Should You Hold Your Building in a Separate Company?

In the usual version, two companies sit side by side. One holds title to the real estate. The other runs the business and signs a lease as the tenant. Devine Millimet describes it with a pet store owner who forms one LLC to buy and hold the property and a second LLC to operate the store, with the property deeded to the first and the store becoming its tenant.

The same people may own both companies, but the two are legally separate. Rent moves from the operating company to the property company, and the property company uses it to pay the mortgage, taxes, insurance and repairs.

This guide covers the questions to raise, not the answer for your company. The right structure depends on how your business is taxed, who owns it, your state's law, your lender and your plans for an eventual sale. Tenant Advisory Group is a broker, so we do not give legal or tax advice. We flag the issue early because the name of the buyer belongs in the offer and in the purchase agreement.

The main reason given is separation of risk. Devine Millimet explains that if the operating LLC is found liable in a lawsuit, in most instances that liability flows only to the operating LLC's assets, and that holding the real estate and business in a single LLC would expose both to a judgment. Doeren Mayhew, a CPA firm, makes the related point that a creditor targeting your business generally cannot reach real estate held in a separate entity, and that the protection generally extends to bankruptcy.

The limits are just as important, and these sources state them plainly:

• Pledged property stays exposed. Both McLane Middleton and Doeren Mayhew carve out real estate pledged as collateral for business debt.
• Your own conduct is not shielded. Devine Millimet gives the example of an owner who negligently builds a porch that collapses, and says it is unlikely that owner can avoid personal liability.
• Insurance is still required. McLane Middleton says legal separation does not remove the need for adequate liability insurance for both entities.
• Formalities matter. Devine Millimet calls adherence to the LLC statute's formalities critical to the protection, and its example comes from New Hampshire law, so your own state's rules apply.

A loan can also cut across the separation. Ask each lender whether it will want a guarantee from the operating company or the owners. If it does, the structure may not separate your risk on that debt.

If the operating company is a C corporation, the sale of the building is a central question. McLane Middleton and Doeren Mayhew both explain that when a C corporation sells appreciated real estate, gain can be taxed at the corporate level and again when proceeds are distributed to owners, while a pass-through holding entity is generally taxed once.

Then there is the rule many owners do not hear about until later. IRS Publication 925 states that if you rent property to a trade or business activity in which you materially participated, net rental income from the property is treated as nonpassive income. An article in The Tax Adviser, published by the AICPA, explains the consequence: the income cannot be used to absorb passive losses from your other investments, while losses from the rental remain passive. Hawkins Ash CPAs describes the same asymmetry. If you hold other rental property that produces passive losses, this matters.

Hawkins Ash also notes that grouping the rental and the business as one activity may be available in some circumstances, based on factors such as common ownership, and that it depends on your facts. Publication 925 covers grouping under its appropriate economic unit rules. The Tax Adviser adds that the same reclassification can have favorable effects under the net investment income tax and the qualified business income deduction rules. Rules can change, so have your CPA run this on your numbers.

Bring your CPA in before the purchase agreement is signed. Changing the entity that holds a building after closing can raise lender, title and transfer questions you could have avoided.

A lease between related companies should be treated as a real lease. The Tax Adviser article warns that the IRS can recharacterize rent above fair rental value as a dividend in the case of a C corporation, can adjust rent that is too low, and that contemporaneous support for the rental amount appears crucial. Doeren Mayhew similarly ties the operating company's rent deduction to rent being reasonable.

That is one place a broker can help in practical terms. Market rent evidence for similar space, in writing at the time you set the rent, gives your CPA something to work with. The lease should also address the matters any lease would: term, renewal rights, who pays taxes, insurance and repairs, and what happens if one company is sold. Your attorney should draft it, and your CPA should review the rent.

Think about the far end of the term as well. McLane Middleton points out that separation lets you bring in investors or employee equity at the operating company without diluting ownership of the real estate, and lets you sell or gift the business while keeping the building and its rent. Doeren Mayhew gives the example of one child taking the business and another the real estate. If the operating company is sold, the lease becomes a contract with an outside party, and the terms you wrote for yourself will suddenly matter. The Tax Adviser also notes that self-rental treatment can continue for up to five more years after a sale of the operating company if the rental entity is retained.

The structure is not free. Doeren Mayhew lists the need to manage separate finances, tax filings and legal structures among its disadvantages. Expect separate bank accounts, a separate set of books, separate tax filings, and budget time for them.

Your loan can shape the decision too. Maynard Nexsen notes that in some circumstances a lender will require a new single purpose entity to hold the property, and advises leaving time to form any new company during or right after the inspection period. If you plan to use an SBA program or another specific loan, ask the lender how it treats a holding company that leases to your operating company before you form anything.

Work through these with your attorney and CPA. The answers feed directly into the name on your letter of intent and purchase agreement.

• ✓How is our operating company taxed, and what happens on a future sale of the building under each structure?
• ✓Who will own the property company, and is that the same group that owns the business?
• ✓Do any owners have passive losses that they hope rental income will absorb?
• ✓Will the lender accept the structure, and which company or owner must guarantee the loan?
• ✓Does the purchase agreement let us assign the contract to the new entity?
• ✓What rent is supportable, and what evidence will we keep?
• ✓What insurance does each company need, and who is named on each policy?
• ✓How would this work if we sold the business but kept the building, or the reverse?