Buyer’s Due Diligence When Buying Real Property

By: Tamara B. Pow, Esq.

Buyer’s due diligence is the process of inspecting all aspects of a property to determine whether or not buyer wants to purchase it. This could start before a purchase agreement is signed, but usually occurs during the period of time provided in the purchase agreement. The seller may have the buyer enter into a due diligence access agreement before allowing the access of the property. This due diligence period usually lasts between 30 to 45 days or more depending on the purchase and sale agreement.

Step 1- Gather documents with the Seller

First step is to get documents organized. It is best to arrange a way to receive all documents and information relating to the property. This can include title reports, deeds, easements, rental leases, and restrictions on the property. Getting documents before a purchase agreement is signed can help the buyer determine how long the due diligence should be, budgeting for each party, and the necessary physical inspections needed to complete the deal.

It is also important to note the type of entity that will take title to the property. For example a limited liability company (LLC) limited partnership (LP), corporation, or possibly a joint tenancy between multiple parties. There are different benefits and limitations with each form depending on the buyers intent, use, and future use of the property, as well as tax considerations. Although these are not documents obtained from the seller, buyer should not wait too long to make these decisions or it could delay the closing.

Step 2- Research the property

Get the inspections rolling. Start scheduling the necessary property inspections as soon as possible because organizing an inspector could be delayed depending on the inspector’s schedule.

Research all recorded and unrecorded documentation that would limit the use or provide information about the land. This includes: documents in the chain of title, current land survey, reciprocal easement agreements, and covenants, conditions, restrictions on use and operation of the property, permits, licenses, subdivisions, zoning reports, and liens. It is very important to ensure that the buyer will not be restricted from using the property the way they intend to use it. Research and inspect the environmental status of the land to ensure there are no pending fines or issues that have not been addressed. This could be a very costly expense if not properly researched.

Research third party property agreements. For example property management, brokerage, leasing , development, and asset management agreements, as these items will need to be reviewed to ensure these documents could be assigned or transferred if the buyer wants these agreements to remain in place, or cancelled if buyer does not want them.

Check the title insurance policy to know what is covered and check if there are any exceptions that are of concern.

Step 3- Finances

Get copies of the financial records including rent roll, appraisals, financial statements, budgets, property tax bills, tax returns, and assessment notes.

After researching the property the buyer will have a better idea of the potential investment including any necessary remediation, deferred maintenance, etc. Further, understanding the taxes and financial statements from the property gives the buyer a clear picture of the cost and benefits of the property.

After buyer completes due diligence and understands the limitations, costs, and benefits about the property, buyer can decide whether or not to proceed with the purchase agreement. The provisions of the purchase and sale agreement are critical to make sure buyer can get out of the agreement at little or no cost if due diligence turns up some unpleasant surprise.

**This information is limited in scope to a fictitious scenario, and a buyer interested in a property should seek adequate and competent representation to ensure the buyer understands and completes proper due diligence.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be address directly to Strategy Law, LLP.

The Buyer’s Checklist to Buying Commercial Real Estate in California

By : Tamara B. Pow, Esq.

Although each of these topics can be expanded on extensively, this is a good overview of the steps you should consider as a buyer of commercial real property in California. Your broker should help you obtain needed items and a real estate attorney can review them to make sure you are protected from the many potential risks in any transaction.

1) Find a Real Estate Broker & Enter into a Brokerage Agreement

  • Find a Real Estate Broker licensed in CA
  • The Broker should be well-versed in the type of property and location the buyer intends to buy
  • The Broker has a satisfactory history of real estate transactions
  • Make sure the scope and representation of the Broker is clear in writing (CA. Civ. Code §§2079.13)
  • Who pays the Broker (Seller/Buyer?) (in CA each party usually pays their own broker)
  • Determine the terms of the transaction (see brokerage agreement blog )

2) Due Diligence

Getting the deal started – either with or without a letter of intent:

  • Arrange meetings with Seller to receive all documents and information about the property.
  • Buyer sends due diligence list to Seller
  • Determine the scope of the due diligence including: length, budget, physical inspections testing

Establish funding/lending & Inspections

  • Buyer does property inspections
  • Title search, and chain of title, including: current ALTA/NSPS Land Title Survey, vesting deed, reciprocal easement agreements, covenants, conditions, and restrictions, easements, and deed restrictions that affect the property’s development and redevelopment, use, operation, maintenance, and access. (Usually reviewed by real estate counsel.)
  • Check entitlements for real property including: variances, conditional use permits, costal development permits (if location is by coast), shoreline development or use permits issued by local agencies, compliance with CA environmental Quality Act (CEQA), check California Land Conversation Act of 1965, check any local unreinforced masonry (URM) ordinances
  • Zoning confirmation letter

Paperwork

  • Get copies of agreements that are binding on the property; including: Joint venture agreements, organizational documents, good standing certificates, certificates of statue, consents, loan documents, guaranties, 3rd party property agreements, leases, occupancy agreements, tenant estoppel certificate, licenses, and services contracts
  • Tenant Estoppel certificates, subordination, non-disturbance, and attornment agreements

Financial/Tax

  • Get copies of financial records; including: rent rolls, appraisals; financial statements, budgets, tax bills, tax returns, and assessment notes
  • Check tax impacts that will result from the acquisition of real property

Permits

  • Permits including: certificates of occupancy, building permits, and liquor license
  • 3rd party approvals or consents

3) Purchase and Sale Agreement

Entity-Who is buying the property (Example: LLC, LP, Tenancy in common or Corporation or multiple parties as tenants in common)

Review the purchase and sale agreement (Broker form or Attorney Drafted)

  • Sale price, financing, 3rd party approvals or consents, leases…
  • Pre-closing terms (conditions, covenants, due diligence, closing deliveries),
  • Post-closing terms (escrow, holdbacks, adjustments)

Special Considerations for CA

  • State statutory disclosures: natural hazards, electrical usage, hazardous substances
  • “As-is” clause (Civil Code § 1542 release)
  • Liquidated damages
  • Warranties
  • Broker’s fee clause
  • Allocation of city and county transfer taxes
  • Independent considerations clause

Contingencies

  • Contingencies: subdivision of property, financing, entitlements, conditional use permits, 3rd party approvals or consents, any other items of concern.

Closing

  • Scheduled date for closing, documents are exhibits
  • Consider maturity date of any financing commitment, any 1031 exchange deadlines, buyer’s loan financing

Restrictions

  • Seller’s right to continue to manage and operate property before closing (new leases, property agreements, and service contracts)
  • Local law

4) Pre-Closing

Between signature of the Purchase and Sale Agreement and before closing

Complying to agreement

  • Liens
  • Statues/regulations compliance
  • 3rd party consents
  • Contingencies, and objection letters
  • Any internal entity matters are completed before closing
  • Make sure the necessary consents, waivers, estoppels and other notices are complied with before closing. (tenants, or other property related agreements)

Finance – review and approve loan documents

  • Escrow – CA uses escrow for closing
  • Get all legal property documents in order

Buyer name (Who is signing?)

  • If it is an entity buying the property – ensure entity is in conformity with CA and registered with Secretary of State and ask escrow if you need to obtain a good standing certificate.
  • Any internal entity matters are completed before closing
  • Deliver organization and authority documents to the title company and lender for approval before the closing

5) Closing

Organization

  • Have a calendar of important dates or expirations of contingency periods
  • Review documents: rent, utility charges, taxes, contracts, operating expenses, leasing brokerage commissions, tenant improvement allowances, deposits, attorney fees, insurance
  • Tenant notice letters
  • CA form 593-C
  • Track documents and deadlines; including: utility reading before cut-off time, inventories, cut-off times for sending money wires, receipt of property files and other related files, keys, passcodes, assumed service contracts, and receipt of any estoppel or SNDAs

Disbursements

  • Title costs and escrow fees based on the final bill prepared by the title company and escrow holder, survey costs, real estate taxes and assessments, utility charges, attorney fees, insurance premiums, brokers fees, due diligence fees
  • Include payoff amount of Seller’s existing debt, deposits on the closing statement, and amounts that Buyer’s lender will fund at closing

Title

  • Check the deed
  • Check the transfer tax declaration and PCOR
  • Check with county recorder that closing documents are recorded
  • Confirm the list of documents required by the title company, Seller, and lender
  • Ensure the person buying (if an entity) is in good standing
  • Check good standing certificate or a certificate of status, organizational documents
  • If it is a foreign entity- confirm it is qualified to do business in California
  • Have consents or resolutions authorizing the transactions
  • Title insurance endorsements

Get all required parties to sign

7) Post-closing

  • Have a calendar to track dates; including: Receipt of final title insurance policy, final survey, recorded documents, expiration of any post-closing indemnity periods, and release of any escrow funds
  • Ensure all payments are made, with a receipt marked ‘paid’
  • Ensure notice to tenants and service contract providers are delivered promptly after closing

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

The Brokerage Agreement – What To Look Out For?

By: Tamara B. Pow, Esq .

When buying a commercial real estate property, the brokerage agreement is the agreement between you (the buyer) and your broker. For the buyer, it is in your best interest to get this agreement in writing, and have it reviewed by a real estate attorney to ensure the best outcome and to have a document that states each parties duties but doesn’t give the broker more than is necessary. For the broker it is required to get the agreement in writing in order to receive the brokerage fee. Any transaction that involves real estate must be in writing to be legally binding. (Cal. Civ. Code §1624(d)).

The broker is an agent of the buyer or seller. An agent simply means that the broker can act on behalf of their client – the buyer or seller. (Cal. Civ. Code §2079.13). Sometimes the broker could act as a dual agent, meaning the broker represents both seller and buyer. If this occurs, be sure to read the brokerage agreement thoroughly to ensure the broker will represent your interest in the transaction. It is advisable to hire a real estate attorney to represent you if your broker is a dual agent.

The benefit of the brokerage agreement is a clear communication between the buyer and the broker. It is a great opportunity to discuss who will perform what tasks. Some tasks to discuss include:

  • Time limitations or expectations of tasks to be completed.
  • How and when the broker will be paid?
  • What kinds of expenses the broker and the client will pay and what will the cap be on these expenses?
  • When will the broker’s representation end?
  • Will the broker be a party to another transaction after the sale is complete? For example leasing the property or finding tenants after the transaction.
  • The attentiveness of the broker and response to notifying the client on progress of the transaction.
  • Indemnification – the broker will seek to be indemnified from the clients acts and as the client you should check that you will not be held responsible for the broker’s act. Because this is an agency relationship, it is important as the client to communicate clearly to the broker on what representations or statements the broker can make on your behalf as buyer or seller.
  • Documents – Who will retrieve any documents that would disclose defects, title validity, improvements, zoning, or environmental issues of the property?

If a disagreement arises between the broker and the client, and the client wants to change brokers, it is best to revoke or terminate the past brokerage agreement before signing a new brokerage agreement. This way there is clarity regarding which broker is representing the party. Failing to do this could result in you having to pay a commission to more than one broker on the same transaction.

The brokerage agreement is a formal agreement between the buyer/seller and the broker. If any dispute should arise between these two parties, this agreement will be the source to understand which duty each party had in the agreement. A real estate attorney can assist you in reviewing and revising the broker’s form, which could otherwise favor the broker to your detriment.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

California Bureau of Real Estate Releases Warning to Real Estate Salespersons Who Mislead Consumers into Believing That They Are Brokers and to the Irresponsible Brokers Who Allow Such Practices

By: Tamara B. Pow, Esq .

Back in September of 2015, the California Bureau of Real Estate ( CalBRE ) released a warning, officially known as a supplemental disciplinary advisory, to salespersons working in real estate who illegally mislead consumers into falsely believing that the salesperson is a real estate broker, as well as an additional warning to actual brokers who permit or support such practices by these salespersons.

Real estate brokers, salespersons, and consumers should review this warning and the hypotheticals below. According to CalBRE, these unlawful practices have continued to occur, to the potential detriment of consumers.

Under CA Business and Professions Code Section 10139, any person pretending to be a real estate broker without a license or license endorsement, or who advertises as such is guilty of a public offense punishable by a fine of up to $20,000 or by imprisonment for a term of up to six months, or both. If this violation is committed by a corporation, that fine can increase to $60,000. Additionally, under Section 10140, a violation for false advertising is punishable by a fine of up to $1,000, imprisonment for up to one year, or both. As mentioned in the issued warning, the Commissioner of CalBRE may also suspend or revoke the license of any broker who is guilty of one or more of these offenses. In regards to prosecution, under Section 10130, it is the duty of the District Attorney of each county in this state to prosecute all violations in their respective counties in which the violations occur.

CalBRE has specifically outlined two examples in which these violations typically occur. The first hypothetical is a salesperson who uses a fictitious business name that would lead consumers to think that this business is operated and managed by a real estate broker. For this scenario, let’s call this salesperson John Doe. John Doe conducts business using the name Doe Real Estate. John Doe then advertises his business with that name, and supplements these advertisements with a webpage or other tangible tools. This unlawful practice allows consumers to believe that John Doe is a real estate broker or brokerage firm and not a salesperson who must be supervised by an actual broker when conducting these activities.

The second illegal scenario is Jane Doe or a team of Jane Does branding or identifying themselves as independent real estate practitioners. It is illegal for salespersons to act and/or advertise as an independent entity in real estate. Teams must disclose the name of the responsible broker or brokers, at least one responsible broker’s license number, and use at least one of the responsible brokers’ surname in the title of the team’s name, along with the terms “team,” “group,” or “associates.”

The use of a fictitious name for a real estate firm is itself not illegal (See definition of “Fictitious business name” under Business and Professions Code 10159.7(a)(2)). However, under Section 10159.7(a)(5)(C), a fictitious business name may not include the terms “real estate broker,” “real estate brokerage,” “broker,” “brokerage” or any other obvious term that would lead a member of the public to conclude that the team is offering real estate brokerage services.

Furthermore, salespersons who are active in real estate license activities in the state of California must be affiliated with and reasonably supervised by a responsible broker. Reasonable supervision is defined in CalBRE’s Commissioner Regulation 2725. Incidentally, one of the activities that qualify for broker supervision is reviewing any and all advertising done by the broker’s salesperson or salespersons. Irresponsible brokers who otherwise allow for unlawful practice are also liable and will face similar discipline.

It is imperative that not only licensees review the disciplinary advisory, but consumers as well to make sure they understand who they are working with. For more information regarding this matter, visit the CalBRE website at calbre.ca.gov , look under Essential Information on the homepage, click the link 2017 Real Estate Law, and review the governing rules in the California Business and Professions Code sections 10000 – 11288.

  • For the complete definition of a real estate broker, see California Business and Profession code section 10131.
  • For the complete definition of a salesperson, see California Business and Profession code section 10132.
  • For the minimum requirements for broker supervision and activities that qualify for broker supervision, see California Business and Profession code sections 10131.01(a)(A) through 10131.01(a)(E)(c).

How to Beat Real Estate Passive Loss Rules and Deduct Rental Losses

By: Tamara Pow, Esq.

For anyone who is currently invested in real estate or is considering doing so, whether you intend on moonlighting as a real estate professional simultaneously with your day job, or transmitting away from your current profession into the field of real estate full-time, you may want to consider the impact of two tax cases recently decided this year by the U.S. Tax Court for how you conduct your real estate activity.

In order to qualify for tax deductions, real estate professionals often have to deal with overcoming passive loss rules by proving that they are indeed real estate professionals for tax purposes. This means that they spent over half of their “work hours” materially participating in their real estate trade or business during a taxable year, no less than 750 hours during a single, taxable year. In order to qualify as a real estate professional, one would have to satisfy any one of several tests that determine material participation first.

According to Section 469(h)(1) of the Internal Revenue code, “[M]aterial participation is regular, continuous, and substantial involvement in business operations.” A passive activity loss is defined in §469(d)(1) as “[t]he excess of the aggregate losses from all passive activities for the taxable year over the aggregate income from all passive activities for that year.” And a passive activity itself is defined by §469(c)(1) as “[a]ny trade or business or activity for the production of income in which the taxpayer does not materially participate.” According to the same section of the Internal Revenue code, rental activity is generally treated as passive, regardless of whether the taxpayer materially participates. In essence, being a real estate professional and materially participating in real estate go hand in hand: you must materially participate in order to be considered a real estate pro, or you are doing neither if the hours do not add up.

In the case of Jones v. Commissioner of Internal Revenue, Docket no. 19645-14S, whose summary opinion was filed on February 7, 2017, it was determined that §469(c)(7) of the Internal Revenue code was not applicable to the petitioner, Alvin Jones, so he was not qualified as a real estate professional and therefore was not entitled to deduct losses from his rental real estate activity. Mr. Jones was a resident of the state of Georgia, owned and operated Georgia First Insurance, LLC (“Georgia First”), and owned 10 rental real estate properties in 2011, and 11 in 2012.

Payroll records for Georgia First indicated that he was paid for 519.99 hours of work in 2011 and 173.33 hours in 2012. However, the hours on the payroll record for 2011 only reflected May to December and did not necessarily show the total time that he spent performing personal services for Georgia First, but rather just the extent of his compensation. Also not included were the working hours in connection to the reported business miles driven on behalf of Georgia First. In regards to the times spent on his rental real estate activity, the petitioner maintained contemporaneous time logs, claiming 951 hours in 2011 and 1,040 in 2012. However, despite these logs and the petitioner’s general testimony, the Court found that the petitioner failed to establish his total hours performing services for Georgia First due to the holes in the payroll records and the lack of other evidence to determine otherwise, making his claim to have spent more than half of his working hours on his rental real estate activity inconclusive, therefore sustaining the IRS’ disallowance of loss deductions, per §469(a).

Six days later, a similar case was decided with a different outcome in the same Court. In Zarrinnegar v. Commissioner of Internal Revenue, Docket nos. 23183-14, 15989-15 , the petitioner was a dentist who owned a dental practice with his wife. The petitioner’s contemporaneous time logs for both the dental practice and his rental real estate activity, as well as the testimony of several witnesses, including the petitioner’s wife, and the general testimony of the petitioner himself, were consistent in proving that the petitioner’s part-time schedule at the dental practice easily amounted to less than half of the petitioner’s working hours, while satisfying the condition that the petitioner work more than 750 hours on his real estate business during the year in question. Among other findings for additional questions presented to the Court in this case, the Tax Court determined that §469 of the Internal Revenue code did not disallow the petitioner’s deductions for losses from rental properties, reversing the original finding from the IRS in that matter.

So, consider your time commitment requirements carefully if you want to deduct your losses from investment in real estate. Passive loss rules can be beaten and rental losses can be deducted under the right circumstances, which may become easier as you reduce hours in your regular profession over time.

LLC Operating Agreements – Failure to Contribute, Part II

By: Tamara B. Pow, Esq.

What do you do if your LLC needs capital and a Member fails to contribute their share?

The question of “What if the Company needs more money?” was addressed in Part I of this blog . If it is at all possible that the LLC will need additional funds in the future, the operating agreement should provide both for the right to borrow on prescribed terms from insiders, and the right to require members to contribute their share of the additional capital needed. This Part II addresses potential provisions to include in your LLC operating agreement to deal with the situation where the members are required to contribute additional capital and a member defaults in this obligation. The operating agreement can provide that either the managers or the non-defaulting members may elect one or more of the following remedies:

Advance the Funds for the Defaulting Member

The non-defaulting members may advance funds to the Company to cover those amounts which the defaulting member failed to contribute and then treat that sum as a loan to the defaulting member at a high interest rate (such as 10% per annum). The terms of the advance could include a mechanism for all cash distributions from the LLC that would normally go to the defaulting member to be paid to the advancing member instead until the advance, including interest, is paid in full. It is a good idea to include a form of promissory note as an attachment to your operating agreement if you plan to include this remedy. You may also want to provide that the defaulting member automatically grants a security interest in his or her membership interest to secure the promissory note.

Adjust Percentage Interests

Another alternative may be to simply adjust the percentage interests of the members after the additional capital contributions are made so that the defaulting member is diluted by the additional capital contributions of the other members. If you plan to use this remedy, your operating agreement should provide a formula or other methodology for adjusting the percentage interests so that an appraisal is not required.

Dissolve the Company

This may be considered the nuclear option. If a member does not contribute additional capital when required, the other members may simply not want to continue doing business with the defaulting member and can choose to dissolve the Company. This could be decided by a majority of the non-defaulting Members (or a supermajority, but not less than a majority of the LLC members), or by all of the non-defaulting Members. The method for dissolution should be set forth in the operating agreement.

Buy Out the Defaulting Member

The operating agreement can provide a right in favor of either the Company or the non-defaulting members to buy out the defaulting member’s membership interest. Terms and conditions should be set forth in the agreement. Because this is supposed to be a penalty for the defaulting member’s failure to contribute funds when needed, the purchase price could be less than fair market value as long as the discount is agreed to in advance (by inclusion in the operating agreement).

Preferred Distributions to Non-Defaulting Members

The operating agreement could include a provision giving non-defaulting members preferential distributions in the amount of their additional capital contributions plus a preferred return thereon so that the non-defaulting members get all of their additional contributions back plus more before the defaulting member gets any distribution.

Loss of Rights

A defaulting member could lose her voting and approval rights, either permanently or until the default is cured. A defaulting member could also lose her ability to participate in management or operations, as applicable, either permanently or until the default is cured.

There could be many other potential remedies depending on the type of business of the LLC. For instance, if the additional contribution required is actually for certain property or services by the member, the Company could choose to require the defaulting member to contribute cash equal to the fair market value of the property or services not contributed. Or the Company could simply require specific performance.

Regardless of which remedies are right for a particular LLC, it is critical that the options for enforcement be included in the operating agreement so that each member acknowledges and agrees that the remedies are fair and reasonable at the time the operating agreement is signed, well in advance of any default.

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company and other business entity formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her spot issues like these when advising owners of LLCs and other business entities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

LLC Operating Agreements – Failure to Contribute, Part I

By: Tamara B. Pow, Esq.

Don’t get caught with an underfunded LLC. Plan ahead in your LLC Operating Agreement.

The question of “What if the Company needs more money?” is often not addressed by an LLC until it is too late, the LLC is in need of cash, and has no ability to borrow and no way to force the members to contribute additional funds. This issue could arise in an operational business limited liability company of any type due to cash flow needs. It can also arise in real estate limited liability companies where the members fund the company initially to provide capital to purchase the real estate, and then additional funds are needed later for capital improvements, repairs, or even operating cash if the tenants leave or are not paying their rent. If the members of an LLC unfortunately used some standard form of LLC agreement found online or copied from a friend, the agreement is probably silent on this matter.

Although investors generally do not want to enter into an agreement whereby they can be forced to contribute additional funds, LLC managers do not want to have their hands tied when a cash flow situation arises. Providing for members to make additional capital contributions is especially common in closely held and family entities, where the intent is not to allow for additional outside investors. Here are some ideas to consider when drafting your LLC operating agreement, to make sure you have a plan to deal with cash flow crunches.

The Right to Borrow from Insiders:

The biggest problem arises when the Company cannot force the members to contribute additional cash and also cannot obtain financing from a third party or institution. In this case, it is incredibly helpful to have a provision in your operating agreement providing for the managers to act on behalf of the Company to authorize a loan from a manager or member to the Company on reasonable pre-agreed terms. In particular, this provision should spell out what interest rate is considered acceptable, and that interest rate should be high enough to entice the manager or member to loan to the cash-strapped LLC. The operating agreement should also set forth the rules for paying back the loan, and whether it must be paid in full before any distributions may be made to members. Keep in mind that members are taxed on profits of the LLC, not distributions they receive, so you may want to provide for minimum tax distributions for the members while the loan is being paid down.

Default:

If no manager or member wants to loan funds to the Company, and the LLC operating agreement provides that members must make additional capital contributions in certain circumstances (usually either by the majority vote of the members, or a decision by the managers), then the operating agreement should clearly state that a failure to contribute such funds is a default by that member. Usually the agreement provides for the managers to give written notice to the defaulting members, with a period of time during which the member can cure the default by making the required capital contribution. However, the agreement must also provide options for the managers or the Company to take action once it is clear the member is in default.

Several options for dealing with a member default for failure to contribute capital are covered in part II of this blog.

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company and other business entity formations, operations, transfers, conversions and dissolutions. Her tax background, including time as a tax consultant at Price Waterhouse, LLP, as well as her MBA and real estate brokers license help her spot issues like these when advising owners of LLCs and other business entities.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

LLC Alert: New FTB Ruling Regarding LLC Fee For Sale of Real Estate Inventory

By: Tamara B. Pow

Are you calculating the LLC fee correctly for an LLC’s sale of real estate?

The Franchise Tax Board just released FTB Legal Ruling 2016-01 (July 14, 2016) regarding the calculation of the limited liability company fee under California Revenue and Taxation Code Section 17942 for real property held for sale to customers in the ordinary course of business, as well as real property held for investment purposes. The FTB analyzed two fact situations. In the first scenario, a California LLC classified as a partnership holds real property for sale to customers in the ordinary course of its business and sells it during the 2016 taxable year. In the second scenario, the same LLC instead sells a parcel of unimproved real property held for investment purposes during the 2016 taxable year. The FTB ruled that the term “cost of goods sold” for purposes of RTC 17942(b)(1)(A) includes real property held for sale to customers in the ordinary course of a trade or business. “Therefore, LLCs that are dealers in real property must add the cost of goods sold (based on real property) back to gross income in calculating the LLC fee.” In the first scenario, the LLC’s adjusted basis in the real property will be added back to gross income for calculating the LLC fee due. In the second scenario, where the LLC sold investment property instead of inventory property, the adjusted basis in the property will not be added back to gross income for calculating the LLC fee.

The FTB’s analysis focuses on legislative history regarding the use of the term “cost of goods sold” as it may relate to real estate. The ruling states that the Legislature’s intent was that the LLC fee be based on gross receipts for all LLCs, including LLCs that are dealers in real property. Similarly, Congress has also used the term “cost of goods sold” in relation to construction of real property by a taxpayer in the ordinary course of business, in the American Jobs Creation Act of 2004. The Tax Court has also used “costs of goods sold” to refer to the cost of the property sold, regardless of whether or not it was inventory. The US Supreme Court has also used the term “gross profit,” which is associated with cost of goods sold, in a case dealing with a real property dealer’s sale of real property. The FTB concludes that if “costs of goods sold” in RTC 17942 could not include real property, then Congress, the IRS and the courts would have been incorrect in their usage. As a result, “LLCs that are dealers in real property must add the costs of goods sold (based on real property) back to gross income in calculating the LLC fee.”

Tamara B. Pow is a founding partner of Strategy Law, LLP in downtown San Jose, California where she practices business and real estate law including limited liability company formations and operations, and both inventory and investment real property sales. Her consistent and extensive work with LLCs keeps her up to date when advising owners of LLCs and other business entities of Secretary of State updates and other changes in structuring real estate transactions and the legal requirements of maintaining business entity liability protection.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Entering Into A Real Estate Loan? Will You Need a Single Purpose Entity?

By: Serge Filatov

The real estate market in the Bay Area and San Jose is booming. With interest rates still low, many real estate investors are taking advantage of cheap debt and either taking out new loans for projects or refinancing existing debt.

One of the common items that I see in commercial real estate loan transactions is the requirement that the borrower be a single purpose entity (an “SPE”) and that it agree to numerous provisions designated to ensure that it remains separate. A single purpose entity is an entity that exists for one purpose. In our context, an SPE is set up for the sole purpose of owning and operating a property, and for no other purpose. By making the entity so narrowly focused, the lender is trying to put protections in place to make sure that the borrower is not pulled into or consolidated with a bankruptcy caused by the problems of affiliates of the borrower.

To ensure a borrower is and remains an SPE, the lender will often impose numerous covenants on the borrower. Below are some examples of the type of covenants a borrower must often agree to:

  • maintain accounts separate from any other person or entity
  • maintain separate books and records from any other person or entity
  • not commingle assets with those of any other person or entity
  • pay for all liabilities out of the borrower’s own funds
  • maintain a sufficient number of employees in light of borrower’s contemplated business
  • not acquire debt or equity of another entity
  • hold itself out at all times as a separate entity
  • maintain adequate capital in light of its contemplated business
  • not create or incur any indebtedness other than the loan and unsecured trade debt or operating expenses

The list can go on and on…

As the borrower, you need to review the SPE language carefully to make sure that it accurately portrays how you will run your business.

For example, will you really maintain a sufficient number of employees to run your business or are those employees really employed by an affiliate? If so, will you need to put in place a services contract between the entities?

If you do not end up operating your business like you have stated, an event of default under the loan can occur and the lender could have recourse against the borrower or any guarantors. Therefore, thinking through these issues is important and a knowledgeable attorney can help you meet the SPE requirements while still allowing you to conduct your business as normal.

The information appearing in this blog does not constitute legal advice or opinion. Such advice and opinions are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to Strategy Law, LLP.

Lenders and Licensing and Exemptions: The World According to the California Finance Lenders Law

By: Jack Easterbrook

Many of our clients, at one time or another, get involved in private loan activities in California as a lender. It may be to help finance a business, purchase or improve real estate around San Jose, Silicon Valley or elsewhere in California, or just to provide funds for a family member. Although most lending has been and continues to be done by regulated financial institutions, opportunities abound for private lenders and many people are attracted to the market, whether for economic gain, to participate in a start-up idea or to just help out family or friends. The purpose of this article is to alert private lenders that California has established licensing rules to govern this lending activity, and to protect them from the risk of fines or even criminal charges for failing to follow these rules.

The California Finance Lenders Law (CFLL) is the name commonly given to the body of statutes imbedded in the California Finance Code addressing most lending activity in California. The CFLL governs the activities of both brokers and lenders engaged in the business of negotiating or making “commercial loans” or “consumer loans,” which broadly covers most lending activity in the state. Essentially, the CFLL requires any person participating as a lender or broker of commercial or consumer loans in California to obtain a license from the California Commissioner of Business Oversight unless the person qualifies for an exemption. Getting the license can easily take over six months to complete and involves a number of requirements, such as making numerous disclosures, paying fees, obtaining a surety bond and demonstrating financial wherewithal. Violations may result in fines of up to $10,000 and possibly imprisonment.

The CFLL, as mentioned, contains numerous exemptions to the licensing requirement and these can become very important to persons or entities involved in lending activity. Banks, credit unions and most institutional lenders qualify for an exemption. Exemptions exist, as well, for many other persons and entities involved in certain kinds of loans. A few of the most significant exemptions are: (a) loans by persons or entities making no more than five commercial loans in a twelve month period so long as such loans are “incidental” to the primary business of the person seeking the exemption; (b) loans made or arranged by licensed real estate brokers when the loan is secured by a lien on real property; and (c) commercial bridge loans made by venture capital companies to an operating company. Numerous other unique exemptions also exist.

The situation can be complicated by the use of intermediaries or separate business entities as the actual lender. The lending entity itself must qualify for the exemption. For example, a loan may be an incidental activity for an individual but not for an LLC actually making the loan.

If you are entering into a transaction in California in which you will be lending money, whether to an entity or a person, one item of due diligence not to overlook is whether you, or the affiliated entity in which you have an interest (if it is going to act as the lender) qualify for an exemption under the California Lender Finance Law. If you identify early the fact that the lender is not licensed and the proposed loan may not qualify for an exemption, it may be possible to develop a way of accomplishing your business objectives by revising some aspect of the proposed deal. Alternatively, the licensing requirement can be included in the checklist and factored into the timeline for making the loan. In any event, a private lender will want to handle the matter in a fashion that eliminates the risk of fines or worse.