When an entrepreneur starts out on his/her long journey of building a legacy with his business; he/she almost immediately focuses on the legal status of his business. Thoughts include: ‘Should I become a limited liability company or an S-Corporation?’; ‘What if I take on partners?’; ‘How do I get more capital without giving up control?’
A limited partnership is a form of entity status where one of the partners is limited (restricted) in the management affairs of the business. With limited partnerships, only the general partner(s) can operate and manage the business. Limited partners generally only have a financial risk limited to their respective investment.
Real estate syndication is how apartment or office complexes are financed? A typical complex will have 80 to 100 units and the cost of construction will approximate $7,000,000. Where does this money come from? Your average person will think it is financed by a mortgage of some sort. Well, this is partially true, but mortgage companies will not finance 100% of the cost of construction. More like 75% maximum financing is used in constructing complexes. The balance has to come from private money.
This is where the value of real estate syndication comes into play. The arrangement is usually a two tier relationship whereby an operating partnership is created that actually owns and operates the asset (the complex). The second tier is a silent partner in the operating partnership. The following sections explain these two tiers in more detail.
Every partnership consists of at least two or more partners. In many partnerships, there are dozens of partners. Each partner is classed into a particular group. There are Limited Partners, General (sometimes referred to as Operating) Partners and of course somebody who is in charge – the Managing Partner. Each of these classes of partners has some form of financial, fiduciary and appointed powers.
Those small businesses using partnership or S-Corporation formats issue Form K-1 to the respective owners. When income is assigned to the owner and there is no corresponding cash related to that income, then this income is referred to as ‘Phantom Income’. In effect, it is assigned income for tax purposes without the corresponding cash to pay the tax liability.
Each of us has our own built in dictionary for terms we hear in our business lives. I find it fascinating that the standard business term ‘Equity’ is interpreted differently within the business world. I often interpret the term using the Internal Revenue Service definition because my background is in taxation. Lawyers use this term to mean ownership and not necessarily financial driven. Bankers convert this term to capital and the associated relationships to debt.
There is a tremendous amount of information to convey to fully understand partnership agreements. This is the first in a series of articles related to partnership agreements. Throughout this series I will explain the various sections and issues a small business owner faces in creating a sound and fair agreement with a single or multiple partners.