If you have a copy of Kim Lisa Taylor, Esq.’s Amazon best-selling book “How to Raise Capital Legally for Real Estate,” these topics are addressed on pages 176, 188-190, and Chapter 29 (How Cash Flows in a Syndicate or Fund). If you would like a free copy mailed to you, text the word SYNDICATE to (844) 796-3428.
Below is a summary of the control, tax, and liability reasons why you should have a separate managing entity for a Syndicate or Fund, versus naming yourself individually as a Syndicate or Fund Manager:
1 – Liability
If the investors sue the manager and the management team is comprised of individuals, they will sue each of you individually. As you have no LLC protection, they can sue you for any equity you have in your personal assets. If you use a Manager LLC, the most they can get is the value of your investment in the Manager LLC, with two exceptions: There is no limited liability for misdeeds (such as fraud, misrepresentation or theft) or for violation of securities laws.
2 –Taxes
- The manager entity earns fees, which are paid for your active role in management. The Manager LLC is not a member of the Investor LLC, so it receives a 1099 from the Investor LLC. The Manager LLC, in turn, issues a K-1 to each of its members. All earnings from fees are passed through to members of the manager, who will pay ordinary income tax rates plus self-employment tax on those earnings. This is the highest possible tax rate.
- The members of the manager (individuals or their own entities) are the Class B Members. Class B Members pay a nominal amount for their Class B Interests ($1,000) to establish a cost basis so that on sale, capital gains tax rates can be applied to the difference between their cost basis and earnings and are considered passive investments. Class B earnings from cash flow are taxed at ordinary income rates (but no self-employment tax — saves ~15%).
- If you combine all of these into a single K-1 (that includes earnings for your active role in management and for your passive role as a Class B Member), you are likely to pay self-employment taxes on all your earnings. The argument you would have to make to the IRS is that part of your earnings were active income and part were passive, and they should be taxed differently— and you may not win that argument. If you do it the way we suggest, you will report earnings from two different companies (the Manager LLC and the Investor LLC), each of which will be taxed differently, and you will never need to make the argument.
3 – Dispute Resolution
The most likely source of lawsuits or disputes in a syndicate is among the members of the management. We have seen this countless times. If the manager has its own LLC and operating agreement, the dispute is settled within the Manager LLC and the problem member can be removed without requiring a vote of or input from investors. If you name the members of the manager as individuals in the Investor LLC, and you want to remove one — first, we would have to incorporate provisions in the Investor LLC Operating Agreement as to how manager disputes will be handled, and second you may have to involve the investors, as any change in management would be a substantive change that they would have to approve. Investors get nervous about management internal disputes.
4 – Continuity
If you are named as the manager individually, and something happens to you (i.e., illness, death or incarceration), the investors have to get involved to vote to remove you and then appoint a new manager. They will be very nervous if this occurs. If the manager is an LLC that has other members (or a Springing Member that can take over management if you can’t perform), the entity still exists and business carries on without affecting the investors.
5 – Preservation of Class B Earnings
The way we have set this up is that the Manager LLC can be removed by a 75% vote of the Class A Members for willful misconduct or failure to perform. However, we have stated in the Investor LLC Operating Agreement that even if the initial manager is removed, it only gives up its fees (which can be paid to a new manager), but not the Class B earnings that the members of the manager own. For this reason, we recommend that the Manager LLC is NOT the Class B Member. The members of the manager are the individual Class B Members. If the management and Class B Members are the same, it will be easy for investors to argue that both the manager fees and Class B earnings should be taken away if a manager is removed.
6 – Lender Underwriting
We can structure a Manager LLC to be member-managed or manager-managed. We would use the manager-managed structure if less than all of the members of the Manager LLC are signing on the loan. Only the managers of the Manager LLC need to be underwritten and/or become loan guarantors. If individuals are named as managers, it is possible that a lender may require all of them to be underwritten and act as loan guarantors, regardless of ownership in Class B.
We hope this helps you understand the importance of using a separate Manager LLC. You are always free to ignore our advice — at your own peril.
We have written hundreds of offerings and we have had our offering documents reviewed by numerous attorneys, investors and CPAs. The CPAs we’ve talked to agree that this structure is the least likely to end up with you paying more taxes than you should on your earnings from a syndicate, without putting your profit-share earnings at risk or involving investors in management disputes.
