A Glossary of Business Entities
How will you own your self-storage assets? Will it be as a corporation, limited liability company, limited partnership or sole proprietorship? Choosing the correct form of entity to develop, own and operate your business is an important decision. You’ll want to consider:
- Federal and state taxation issues
- The cost of establishing and maintaining the entity
- The entity’s effectiveness in protecting you from liability
- The entity’s suitability for the sale, refinance or transfer of the asset
To conduct a rational analysis of federal and state taxation issues, it’s best to consult your attorney and tax advisor. While federal tax law is generally applied across all states, there are some state-related issues that make it worthwhile to engage a professional. For example, if you buy a property in Texas but live out of state, the form of ownership entity you choose will determine whether the asset is subject to state franchise taxes.
To avoid unpleasant surprises, it’s critical to involve your tax advisor before you form any business entity. If you don’t, your business could easily operate for as long as a year before your accountant notices you’ve already suffered unanticipated tax consequences. Most advisors will be astonished to be involved at the planning stages, but also happy and relieved, as this makes everyone’s job easier.
Businesses are either taxed at the entity level or considered “pass through,” which means they allocate income and losses to their owners. To complicate matters, tax elections (mistakes) may cause a pass-through to be taxed at the entity level and vice versa. Accompanying the taxation decision process is an analysis of the requirements to file or not file an information or tax return. With some entities, earnings are even subject to self-employment tax.
Another issue that can arise is the unintended “trapping” of an asset’s gain inside a corporation. In this case, any appreciation in the facility will be taxed twice—once when the corporation sells the asset and again when it pays out the proceeds to the shareholders or liquidates. This problem typically occurs when an owner sets up an entity himself or decides to save money by recycling one that was set up for a previous venture. In trying to save a few hundred or thousand dollars, he ends up making a mistake that costs several hundred thousand.
In some states, an owner can benefit from multi-entity ownership plans. For example, Texas doesn’t currently apply the state franchise tax to limited partnerships. So a common ownership structure in that state is a limited partnership in which the limited partners are the individual owners and the general partner is an LLC or corporation. The partners enjoy limited liability, but the entity still manages to escape the franchise tax.
Costs to Establish and Maintain
The cost to establish an entity will range from $1,250 to $3,000, depending on the state of filing and the type of entity chosen. This includes state-mandated filing fees and professional fees for the attorney who prepares your documents. The cost to maintain an entity after it is formed includes any annual fees required by the state and the cost to file any information or tax returns. Since a typical self-storage entity is not very complex, the cost to file returns usually ranges from $500 to $1,500. This will vary depending on the complexity of your business.
To form an entity, you’ll need to prepare two types of documents. First, you must file an application-style form to receive the charter (approval) to operate in your particular state. Owners sometimes think this is all they need, but you also need to prepare internal-operating documents, such as corporate bylaws, LLC operating regulations and LP agreements. These establish the rights and responsibilities of the entity’s owners to each other and the entity itself, as well as the entity’s obligations to the owners. They can also affect the entity’s rights and responsibilities with third parties such as creditors.
Parties joining resources to establish an entity should think of the internal documents as a sort of “prenuptial agreement” that can assist in the resolution of any future disputes. In addition, many lending institutions require that a set of internal documents be examined as part of the loan underwriting and closing process.
Protection From Liability
One of the primary benefits of an ownership entity is it can often protect the individual from the liabilities of the business, including contractual obligations and tort liabilities. The former refers to items such as the postage-meter lease, utility bills and other vendor-based contracts. The latter are those that relate to damage or injury. They pose the biggest threat to an owner, though they often stem from fairly common occurrences:
- The contents of the wrong unit are sold at lien sale.
- A tenant’s unit is flooded or damaged by fire.
- A tenant is injured or his vehicle is damaged by the security gate.
- A guest of a tenant is injured while on the property.
- An employee is injured while carrying out his duties.
It may be that an owner can contractually restrict his liability for some of these events, but he may not be able to exclude all of them. For example, an owner limits his liability by having tenants sign a rental agreement; but this does not protect him from incidents involving tenant guests, who have not signed such a contract. In addition, many states limit the effectiveness of such a liability release. Finally, some states have statutory “consumer protection” causes of action that cannot be waived or limited by contract.
Some owners carry liability insurance rather than rely on an entity structure to limit their risk. While insurance is important, it will not prevent an owner from being sued. If a customer sues for a loss and the facility is owned by an individual, the injured party will seek to recover from the insurance policy as well as the owner’s personal net worth.
However, if the business is owned by an entity, the individual’s personal assets are not accessible. Particularly in cases of no insurance or low-limit insurance, owners will be vulnerable to legal judgments—unless they have protected themselves with an ownership entity.
A word of caution: Some owners operate multiple facilities under one entity, but combining assets this way defeats the purpose. For example, if you own four sites through a single entity, a liability-producing event at any one of those facilities can extend to the value of the other three. However, if each facility is set up as its own entity, there is a “firewall” of protection to prevent liability from passing to the other locations.
Suitability for Sale, Finance and Transfer
Owning self-storage through an entity may make it easier to sell, refinance or transfer the asset later on, especially if you own multiple facilities. For example, if each site is set up as its own entity and you choose to sell one, it will be much easier for a buyer to perform due diligence, since all income and expenses are self-contained and there are no “related company” transactions to examine.
If you expect to use any securitized loan products such as commercial mortgage-backed securities in the acquisition or refinance of a facility, the lender will almost always require the asset to be part of a “bankruptcy remote,” “single asset” or “special purpose” entity. In short, it will want the only business activity carried on by the entity to be that relating to self-storage. This is because the lender needs to ensure the collateral and income stream are available to pay the debt service for the loan—it can’t be attached or spent elsewhere. It also wants to make sure the asset won’t be part of the debtor’s estate should the individual loan “sponsor” file for bankruptcy.
For estate purposes, it’s usually much easier to transfer the ownership interest of an entity than its underlying assets. If property is titled in an individual’s name and that individual dies, the state may require that his estate be “probated” before title can be transferred to a beneficiary under a will or heirs under law. However, an entity will continue to exist after the death of an owner, and the shares of stock, membership interests or partnership interests can simply be transferred on the books.
Other estate benefits can be enjoyed by using different entities and trusts. Consult a qualified estate-planning attorney to review your assets, liabilities and goals and decide which entity will be most advantageous.
It is part of human nature to avoid necessary expense, and many business owners prefer not to pay legal and accounting fees for something they can do themselves. But when it comes to setting up a business, it’s wise to invest in planning and advice. Failure to do so could result in expensive lawsuits or unnecessary tax ramifications. It always costs more to fix a mess than to set up the right entity from the start. Consider consulting an attorney and licensed accountant before you launch your venture, and you’ll be glad you did.
Will Farrar, attorney at law, is licensed in Colorado and Texas. He has been involved in self-storage as the developer and owner of numerous facilities since 1985. He is a past member of the Central-Region Board of Directors for the Self Storage Association and a past-president of the Texas Mini Storage Association. He practices law at the firm William D. Farrar PLLC in Tyler, Texas, and provides management and consulting services through Self Storage Advisors LLC. For more information, e-mail firstname.lastname@example.org; visit www.selfstorageadvisors.com.