, the profits and losses are passed through to the individual partners who report them on their personal tax returns, thereby avoiding the issue of double taxation.

Access to Capital Gains Taxation

California Limited Partnerships, similar to California LLCs and California General Partnerships, have direct access to capital gains taxation. This implies that the sale of a property that has appreciated in value is taxed at capital gains rates, which are typically lower than personal income tax rates. This can significantly increase the potential returns on investment in real estate development.

Lack of California LLC Fee

California Limited Partnerships, just like California LLCs, California Corporations, and California S Corporations, are subject to an annual franchise tax of $800, levied by the California Franchise Tax Board, regardless of their income level.

However, California Limited Partnerships are not subject to the California LLC Fee, thus they only pay $800 per year.

Detriments of California Limited Partnerships for Real Estate Development

Liability for General Partners

One of the main drawbacks of a California Limited Partnership is the unlimited liability faced by general partners. They are personally liable for all the debts and obligations of the partnership, which could prove risky, especially in high-stakes fields like real estate development.

A Solution for the Liability of General Partners

However, real estate developers concerned about the unlimited liability risk associated with the role of a general partner in a California Limited Partnership may use a limited liability entity, such as a California LLC, California Corporation, or California S Corporation as the general partner.

By doing so, the liability that the general partner (in this case, the limited liability entity) faces is limited to the assets of that entity, not the personal assets of the real estate developer. This arrangement can provide the needed liability protection for the personal assets of the real estate developer, ensuring that any risks associated with the real estate project are borne solely by the limited liability entity serving as the general partner.

Self-Employment Taxes

Like California LLCs and General Partnerships, profits from a California Limited Partnership are subject to self-employment taxes. This could significantly increase the tax burden for the general partners who are considered self-employed.

A Solution for Self-Employment Taxes

Using a California LLC, California Corporation, or California S Corporation as the general partner of a California Limited Partnership for property development can also solve the self-employment tax problem for general partners.

California Corporations, California S Corporations, and California LLCs taxed as S Corporations are not subject to self-employment taxes, and only salaries paid to the owner-employees are subject to employment tax. The remaining income distributed as distributions, is not subject to employment tax.

Conclusion for California Limited Partnerships for Real Estate Development

In light of these considerations, it becomes apparent that utilizing a California Corporation, California S Corporation, or a California LLC taxed as an S Corporation as a general partner in a California Limited Partnership effectively mitigates all the potential detriments associated with real estate development as a California Limited Partnership.

By adopting this approach, a real estate developer circumvents the risk of unlimited personal liability as well as the burden of self-employment taxes. Therefore, it stands as the optimal choice for real estate developers, given the combination of both the benefits of a Limited Partnership and the protections offered by a limited liability entity.

This arrangement is especially beneficial if the annual gross revenue surpasses the California LLC fee of $250,000. However, for those developers whose revenue falls below this threshold, a California LLC may be more cost-effective.

Ready to Optimize Your Property Development?

If you are a real estate developer looking to optimize your business structure, allow the experienced corporate attorneys at San Diego Corporate Law to guide you to the best solution. Our team has a deep understanding of residential and commercial real estate development companies and can help you select and establish the ideal business entity for your unique needs. Do not let legal structure complexities hinder your growth, Contact San Diego Corporate Law today and let us help you build a solid foundation for your real estate development endeavors.