A “New” Form of Entity for Pennsylvania Real Estate Transactions?

On behalf of Kaplin Stewart Meloff Reiter & Stein, P.C. posted in on Oct 25, 2016.

In Pennsylvania, the limited liability company has been in existence for over 20 years. A limited liability company is simple and relatively inexpensive to form, does not require the demanding procedural upkeep of a corporation, is very flexible in allowing its members to structure it to meet their specific needs, shields all of its members from personal liability, and can receive the same tax treatment as a partnership or Subchapter S corporation. Most owners of real estate in other states use the limited liability company as the primary entity for owning real estate. Notwithstanding all of these benefits, most people’s first choice to own real estate in Pennsylvania is still the limited partnership. The main reason for this is that in Pennsylvania, a limited partnership is exempt from the Pennsylvania Capital Stock Tax, and a limited liability company is not.

The Capital Stock Tax is a tax assessed on “corporations.” The term “corporations” is broadly defined to include certain other entities, including limited liability companies. Limited partnerships are excluded from the definition of “corporations” and are therefore not subject to the tax. Generally speaking, the Capital Stock Tax is a tax imposed on the capital stock value, or net wealth of a company, as derived by the application of a formula. The Capital Stock Tax is computed by multiplying the “capital stock value” of the entity times the “capital stock tax rate.”

The “capital stock value” is determined according to the following statutory formula: the product of 1/2 the sum of (1) the five year average net income capitalized at the rate of 9.5% plus (2) 75% of net worth, from which product shall be subtracted $160,000. The “capital stock rate” is currently 0.45 mills (00045). Through this formula, a limited liability company doing business solely in Pennsylvania that has $1 million of book net income and $10 million of book net worth would owe capital stock franchise tax of approximately $4,000. While this is not a significant tax (the millage has decreased significantly since the introduction of the Capital Stock Tax), real estate owners still need to discuss this tax with their tax professional prior to making a decision on the choice of an entity to own real estate.

The most common alternative to a limited liability company has been a limited partnership. With a limited partnership, each limited partner is also shielded from personal liability for the debts of the limited partnership. However, a limited partnership is required to have a general partner, which is fully liable for the debts of the limited partnership. Because of this, most real estate owners form a second entity, either a corporation or a limited liability company, to act as the general partner of the limited partnership. This requires a second set of organizational documents and agreements. Additionally, the limited partners are not permitted to exercise day-to-day control over the limited partnership at the risk of being characterized as general partners and therefore subject to personal liability. There is much less flexibility with a limited partnership as opposed to a limited liability company. If not for the Capital Stock Tax, most would prefer one-tier limited liability company structure over the two-tier limited partnership.

The Capital Stock Tax has been scheduled to be phased out many times in the past, but due to budget concerns, has survived. Currently, the Capital Stock Tax is scheduled to expire at the end of 2015, and it appears that this may actually occur. If the Capital Stock Tax actually expires, limited liability companies may become the primary Pennsylvania method for owning real estate, providing real estate owners with a “new,” and more flexible form of entity.