A decade ago it was easy. If you were purchasing real estate as an investment, you either held it individually or as a partnership. The partnership had one of two forms: It was a general or a limited partnership. Corporate ownership of real estate was not really an option for the small investor because of the negative tax implications, and the real estate investment trust (REIT) was not a practical alternative as an operating entity. As a result, most private real estate was held by individuals or partnerships.

The problem with holding real estate individually or in partnership was that the owner's entire net worth was on the line if things went wrong. The limited partnership offered liability protection to the passive investors. However, the law still required that there be one or more general partners who were personally liable for the partnership's debts and obligations. Lawyers became skillful in creating limited partnership structures that provided the property owners with liability protection that was "almost as good" as that provided by corporate ownership.

What a difference 10 years can make. Today, the real-estate investor has a plethora of business entity choices. A partnership is still an option, but today, corporate ownership, or even a REIT, is a possibility. The newest ownership entity, the limited-liability company (LLC), is probably the best choice for most real-estate investors. Why is the LLC such a good way to hold investment real estate? The short answer is that it gives the owners the same liability protection enjoyed through corporate ownership with all the federal tax advantages associated with the partnership. In the past 10 years, state legislatures have made LLCs easier to form and clarified the scope of liability protection enjoyed by the owners. At the same time, the IRS has simplified the process of achieving the desired single level of taxation.

To understand the LLC, you need to consider the historic advantages and disadvantages of holding a real-estate partnership or corporation. In a world without taxation, all businesses would probably be conducted in the corporate form. This is because the stockholders of corporations are not personally liable for the debts and obligations of the corporation. Their liability is limited to the amount they have invested. Now consider a general partnership. Each general partner is personally liable for all debts and obligations of the partnership. The liability shield provided by corporate ownership makes it an ideal vehicle for business ownership.

Unfortunately, we live in a world where taxes matter. From a tax standpoint, corporations are not very good entities for holding investment real estate. Corporate profits are subject to double taxation. Income is first taxed when earned at the corporate level and taxed again when income is distributed to shareholders. For tax purposes, partnerships are a great way to hold real-estate investments. The partnership is not a taxable entity, and all profits and losses are allocated to the individual partners.

As alluded to above, lawyers and accountants have worked long hours developing complicated business structures to meld the liability shield provided by the corporate structure and the tax advantages of a partnership. This gave rise to the limited partnership and the less commonly used S corporation as real-estate-holding business entities. Neither of these devices was the perfect solution to the problem.

The LLC is the almost perfect entity for holding investment real estate. An LLC is a hybrid, unincorporated entity created by state law. It is a cross between a corporation and a partnership specifically designed to provide the owners three significant benefits:

The primary advantage the LLC has over a corporation is how it is taxed. The primary advantage over a partnership is that the liability shield applies to all owners. Unlike the limited partnership, neither passive nor active owners have personal liability for the LLC's debts and obligations. Consider the following:

Jim Johnson and Fred West own ABC Mini Storage. One day, Fred decides to take the day's receipts to the bank. He drives into four young men in a crosswalk. The young men are the members of the band YUK. Their projected five years' earnings are more than $100 million. If ABC is a general partnership, all of Fred's, the partnership's and Jim's assets may be at risk if Fred were found negligent. If ABC were an LLC, however, all of Fred's assets would be at risk because he was driving the car. The assets of the LLC would be at risk because Fred was on company business when the accident occurred. Jim's liability would be limited to his investment in the LLC. If the driver was the facility manager rather than Fred, and ABC was an LLC, neither Fred's nor Jim's personal assets would be at risk. However, if ABC was a partnership, not only would the business' assets be at risk, but all of Jim's and Fred's personal assets as well.

As demonstrated in the above example, how you organize your business will have significant consequences. Investors should select their business entity with care. Real-estate investors developing a new project have more choices of business entities than even a few years ago. The LLC generally offers the best solution to the taxation/liability dilemma. This business entity offers a flexible structure, federal partnership taxation and corporate liability protection. The LLC is especially well suited for the small- and medium-sized real-estate investor, and will usually prove a superior choice to partnerships and S corporations. It is a business structure that every self-storage facility owner should discuss with his attorney and accountant.

D. Carlos Kaslow is an attorney specializing in legal issues pertaining to the self-storage industry. A frequent contributor to Inside Self-Storage and a seasoned speaker at Inside Self-Storage Expos, Mr. Kaslow is also the editor of The Self-Storage Legal Review, a bimonthly newsletter on the legal issues pertaining to the self-storage industry. For more information, or to obtain a subscription, Mr. Kaslow can be reached at 2203 Los Angeles Ave., Berkeley, CA 94707; phone (510) 528-0630.