Chapter 9 – Business Organizations
TABLE 9 – 1
Comparison of Business Organizations
Advantages and Disadvantages
1. Sole Proprietorships: The sole proprietorship is the simplest business organization, and can quite
literally be formed by declaration at the moment an investment piece of real estate is acquired by an
investor. It has the additional advantage of all income and expenses flowing directly through to the
taxpayer/proprietor. A major disadvantage is the exposure of the proprietor to individual liability for all
the debts or obligations of the “business.” The proprietorship terminates upon the death of the founder,
and capital access is limited to the wherewithal of this founder. Ownership transfer, cash distribution and
asset sales are at the discretion of the founder, subject to credit and mortgage requirements.
2. General and Limited Partnerships: The general partnership is a stepped-up version of the sole
proprietorship in most states, and involves additional tax and administrative duties beyond those
required of a sole proprietorship. Income and expenses flow through to partners, according to partnership
agreement, based typically upon the relative investment in the partnership by the partners. Partners are
subject to taxes and liabilities deriving from the partnership, independent of any cash distributions.
Capital access is limited to the partners, and the partnership may terminate upon the death of a partner.
Partnership interests are not easily bought or sold. A limited partnership, used commonly in real estate
investments in the early to mid 1980’s, limits the liability of the limited partners to the capital invested,
but limits their income potential, as well. Limited partnerships were often employed to allow passive
investment by high-income investors in real estate deals whose primary appeal were the pass-throughs of
substantial tax write-offs against marginal tax rates at the time of 50% (or more, including state taxes).
Many limited partnerships were disallowed by the IRS in the late 1980’s. The limited partnership has
been largely displaced by the LLC in obtaining the same or superior objectives in the late 1990’s and
2000’s.
3. Limited Liability Company (LLC): The LLC is a hybrid between the corporate and partnership forms
of business organization. It is allowed in all 50 states, though modest administrative differences exist.
An LLC investor is a member, not a shareholder. The largest advantages include: the flow through of
income and losses; the allowance of members that are not individuals; the separation of the owners from
direct liability; and the easier transferability of ownership interests than a partnership, typically
according to the by-laws of the LLC. Gains and losses flow through to investors based upon their
percentage investment in the property acquired by the LLC. It is governed by a managing member,
typically elected by a majority vote of membership interests. Its disadvantages include: capital access
limited to the owners’ wealth; the frequent requirement for personal guarantees of LLC mortgage
funding; the potential ease of “piercing the corporate veil” of the LLC; and the misallocation of LLC
resources by the managing director.
4. Real Estate Investment Trust (REIT): The REIT was created with federal legislation passed in 1960
to allow the accumulation of capital to fund large-scale real estate investment. Founded and managed
largely like a typical public corporation, the REIT is afforded special tax treatment if: 75% of the assets
and income of the REIT are derived from real estate or mortgages; no less than five shareholders control
50% of the REIT; and a specified portion of the REIT’s income or funds from operations is paid out in a
non-qualifying dividend each year. The greatest advantages of the REIT are the non-payment of taxes at
the corporate level, the liquidity of the REIT shares traded on the stock exchanges, and the substantial
availability of capital. The clearest disadvantages are the agency costs suffered with any large company.
5. General or C-class Corporation: Large corporations, such as those traded on the organized stock
exchanges, are often note well-suited for firms dedicated primarily towards real estate investment. The
primary advantages of the general corporation is the liquidity of the ownership interests, as the shares
can be bought and sold with some ease, and the access of the firm to substantial capital though stock or
bond sales. Real estate assets are not highly liquid, but publicly-traded common stock is. The major
disadvantages include the double-taxation of income, at the corporate and personal level as dividends are
distributed, and the agency costs arising with the separation of owners from management.
6. Subchapter S Corporation: Like the LLC, the Sub-S is a hybrid exhibiting features of both
partnerships and corporations. The Sub-S has the primary advantages of a pass-through of income or
losses, and modest (though penetrable) protections against the liabilities of the business for the
shareholders. Disadvantages include restrictions on ownership to individuals, the limited ease of
ownership transfers and shareholder tax obligations independent of cash distributions by the Sub-S. This
form has been largely supplanted by the LLC for most real estate investments that might previously been
pursued using the Sub-S form of business organization.
Selected chapter 9 objective practice questions:
1. All of the following items might be considered disadvantages of a general partnership EXCEPT
(A) the partnership itself pays no income tax
(B) each partner has unlimited liability for partnership debt
(C) partnership can be terminated by the death of a partner
(D) an interest in a partnership is not easily sold
2. Perhaps the greatest advantage of an LLC over a Sub-S corporation is:
(A) that a non-living entity like a trust or other corporation can be a member of an LLC, whereas
only a living person can be a shareholder in a Sub-S.
(B) the number of eligible investors in an LLC is unlimited, whereas it is limited to 35 for a Sub-S.
(C) Sub-S ownership is restricted to shareholders in a single state, whereas LLC members can come
from various states, or countries.
(D) LLC bylaws are the same nationwide, whereas Sub-S rules vary by state.
3. The ownership of a corporation is evidenced by
(A) ownership of corporate bonds
(B) a written contract filed with the chartering state ,
(C) ownership of shares of corporate stock
(D) a valid corporate purchase agreement
4. When a partnership files its Form 1065 tax return, each partner is liable for paying taxes on
(A) only the cash received as income during the tax year
(B) his or her share of income whether or not received
(C) only qualifying dividends
(D) only the salary received during the tax year
5. All of the following may be considered advantages of the corporate form of business EXCEPT
(A) the life of a corporation need not be limited
(B) corporate shares of stock are more easily sold
(C) the shareholder has limited liability
(D) both corporate income and dividends are taxable
6. An S corporation or LLC offers a special advantage not available to a regular C corporation, which is
that it
(A) pays no corporate tax
(B) pays no dividends
(C) has no corporate indebtedness
(D) is not required to hold stockholder meetings