Summit 6 Legal is proud to be a sponsor of the Gates Tennis Center in Cherry Creek. No animals were harmed in the making of this banner ad (we cannot say the same for tennis balls).
Summit 6 Legal is proud to be a sponsor of the Gates Tennis Center in Cherry Creek. No animals were harmed in the making of this banner ad (we cannot say the same for tennis balls).
Most residential real estate transactions are handled by real estate brokers. Traditionally, sellers execute a listing contract with a seller's broker who, in return for a commission of around 6% of the sales price, markets the seller's property on a multiple listing service (MLS). Brokers representing buyers then show their clients properties of interest. When a sale closes the brokers split the commission. One common exception to the standard process described above is when a "transaction broker" represents both parties. Today, to stay competitive, many brokerage firms are starting to offer flat fees for facilitating transactions. Most straight-forward residential deals don't necessitate an attorney being involved on either side. My opinion is that in most instances, competent brokers are more than capable of facilitating real estate transfers using the form contracts produced by the Colorado Real Estate Commission (CREC) for that purpose. Also, brokers have access to resources such as the MLS, their own property databases and word of mouth intel on properties coming to market that real estate attorney can't provide. The best brokers also bring marketing expertise and property staging expertise to their clients. Therefore, until recently, my involvement in residential deals has typically been limited to helping buyers and sellers and their brokers in transfers involving high value, luxury class properties that involve significant changes to the CREC contracts, or in sales that have become contentious or involve some problem or extraordinary circumstance. So far this year has been different noticeably different.
While the bulk of my law practice remains focused on commercial real estate deals, finance and leasing, lately more buyers and sellers are asking me to get involved with their straight forward residential deals on the front end. While I'm happy to help; I've also been curious why the volume of this work has increased so noticeably. I perceive several reasons for this increase in residential deal work. obviously, since leaving big firm life in January, I'm closer to the ground (both literally and figuratively) with office space in a building dominated by younger, dynamic entrepreneurs and tech oriented tenants so, I find myself talking to a variety of people and fielding questions about real estate throughout the days rather than talking to the same old people every day, and some of these conversations lead to residential work as these folks are looking for homes in a tight market. Its no secret its a seller's market around Denver these days, with quality properties going under contract very quickly (often 24 hours or less) and commonly escalating into bidding wars. Ready buyers abound and the higher the sales price, the larger the commission due from the seller at closing; consider that 6% of $400,000.00 is $24,000.00. With buyers easier to find than ever and the supply of available properties at an all time low, I see sellers foregoing the MLS and coming together with buyers on their own through alternative means such as Zillow or most often, through word of mouth. These sellers and buyers need someone to draft the contracts, deeds and other paperwork necessary to transfer the property and to coordinate closings with a title company - that is where I come in.
One fact that many people outside the real estate world don't realize is that brokers don't actually draft contracts. While they offer many services a lawyer can't (see above), when it comes to drafting they simply fill in the blanks on CREC form contracts. They are actually forbidden by law to make changes to these forms other than filling in the blanks and their forms are locked. I use the same CREC form contracts as the brokers but, as a licensed attorney I have access to alterable MS Word versions. That makes these deals fun for me since I can make some changes to these contracts that benefit my clients! Since I can draft contracts and coordinate a straightforward residential closing for in between 4 to 8 hours of total attorney time, regardless of the purchase price, the sellers I work with are usually very happy that my legal fees are substantially less than the brokerage commission would have been! Buyers can also benefit from that fact and sometimes use it to bargain for a price reduction. The two most common situations where I find myself drafting residential contracts for sellers and buyers these days are: when a landlord wants to sell their condo or town-home to their tenant; and when a seller is providing the financing for the buyer and taking back a note and deed of trust at closing. I'm always happy to help sellers and buyers close residential property sales.
Did you know that operating a private home as an Air BNB, VRBO or as a similar short-term rental property, is currently illegal in the City of Denver? Denver’s zoning code specifies the types of uses that are allowed as accessory to residential use and in almost all cases, short term rentals of 30 days or less (“STRs”) aren’t listed. The city’s position is that currently, these short term rentals are not allowed under most residential zone districts but the city also does not enforce the prohibition. According to an April 7, 2016 letter to the city from the Denver Short Term Rental Alliance, to date the city has only received six (6) complaints about STRs. One exception is that in mixed use commercial zone districts, an STR may be allowed as a “lodging accommodation” if the owner obtains a zoning permit and complies with relevant parking and building ordinances.
Tonight the Denver City Council is scheduled to vote on two bills: one would revise Denver’s zoning code (CB16-0261) to permit short term rentals in an owner’s primary residence; and the other, a companion bill (CB16-0262) would enact a licensing and regulatory framework for short term rentals in primary residences. As drafted, the zoning code amendment is expressly conditional upon passage of the companion bill. As drafted, the proposed zoning code amendment legalizes STRs in primary residences. By preventing owners from using investment properties and vacation homes as STRs, Denver’s zoning ordinance limits owners to a single STR. The intent to prevent investors and businesses from operating STR portfolios or STR investment properties in residential neighborhoods underlies the proposed ordinances which expressly forbid STRs operated by entities such as corporations or LLCs, joint ventures or associations. While owners may be absent during the short term occupancy, as drafted the proposed zoning amendment expressly requires that owners live in the residence. The companion bill would delegate authority to the Denver Department of Excise and Licensing to license and regulate STRs. In addition to numerous other requirements, under the proposed licensing ordinance STR owners will be required to apply for a license, register with Denver Excise and Licensing and obtain a lodging tax identification number. Lodging taxes on STRs would be the same as for a hotel room (10.75%). Additionally, if the bills are passed, STR owners will be required to maintain fire, hazard and liability insurance at levels set by Denver Excise and Licensing, maintain a minimum level of life safety systems in a residence used as an STR, and include the STR license number in all advertisements. The fee for the STR license will be $25.00 per year and fines for advertising without a license and/or operating without a license will be up to $999.00 per incident.
In the two-year run up to the vote, council members and staff received varying input from numerous parties running the gamut from individual homeowners and neighborhood associations to property investors and short term rental industry groups. Much of the feedback received by the city characterizes the primary residence requirement as anti-small business and complains about the increased regulation of private property, increased taxes and favoritism toward the hotel industry. The Denver Short Term Rental Alliance’s letter states that the primary residency requirement will effectively lock VRBO (Vacation Rentals by Owner) out of Denver and the city will be deprived of a significant tax revenue stream. Proponents of the primary residence requirement feel it is appropriate in that it limits STRs to small businesses that generate supplementary income for homeowners and cite concerns about investors buying up entire blocks or apartment buildings and operating them as STRs in otherwise primarily residential neighborhoods. In general, they feel such operations would pose a risk to public health and safety and detract from the quality and vibe of Denver neighborhoods; the obvious concern being strange cars and stranger people steadily coming and going.
A seemingly simple issue on its face, legalizing STRs in Denver has broader implications. If the council votes in favor of these bills tonight, individual owners renting out a room or garage apartment on a short term basis, as a means of earning supplementary income will be permitted to continue doing so and now, legally, although now subject to applications, annual reporting and taxation. Owners operating investment properties as true STR businesses, or desiring to do so, have been kicked out of the pool in the interest of protecting neighbors who own or who are traditional renters. The STR game in Denver may be more exclusive and predictable by the end of the day; and also more expensive to play. One cannot help thinking that many STR owners will miss the days of the wild west.
This is the second in a series of three posts concerning LLC basics; the first covered operating agreements, this one covers taxation and a future post will cover liability protection and piercing the corporate veil.
Working with entrepreneurs in real estate and other realms is a lot of fun because it affords many opportunities to listen to the plans and ideas of creative and intelligent people and and assist them with making those plans a reality. Almost daily, people call or sit down across from me and want to talk about creating an LLC. The plans for the entity and experience of the clients vary. Sometimes, they are financially savvy and/or they’ve talked extensively with tax advisors in advance and have a solid understanding of LLCs, why that entity will work best for their purposes and exactly how it needs to be structured to reap the maximum benefit for them and their co-venturers. Other times they haven’t thought about entity formation much beyond knowing they need one and they’ve heard that LLCs are a great choice from a tax perspective. To me, the first scenario is always preferable because while I can describe the different ways that various entities, including LLCs, will be taxed, I don’t purport to advise clients on the consequences the taxation regimes will have on the various members, partners or shareholders. When it comes to planning the structure of an entity, all but the most sophisticated clients are best served by working with a team of advisors which includes, at a minimum, an attorney, a business CPA and a financial advisor. Depending on the entity chosen, income generated or losses incurred are treated differently for tax purposes. Let’s take a close look at how the IRS treats LLCs and some of the basic structuring options that are available to owners that choose to operate as an LLC.
The IRS treats single member LLCs as disregarded entities. The entity does not file a return. From a tax perspective, it’s as if the LLC doesn’t exist. As with a sole proprietorship, the member simply attaches a Schedule C reporting the profits or losses of the business to their individual tax return. Unless the LLC elects to be taxed as a corporation, LLC income is passed through to the member and is taxed as his or her individual income. Unlike single member LLCs, corporations are treated as separate entities by the IRS. As such, C corporation income is taxed at the corporate tax rate and when part of that income is paid to shareholders as wages or salaries, it is taxed again at the individual tax rates (unless the corporation is an S corporation); this is the infamous “double tax” synonymous with doing business as a C corporation. So, if a single member LLC is taxed like sole proprietorship, which doesn’t require any formalities, why form and operate under an LLC? Unlike with a sole proprietorship, the members of a properly organized and operated LLC are insulated from the debts and liabilities of the LLC. For that reason alone, in most cases creating and operating as an LLC is worthwhile; certainly if there is any possibility of exposure to third party liability.
Unlike single member LLCs, the IRS recognizes multi member LLCs as reporting entities, like a partnership. They file a separate return, but the multi member LLC’s income or losses are passed through to the members rather than taxed to the LLC itself. In common parlance; pass through entities such as partnerships, multi member LLCs and S Corps are tax reporting but not tax paying entities. The pass through is accomplished by attaching Schedule K-1s to the LLC’s tax return describing each member’s pro-rata share of the LLC’s income.
One thing to bear in mind when evaluating choice of entity and whether an LLC is the best entity form for a business is that the most substantial tax savings realized by LLC members is often not on income taxes. Individual and corporate tax rates are not widely disparate until income amounts are very high; that isn’t a problem commonly suffered by early stage companies. More substantial tax savings can be realized by LLC members if the business expects long term capital gains or if it incurs losses. The individual tax rate on long term capital gains is 15% for all but top earners. Conversely, corporate long term capital gains are taxed at the corporate income tax rates: 15% on the first $50,000, 25% on the next $25,000, 34% on the next $25,000 and then 39% on the next $235,000.
At the risk of stating the obvious, many startup companies and early stage businesses experience losses in their early years. If an individual is a member of an LLC with losses and that person has other alternative sources of income, it may be possible to offset the LLC’s losses against that other income and/or completely eliminate income taxes otherwise due. Each business and its principals have a unique equation so, it’s important to closely scrutinize choice of entity. That being said, the advantages with respect to treatment of losses and of long term capital gains present a strong case for many early phase businesses to utilize an LLC instead of a corporation.
At this point, you may be wondering ‘why not elect corporate taxation and file an S election so the business can utilize the corporate structure, benefit from a liability shield and obtain pass through treatment for income tax purposes?’ Additionally, S Corporations have an employment tax advantage. Wages and salaries paid to S. Corporation shareholders are subject to employment taxes, paid through withholdings, but not other S. Corporation income reported on a shareholder’s K-1. The S. Corp can hold back income for reserves or capital acquisitions and avoid employment taxes on that corporate income when it’s distributed as dividends or when shareholders sell their stock. Despite other tax advantages, LLC’s aren’t ideal when it comes to employment taxes. All LLC income is treated as wages to the Members and as such it subject to employment taxes. In 2016 the rate is 15.3% on net income up to $118,500.00 and 2.9% of the rest.
Still with me? In summary, subject to exceptions based on circumstances and plans, an LLC is often better than a C corporation for early phase businesses but LLC’s do not enjoy, at least not readily, certain tax advantages enjoyed by S corporations, such as employment tax savings. S corporations also enjoy tax free reorganization benefits that are especially attractive in certain acquisition contexts. If you are thoroughly caffeinated, you may now be wondering why one would consider an LLC when it’s possible to obtain pass through taxation and employment tax advantages by incorporating as an S corporation. The short answer is, it’s not that simple! S corporations have several disadvantages, mostly in the form of restrictions, that LLCs do not suffer from. To name a few big ones: S corporations may only have a single class of stock; unlike LLCs, S corporations can’t use special allocations to assign disproportionate losses (or gains) to certain shareholders that may want those losses; and likewise, S corporations must distribute their income pro-rata, according to share ownership. This last restriction, when combined with the first, makes preferred returns very difficult. In short, S corporations afford many of the same benefits as LLCs, as well as some notable extras such the employment tax advantages, but they are much less flexible than LLCs from a structural standpoint. At some point, I’ll do a post examining the relative advantages and disadvantages of S corporations, but, sticking to the theme, LLC basics, there is a final twist: LLCs, even single member LLCs, may elect corporate taxation, then file an S Election and thereby enjoy the employment tax benefits of the S. corporation structure!
When an LLC makes an S election it agrees to play by the S corporation rules. That can be a non-starter for many businesses; it’s a decision that should be carefully evaluated. An LLC that elects corporate taxation may not change back for 5 years and then must wait 5 years before it may again elect corporate taxation (i.e., a company cannot pick and choose based on how any given year is going). Further, changing back to an LLC is treated as a liquidation which can be a taxable event.
This blog only scratches the surface, the waters become deeper and murkier fast. There are many nuances that are not addressed here in the interest of sticking to the theme. Ideally, when working with clients on choice of entity matters, its best for attorneys who are not tax specialists (such as myself), to work with a team comprised of a business CPA and/or a financial planner, at a minimum. While most business attorneys should understand and be able to explain the basic tax methodologies applicable to different business entity forms, a CPA or tax specialist should consider and advise clients on all the nuances and how they impact a particular client’s overall financial picture. Thanks again for taking the time to read the Summit 6 Legal blog.