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Drafting Real Estate Operating Agreements

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Drafting Real Estate Operating Agreements

In this course, attorney Nate Osborn, will provide a detailed overview of the essential aspects of drafting real estate operating agreements. This course will take attorneys through the steps of drafting real estate operating agreements and help them understand the related legal considerations involved. Attorneys should walk away from this course with a practical understanding of how to best advise clients who want to form a real estate LLC.

Transcript

Hello, everybody. My name is Nate Osborn. I'm an attorney in Greenwood Village, Colorado, which is just a little town south of Denver. I'm actually working in the tech center now, which is, like I said, just a little enclave south of downtown Denver. I'm a real estate attorney. I kind of eat, breathe and live real estate and have been since 2010. I do a lot of real estate related litigation. Kind of grew up on that. And that in turn has led to a lot more transactional work, including lots of drafting and enforcement and litigation regarding real estate, LLC's operating agreements, real estate partnership agreements, you name it. I've probably been to court over it. So I like to think that I'm coming at this presentation kind of from a unique perspective because I've seen where things can go wrong. And, you know, when I'm drafting real estate operating agreements in particular, I like to think about, you know, potential pitfalls that we can address on the front end. So we're not fighting about it on the back end. Um, I'd like to start out my presentations with some quotes that I at least think are applicable. Um. Franklin D Roosevelt. Real estate cannot be lost or stolen, nor can it be carried away, purchased with common sense, paid for in full and managed with reasonable care. It is about the safest investment in the world. Michael Lewis in Bakersfield, California, a Mexican strawberry picker with an income of 14,000 and no English was lent every penny he needed to buy a house for $724,000. That book. That's from the book The Big Short, actually, once one of my favorite books that was also turned into a movie. And that was just a quote from that book. And why do I include those quotes? Really? Because I think it's important for us all as real estate professionals to understand, you know, kind of just how important, you know, these sort of issues are for people. Real estate is a big deal. It's it's the livelihood for many. It's an investment vehicle for a lot of people. And when they come to us as real estate professionals, it's important that we understand what we're doing and also be competent and precise. And so anyway, the takeaway from this presentation I hope you all get is that I'm going to get get you better educated on the topic of real estate operating agreements. And also you have a practical takeaway so you can start implementing implementing it in your own practices. Understanding the business top questions. So the way I've kind of organized this presentation is, say a client comes into your office and you're consulting with them. This is kind of typically what I do when I'm talking to someone who's interested in setting up some sort of corporate vehicle to buy, sell, develop, fix and flip real estate. Some of the questions I'm going to be asking them include Are you in the business or are you engaged in a business where you will get sued any anytime you're dealing with real estate? The answer to that is always yes. Sometimes if there are different sorts of businesses involved, that answer might not necessarily be yes. But when you're dealing with a real estate venture of some sort, most times that answer is yes, because you can always get sued. And so therefore, you know the answer. And what I'm starting to think about in my head is, well, we got to start coming up with some sort of corporate structure to protect my client from potential liability. Do you expect to operate at a loss for the first few years? The pass through taxation, which we'll talk about, there's tax implications. If you're reinvesting, you know, what does that look like on your own tax returns that impacts whether you're going to be a corporation or an LLC or a partnership. Will you invest profits back into the business? And are there any foreign owners? The foreign owner issue is relevant because you cannot under corporate law, you can't be an owner of a C corp if you're a foreign owner. That prohibition is not in intact for a limited liability company. So it's something to always think about when you're trying to decide what sort of structure to use. Are you looking to persuade outside investors right away? So, for example, in the in a real estate development company, a lot of times you're trying to get people to give you money so that you can have the capital to go out and start doing stuff, start developing, start planning, start doing entitlements and things like that. Um, some old school investors, you know, might feel more comfortable putting money into a more, um, a C corp or something that's more corporate looking appearing. Sometimes it sends the message that you're serious, that you might be more serious than somebody doing a limited liability company. Um, but that's not obviously always the case. And I find that, you know, changing too, as more and more people use real estate LLCs to invest in real estate. Do you like uncomplicated processes? The beauty of real estate investing is anyone with some desire and at least a little bit of money or the ability to borrow money can get involved. And lots of my clients, so I wouldn't say lots of them, some of my clients, you know, they're not really they're really good at real estate. They're really good at finding deals. They're good at maybe doing the work to make the property beautiful, but they're not really good at keeping accounting records or, you know, having votes or, um, uh, you know, having annual meeting minutes or monthly meetings and then having accompanying minutes, um, those sort of things. You know, an LLC is going to be a lot better because there's just fewer rules and we'll talk about this here in a bit. But the LLC itself, much more so, allows for freedom of contract than maybe a corporate structure. How good are you accounting and following the rules? Again, same thought process there. And LLC gives you more flexibility. What type of business are you again? Um, just going back to potential liability concerns that you got to be thinking about, and then where do you want to set up your LLC is a question I always ask. Um, you know, my, my potential client or, or my new client. Um, once we kind of get through the initial question and answer period, when I start understanding what it is that they're trying to accomplish, you know, are they going to be renting properties, buying and selling properties, developing properties? I start going through my Rolodex in my head of, well, what's the best structure for this real estate company? And there's all sorts of entities, as you all know. So there's going to be the limited liability company. There's business corporations, nonprofit corporations, special purpose corporations. Under Colorado law, there's 16 different types of partnerships. They have acronyms all over the place. Lps, LPs, you know, they go on and on and on. Um. But at the end of the day, honestly, LCS I've found to be the most popular. And that's just that's a actually a picture of my son. He's nine now, but this was when he was, I think, starting kindergarten. And he just started to think about, you know, what it takes to be popular. So it's a it's a commentary on popularity of LCS. Um, the last time I looked this up and obviously, you know, a few years have passed since then, but in Colorado, which obviously is the state I practice in, in 2017, 88,248 LCS were formed, while only 11,373 corporations were formed. Um, also from personal experience, when somebody is asking me to set up a business structure to deal with real estate, they're asking for an LLC about 80 to 90% of the time. They're very popular. And sometimes when people come in and are even talking to you about and asking questions about what structure should should they have, they don't even know what an LLC is. But the end result is I'm recommending that they set up their entity as an LLC. And there's good reason for that, right? Because there's a lot of advantages to an LLC, an LLC, especially when you're dealing with real estate, has default rules in Colorado and in most states I've ever researched or practiced in. I'm also licensed in Nebraska, but they have default rules in Colorado, the LLC act that define the deal. If the operating agreement does not provide otherwise, most rules are waivable, and the goal is to give quote and this comes from a case actually in Colorado to give maximum effect to the principle of freedom of contract and put in their query What if there's no signed agreement, which happens sometimes? This is an advantage of LLCs. There's laws on the books. So oftentimes we're talking about operating agreements today. The advantage of an LLC is if you forget to put a provision in an operating agreement or there is no signed operating agreement like my my hypothetical has here, well then there's some laws at least somebody can look to about what should happen when, you know, a manager dies or somebody is trying to sell or whatever, you know, I mean, these issues come up all the time, especially in real estate, because they're high stakes situations. So an advantage of the LLC is we have default rules. The ease of administration, like I talked about before, the LLC, there's not a lot of laws on the books about having to have boats and all sorts of stuff. And it basically, at least in Colorado and again, most states I've researched, the operating agreement allows you to kind of have a contract about what you want to do with the business. It's very personalized. It's it's not something that is difficult to run and operate. Um, and then the owner's risk exposure would be insulated, leaving only assets owned by the LLC subject to creditors. And what I mean by that is, if I own real estate in an LLC, then that real estate asset is really the only recourse. As long as you're doing things correctly and following corporate structures. The LLC asset, the real estate itself is the only thing a creditor, a creditor has recourse on, which is a great advantage of an LLC. Pass through taxation, which is what I was talking about before. Corporations are subject to double taxation first at the corporate level and then when dividends are distributed to shareholders. So you're actually paying two taxes if you start up double tax. You know, there's a chance for double taxation when you own and or sell real estate in a corporation while in an LLC, income and capital gains can pass directly through to the owner who simply has to pay taxes as an individual. You know, the other advantage that I've seen, especially in real estate situations people utilize or take advantage of is that multi-member LLCs can pass through pro rata share of profits or losses for that matter. So it helps you on your individual tax returns when you hold and own real estate in LLCs. Homer Simpson. Marge, if anyone asks you, you require 24 hour nursing care. Lisa's a clergyman. Maggie is seven people, and Bart was wounded in Vietnam. That's just a joke. That's Homer. He's doing his tax return anyways. And that's his explanation to his wife about why certain answers were the way they are. Other advantages of an LLC in real estate is that when you delegate management responsibilities. Llcs have a greater flexibility. And what I mean by that is an LLC can easily be managed by the owners. Third parties. You can figure out what sort of management structure you want and then put it in the operating agreement, whereas corporations have to have officers and directors. Um, there's also an allowance for flexibility in the distribution of profits. Corporation is going to be pro rata, and LLC can reward someone for sweat equity like a real estate promoter, oftentimes. And we'll talk about this later when we're talking about certain provisions that are helpful in operating agreements. But oftentimes I see people like a real estate promoter or maybe someone who can come in and actually do the stuff to fix up the property, a general contractor, for example. They get rewarded for their sweat equity, so they may not have cash or capital to put into the LLC, but they can do work and get rewarded accordingly. And you can also incentivize their work through distribution provisions in the LLC. Foreign ownership is allowed. We talked about that earlier. It can be used as a great estate planning device for family owned property. I've done operating agreements where the goal was that a property stay within the family, a ranch in Colorado, stay within the family because the elder statesman did not want to see the you know, the younger kids sell. You can't put a complete restraint on alienation, but you can, in an operating agreement, have buy sell provisions, options. You know, just put provisions in there that make it real difficult to be able to sell out and not keep a ranch, a beautiful ranch that's, you know, a family has had for decades upon decades and, you know, keep it within the property. And at the end of the day, the LLC really is the best choice. If the persons forming the LLC understand their real estate business deal, i.e. management, governance goals, payout and the persons forming the LLC, negotiate and draft a clearly defined operating agreement. I will warn you all that clearly defined operating agreement obviously is a term of art, but it's very important and we'll talk about that. Some of the drafting techniques that I utilize to make sure they're clear, because if it's not clear or if it's, you know, ambiguous in a in a place that shouldn't be ambiguous, although there are some places the ambiguity might be helpful. But if it's ambiguous in a place that shouldn't be ambiguous, that can lead to litigation. The answer is clear LLCs are the best. Are we all excited now? And this is a picture of all three of my boys. And I walked in on them, and this was a live action shot of my eldest son playing video games and my two younger sons watching. Very exciting. So what is the potential liability we have to be thinking about when we're drafting operating agreements and when we're advising our clients or LLCs or managers of LLCs or what have you, about what to be thinking about. Well. There's a lot of potential liability, right? You can be liable if you're a manager for making a wrongful distribution. You can be liable individually if a court pierces the corporate veil. Um, a charging order can have a creditor. A creditor can come in and. And assume the rights of a member, you know, subject to some of some of these limitations. The charging order is actually a crazy document That's actually really helpful if you're if you're a creditor. Um, so how do we, you know, think about all this stuff? Well, the wrongful distributions, obviously, you know, that's going to be something we're going to consider in the operating agreement. Most wrongful distribution situations are when the operating agreement is silent or there is no operating agreement. And the manager who is, you know, essentially running the company, starts paying himself money for the work that he or she is doing. And then, you know, somebody else comes in and and disputes their ability to do that. That would be excuse me. Um, very, very normal common example of someone alleging wrongful distribution. So how do we attack that in the operating agreement? Well, we clearly define when somebody is or is not entitled to a distribution. Piercing the corporate veil. So that's going to be a situation where a manager or a member is using the LLC as an alter ego. And then the court comes in and says, look, this is unfair to allow you to have asset protection through your corporate structure, so you should be individually liable. There are things we can do in the operating agreement to protect our members, i.e. pay their attorney fees, do things like that, defend them, indemnify them. If there are allegations that are made to try to assess individual liability, um, a charging order, again, you can put something in the operating agreement to talk about. If a creditor gets a charging order, then they have no right to do anything other than we'll pay them some money to satisfy their debt. These are things to think about when you're drafting the operating agreement. Um, the piercing the corporate veil statute and the thought process behind it again is, is that a member shouldn't be protected. Shield himself, him or herself through an LLC when they're failing to follow the formalities or requirements relating to management of business affairs. Um, the Sheffield Case V Trowbridge is a very interesting Colorado Court of Appeals case where they held the manager non of a limited liability company liable for an LLCs breach of contract, finding that the LLC's managers are similar to corporate officers, directors and that LLC should be treated like corporations when considering whether to disregard the legal entity. So that case really expanded the scope of when a manager member of an LLC can get held personally liable when corporate structures are not being followed. And that goes back to, well, what is the corporate structure? And that goes back to why LLCs and then the related operating agreements? Why drafting them is so important because you're going to be able to protect your owners from obtaining or having personal liability be be be instituted on them. Um, LLC protection might also be at issue if a bankruptcy is filed and we can put something in our agreement about what happens if a bankruptcy is filed. But this Colorado case, this is a really interesting one, the Albright case and the Albright case, the debtor was an individual and she was the sole member of an LLC. The LLC did not petition for bankruptcy. The trustee then took over the LLC. The court found that the trustee held all rights to governance of the LLC, including the right to sell real estate to pay off creditors over the debtors. Objection. So this was a case where there was a single member LLC, the LLC owned the real estate, the individual petition for bankruptcy, and the trustee came in and said, I don't care about that. I'm taking over your right to the LLC so I can sell this property and pay off creditors. So that would be a situation where an LLC owned real estate thought they were protected, but then they weren't. And frankly, you know, this is something that, you know, the people, although a trustee can do what they want, but having a provision into the in the operating agreement that accounts for what happens if there is a bankruptcy might have been a smart way to try at least to protect themselves. Real estate for sale. You'll need to put these on before inspection. It's funny. And there's my mom and Beckett. No reason for that one. Really. That's just a picture. Okay, so now let's get into the nitty gritty of drafting a real estate operating agreement. Okay. So structuring I'm going to obviously the sky's the limit on provisions in an operating agreement. I mean, there's so many different provisions that I've read, seen or drafted that it's hard to go over them all, especially in just an hour. But I'm going to go over some of them now in the next, you know, 30 to 40 minutes that we have left, um, structuring capital calls the right way. Okay. So what are capital contributions? Well, they're the money and assets given to the business by members. Okay. They're what happens typically at the start of a limited liability company and their efforts to buy and sell and and or develop real estate members are often required to contribute capital to an LLC. The amount of capital contributions, if any, are set forth in the operating agreement. Please note and this is a big, big practice pointer that I hope you guys remember in your own practices. But I suggest you always set forth the amount of capital contributions in the operating agreement and the timing of payment. You should also set forth what the capital contributions are to be used for and or if they're to be paid back. Okay, So the reason for that, here's a war story. Had a client or a situation that I became aware of where there was a dispute over. How much the capital contribution was. Okay. And the reason for that was there was a number actually in the operating agreement. It said Nate Osborne was to contribute. And I'm just using my name. Obviously Nate Osborne was to contribute $100,000 on or before September 1st, 2023. Um, but I ended up paying $200,000, but it wasn't documented. Well, then a fight ensued over the amount of capital contributions, and it wasn't as clean as you might think. So there was, you know, $25,000 check here that, you know, $100,000 check here. And all this money, in my mind was meant to be a capital contribution. But the opponent in the litigation or in my example, my business partner thought didn't agree to that thought. Some of it was a gift, some of it was a capital contribution, some of it was a loan. And it all matters because the operating agreement talked about how to treat capital contributions. So, um, so putting it, you know, I learned from that situation, putting the specific dollar amount on the of the capital contribution and the timing with which payment should be made is an important provision to have in your operating agreement. Operating agreements often provide that members contributing extra amounts will get a preferred return. You always you know, I'm sure all of you have heard the term preferred return, but what that really means is, hey, and a lot of times, you know, especially in a real estate LLC, it's a great idea, hey, to incentivize, you know, Nate Osborne to loan or to give money to the LLC, you say, look, you give us a million bucks, you get paid back first, right? So before anyone else gets paid because you gave us $1 million, you get paid back first. And and that's a good way to structure your operating agreement sometimes. A real tricky issue that obviously needs to be addressed in the operating agreement is what to do if an LLC needs additional capital in the future. Please know practice pointer. This often happens in real estate deals. In fact, I would say the exception to the rule is when this doesn't happen. It's a very common thing because, you know, predicting how much something will cost now or in the future when dealing with real estate is almost impossible. Material costs go up, labor costs go up. Um, real estate prices go down. There are delays on getting a certificate of occupancy because you find asbestos when you're trying to rehab a commercial building. So, you know, these things never go as fast as you want and they always cost more. So what do you do if the LLC needs more money? Well, oftentimes an LLC can get a loan, but it's smart to set forth the guidelines for obtaining a loan in the operating agreement, i.e., who has the right to obtain a loan for how much and for what purpose? So, for example, in the loan situation, if I have a manager, it's a manager managed LLC and the manager says, Hey, we need 100,000 more dollars to fix up the place before we sell it. Can that manager, on behalf of the LLC just go take out a loan on his or her own accord without having a vote or anything? Well, the answer to that is it depends what the operating agreement says. So my advice is put it in the operating agreement. Whatever you want to do is fine, but put it in the operating agreement. Sometimes people are fine with the manager making unilateral decisions to get loans because they trust the manager and they don't think they need any oversight. Sometimes a situation like that necessitates a majority vote or a unanimous vote or we'll you know, we'll talk about that later. But just whatever fits and is good for a certain business makes sense. Just remember to put it in the operating agreement. Um, you know, if your LLC, your real estate, LLC needs more money, another way to handle that, as opposed to getting a loan would be to set forth in the operating agreement when and how additional capital contributions are required from members. Um, because I will tell you, 99 out of 100 times when additional capital contributions are required, things might not be going well and no one likes to get the call, you know, at 9:00 on a Friday saying, hey, we need you to make another capital contribution. People always have questions. There's always a fight. So in order to avoid the eventual fight, or at least have clarity on the fight, you should put forth the guidelines on how to deal with the situation and the operating agreement. Um, sometimes you can make additional capital contributions mandatory. Um, the provisions I've seen that are helpful or clear at least is sometimes in an operating agreement. You can require additional capital if, for example, amounts are needed to pay construction loans, amounts that are needed to eliminate safety hazards or for repairs to property, or if amounts are needed to pay off mechanic's liens. Again, if you make capital contributions mandatory, smart to give those people who make contributions a preferred return. Um, also if you have construction, kind of like what we talked about before, it's a good idea to put in the operating agreement how to pay construction related fees. Meaning if your cash flow is not enough, should you get a loan, a capital contribution, Should your members take a smaller distribution to assist you with the construction payment? That's another way I've seen people do that. Um, you know, that makes sense to me, right? You can also make additional capital contributions non-mandatory. Um, and we will talk about this. Here in a moment. Who makes the decision for an additional capital contribution? Well, you know, there's lots of people who could do it. You could have a vote, but it's usually the manager here. That's what I've seen. And if you have more than one manager, then you can have a dispute resolution in case not everyone agrees. So, for example, operating agreement says additional capital contributions shall be made by the manager managers. Right? If it's one manager, great. Then the manager can just, you know, weigh the pros and cons, read the operating agreement and make a decision about whether a capital contribution is the best path forward. Um, if there are two managers, then you know, a provision in the operating agreement you should have is what happens if the managers are in a deadlock? What happens? So for example, Manager A says no additional capital contribution manager B says yes, we should get a capital contribution. It makes sense. Well, you're in a stalemate and what should happen? Well, you don't want dissolution or the business just to shut down. So oftentimes what I see done or what I'll do is you put a third party arbiter in there as the decision maker. You write a letter to an arbitrator and they make a decision real quick. You get them to agree beforehand about what the scope of their duties are and, you know, bang, bang, you're done. Right. It's not a bad way to handle that. Um, the required capital contribution. So if that's mandatory or non mandatory or it doesn't really matter, even if it's mandatory, you know, people don't always have the money available to pay capital contributions or if it's non mandatory, you know, people might elect not to pay it. So what happens if some people pay the capital contribution and some people don't? What do you do? Obviously, that's an unfair result. So something has to be done. We have to put that in the operating agreement right ways. I've seen people attack this problem is sometimes they'll penalize the non paying member they have the paying members pay for the non paying member and then make this additional capital contribution alone to the non paying member at a high interest rate. The loan then gets repaid through distributions so that, you know, it's pretty self explanatory. If my wife's name Cindy, if Cindy and Nate myself are members of an LLC, the manager says capital contribution. Cindy or I don't have the money. Cindy has the money Cindy pays on my behalf and her behalf that's treated as a loan. And then when the year end distributions come around, I have to pay Cindy back, right? It's added interest. So it's a way to incentivize payment and then also incentivize people to cover the non paying member. Another way to do it too is to dilute the interest of the non paying member. So usually what I've seen work well in that situation is you have some sort of formula. So if you have a non-paying member and a paying member, a paying member gets a larger interest based on, you know, whatever had occurred. And it usually, you know, is consistent. There's a formula in the operating agreement that tells everybody so it's clear and transparent how the new interest will be calculated. Um, crafting distribution provisions to share real estate profits. So LLCs are always started to make money, right? There's nothing. No shame in that. Nothing wrong with that. People get involved in real estate so they can make money. So oftentimes when you're drafting an operating agreement for a real estate LLC, people are going to want to know, well, how do I get paid back? Right? So these provisions are usually hotly negotiated and contested. Um, a return can be made on investment via a salary. So a lot of times the manager or someone who's doing the day to day stuff where we we hire that person as the whatever project manager and then they get paid a salary and the salary is approved and then there's no that person is getting paid back through W-2 payments. Sometimes even an employee of the LLC, you can get paid back from capital gains through the sale. Or very frequently through distributions. Distributions, How they're made when they're made and who has the decision to make them again are important provisions and it's important to negotiate them so your client or clients are satisfied. Some distribution provisions that I've seen work and that I've used myself are you can distribute on a pro rata basis based on capital invested. Pro rata by membership interest or based on a more complicated formula. In the real estate deal, there may be equity investors and managers who receive distributions based on performance of the LLC. So, for example, I was just involved in a case where the amount a commercial building was sold for was wrapped into how much somebody would get paid. If it's more, you know, say just using round numbers. If the sale is more than $500,000, you get an additional 2% or whatever of the gross profit. You know, interesting ways. I find one of the reasons why I really like LLCs and drafting operating agreements is it's really about it's kind of like the IRS tax code. It's about incentivizing behaviors, right? So you want people to work hard and maximize profit, then give them money on the back end for doing a good job or whatever. Sometimes when people just get paid in a very predictable format, you know, sometimes that's not doesn't tie well with incentivizing behavior. Sometimes it does. It just kind of depends. But sometimes it doesn't. And, you know, I found operating agreements very useful, you know, in the distribution provisions, when they incentivize someone to work hard and try to maximize return for all the members. Um, it's also common to have promoters of a project receive large distributions if the project receives. This encourages sweat equity. Like I said, you know, someone who maybe a broker is out there pounding the pavement every day trying to sell condo units. Well, you give that person a 5% member interest and then you have them, you know, working hard out there. Well, they can get paid back in return. So maybe you can't pay him a massive salary or you can't pay him massive commissions upon sales, but you can give him a distribution if the project overall succeeds once all the properties have been sold. It's a great way to get real estate professionals and good ones to, you know, a lot of people are familiar with incentive based pay and you can put that in your operating agreement about how to incentivize, you know, good quality efforts. Waterfall distributions are common in real estate deals. This is a formula where there are tiered distributions. The first level get paid and then distributions pour over to the second level, etcetera. Um, you know, these are always interesting ones, but and I've seen them work, but the people who get mad is if you're a minority member, you're going to want to mandatory distributions on a set basis because if the manager is making discretionary distributions whenever they want and you're only a minority member, there's not much you can do about forcing distributions or whatnot. But sometimes if you're a majority member, you want to just have discretion or have the manager have discretion because, you know, sometimes you don't have cash available to distribute. And there are some default laws about, you know, you can't really distribute money and make your company bankrupt or that would be a breach of your fiduciary duty or whatnot. But in that same token, you know, giving the manager, you know, flexibility is is definitely not a terrible idea because you never know when a real estate entity is going to have money to distribute. Um, this would be an example of a distribution provision regarding, you know, specifically talking about sharing real estate profits that I've seen. And then I'm happy to share with you today. Um, but this, I thought this one was kind of interesting. So it said the managers have the option to cause the company to make distributions of available cash flow after establishing such reserves. To the extent the managers can do so without materially adversely affecting the business of the company, to the extent that managers can do so without materially adversely affecting the business, the company, the managers may cause the company to make distributions to the members to compensate them for taxes. Et cetera. Et cetera. The company will not make a distribution if such distribution would violate violate the act, or if the company is in default on any of its payment obligations. So this is kind of a broad one with some, you know, some criteria. You can't make the company bankrupt. You can't materially, adversely affect the business of the company. But other than that, the manager has a lot of discretion in this provision. So it's a little ambiguous, but sometimes ambiguity. Like I said, if you trust your manager and you have a good manager, it makes sense because then the manager has discretion when to pay people and he or she pays people when it makes sense for the company to pay people. It gives you more discretion than maybe, you know, a mandatory distribution time or period or things like that. Query. What do you do under a discretionary distribution procedure? The manager. When the manager is only making distributions to himself and not the other members, Well, you know, those are situations where you might get an attorney involved, frankly, to write a demand letter, to Sue, to say this is a wrongful distribution or violation of operating agreement. But at the end of the day, it's it's difficult. Sometimes you literally have to go to trial over forcing a manager to distribute or, you know, recouping some of the losses based on wrongful distributions. Robert Kiyosaki. At the height of the Enron mania, the company's market value was 65 billion. Once the dust cleared, the final value was $0. Crazy. Absolutely nuts. I keep that in there because it's just crazy. And he's the. Robert Kiyosaki is the author of Rich Dad, Poor Dad, which is actually a really good book. Lewis Black. You don't want another Enron, here's your law. If a company cannot explain in one sentence what it does, it's illegal. Which is kind of funny and probably pretty true and accurate. Um, other essential provisions for real estate. Llcs. Um. You know, big picture, what provisions of the act are non-waivable in operating agreements. So, you know, one thing, and this is most these aren't going to be enforceable provisions regardless of where you live, but Colorado has a specific law that it says the operating agreement may not eliminate the operation of good faith and fair dealing. But may prescribe reasonable standards to measure from, restrict rights or impose duties on non-consenting third party parties, etcetera. So you can't you can't say, hey, the manager can lie, cheat and steal. You can't that that's not enforceable provision. And it makes sense why that wouldn't be an enforceable provision. Um, but what you can do is say something to the effect of the manager is required to act in good faith and deal fairly. And here would be examples of things that are not in good faith or dealing fairly. One, you know, distribute money when the company is bankrupt to directly compete against the company. Three And et cetera. Et cetera. So. You know, these sort of things are important because sometimes, you know, I've had situations where, you know, a manager or a member is competing against the company and, you know, it's not in the operating agreement. You know, there is a law out there what's considered competing, you know, spelling it out based upon your, you know, particular circumstances is very much probably the the best way to go in this situation. Um. Watch out for unintended violations of due on sale transfer clauses. So this is just, you know, this is kind of just a practice pointer. Oftentimes I'll get people calling me saying, Hey, I want to own my real estate. My rental property in an LLC. I say, Great. I say, Do you have I asked them, you know, do you have a mortgage or a deed of trust? Encumbering the property? They said yes. I start looking at that document and it says, If we convey title, if title transfers from Nate Osborne to an LLC, it doesn't usually say that. It just says if it transfers, then we can invoke the due on sale clause. Does that always happen? No. But is it a concern of mine? Constantly? Yes. So just something to think about. You know, other things that I think are important are to reduce the effective tax rate from purchase to sale. Real estate should be held through an LLC that has not made a corporate tax election. That's an important thing to to always consider when you're working with real estate, LLCs. Um, other essential provisions and we'll talk about all of these. I think we have, oh, 15 or 16 minutes left now, um, reasonable limitations on manager authority cost benefit analysis. Okay, so what do I mean by that? Um, so managers, it depends who your manager is and how many partners you have. But oftentimes a manager is given essentially free rein over the business and sometimes that manager can run into problems by exceeding their scope, signing bad contracts, doing bad sales, getting a bad purchase price. And so you want to you know, even if one manager is getting paid to run the day to day operations, maybe upon sale, you have to get a majority vote of all the members to sell a piece of real estate. That would be a great example that a lot of operating agreements have and where, frankly, if I was the manager, I'd want that in there because I wouldn't want to be making the sole decision about selling a property and then have the members come back and tell me how dumb I was for selling the property at a certain price. So that would be a, you know, a very typical reasonable limitation on a manager's authority is requiring a majority vote or a unanimous vote if the real estate asset that's owned by the LLC, if the if the company wants to sell it, um, other manager authority. I've seen that it's been useful and helpful is a man a manager can be limited on his or her authority to take out loans. Sometimes I'll say, you know, $100,000 loan or less. You can do it, you know, whatever. As long as it's in the best interest of the company, make your sole, you know, have sole discretion to make such a decision. But if it's over, you got to get a vote. Um, you know, usually those are situations that I see come up where a vote oftentimes makes sense. Um, you know, leasing out a space. Well, sometimes you don't want to have to vote for that. Maybe you give a manager authority to do that, especially if, you know it's a place with a lot of leases. If it's only one lease, well, then maybe you want to vote to approve a lease. But if it's an apartment complex where there's 400 units, then that's, you know, we don't want to have a vote every time we evict someone and get a new tenant. Right? That doesn't make any sense. So. Anyways, all of these sort of limitations and provisions regarding the scope of of of authority for a manager are just, you know, things that I think people just breeze through. But if you actually sit down and think about it, I think it will help your company in the long run. Situations that require a vote. So this this is all over the place in operating agreement. Some people like to vote on lots of stuff. Some people have provisions in their agreement that require votes, but then no one ever votes. And sometimes, you know, the manager just makes all the decisions and there are no votes or no even required votes. Right. So these are, you know, important decisions to make about what situations should require a vote. If we want to elect a new manager of the company, does that require a vote? Most times, you know, that's that's a vote that's typically required. Um, should you to, um, you know, sell the real estate. Well, that's a, that's a typical situation where votes are typically required. Um, do you want to, um, take out a home equity line of credit to rehab it? You know, that might, that might be something that necessitates a vote. And then when you get into the voting provisions and operating agreements, you start thinking about, well, is this a unanimous versus a majority? Do we need all four members to 100% vote yes? Well, good luck. I mean, if you have 4 or 5, six members of an LLC, getting 100% of anyone to vote on anything is difficult. But maybe there are situations where you really want a unanimous vote to like to dissolve the company or sell the property. We want something that's unanimous, not just majority things to think about and to consult with your client about. Um, what happens if a manager, a majority owner sells interest or wants to resign. So that happens where I see provisions, you know, if I'm a majority owner, I have a 75% stake in a real estate LLC, and I sell to somebody, uh, you know, what does that mean? Can I be the manager anymore if I sell my membership interest? But I'm the manager? Like, what does that mean practically for the company and for the person who did that? What if the manager says, Look, I don't want to be the manager anymore, I'm tired, I want to move on? Um, can they do that? How do they do that? How do you elect should there be a vote on the re-election of a new manager? Um, these things happen to, like, years down the road. So I've been involved in situations where an entity is established in the early 90s. They sell, they sell a commercial property. In 2022, everything's changed. Well, what happens? How do we elect a new manager? The manager is deceased now. You know, those sort of things. Dissolution provisions, I think are also essential provisions in a real estate situation. You know, oftentimes a real estate LLC is a single asset LLC, meaning it's established to own, develop, potentially sell one piece of real estate. Well, if they sell the real estate, what what else is left to do with the Real Estate LLC? Right. So you should probably have a provision in your operating agreement that says upon sale of all the assets, the Real Estate LLC shall dissolve because then it requires, you know, the manager or whoever has distribution authority to wind up the business once the property sells, which is probably the best way to do it unless you have an LLC that wants to reinvest the money or whatnot. Um, but you know, thinking about and discussing and drafting dissolution provisions I think is important. Um, the dispute resolution is a provision that I think oftentimes people, you know, don't pay too much attention to. The parties shall mediate before they go to court. Sure. That's great actually, if you have that in there. But then, you know, can you go to court? Do you have arbitration? Do you have to mediate in good faith? These are all things that are very highly personalized. But there's something that you should think about when you're drafting these agreements and then the amendment procedure. So, you know, how do you amend the agreement? Do you have to vote on the amendment? Does it have to be documented in writing what happens when it's not? So I've seen situations where a new manager is elected. There's zero in writing. The manager has been performing for a year, so if they've been performing for a year, but we didn't follow the rules, does that mean they can't be a manager anymore? Um, I mean, you'll see every possible variation of that fact pattern imaginable. And you know, sometimes it's hard to keep up, but these are provisions. You know, once we put them in the operating agreement, you're going to expect people to follow, you know, to the best of your ability. Um, I only have eight minutes left, but I wanted to talk a little bit about tax because the LLC and the, you know, the related operating agreement in deciding to put your real estate company in an LLC has so much to do about taxes. And I think you need a basic understanding of the taxes to be able to advise clients on what provisions to put in your operating agreement. Oh, and as a caveat, I'm not a tax attorney, but I just I've been around it so much, I just see things. So my my commentary to you is not from a tax attorney perspective, but more from just a practical perspective, seeing how things go in these real estate deals. Mark Twain. The only difference between a tax man and a taxidermist is the taxidermist leaves the skin super funny. Mick Jagger. I love America, but I can't spend the whole year here. I cannot afford the taxes. Again, funny stuff. Maximizing tax benefits. So. Something to consider and actually allow for in the operating agreement is a lot of real estate investors. They have IRAs and then they, you know, want to invest money in a self-directed IRA into your real estate venture. Well, sometimes you can do that. And if you pay back, you know, something to think about is if you pay that money back within a certain period of time, it's a tax free transaction. It's, you know, the taxes are deferred. But if you're, you know, in a situation where one of the business partners is putting money in, the other partners need to know about the requirement to pay back within a certain period of time, if there is one. And then probably incorporate that somehow in the operating agreement about how to handle that situation. But it's a great way to invest money in real estate. For those of you out there who have that opportunity or who have clients that have that opportunity. Holding strategies and double FICA taxes. Okay. So this is just something to think about. You know, when you're advising your clients for real estate, LLCs, the IRA, of course, we talked about. But the one year property hold is something to think about honestly when you're drafting the operating agreement, talking to your clients when you own something for less than one year and you sell it for profit, that profit is taxed at your normal income rate. If you flip more than a few properties per year, the IRS can classify you as a self employed dealer and subject your earning to double FICA taxes. One option is to own properties for over a year before selling. You will not be classified as a dealer then, and it makes your taxes to be capital gains instead. You could also flip them rent for one year. So these are things to think about when you're putting in the scope of what your business is and the operating agreement. Well, you might want to hold the property for a little bit and that might factor into your distributions or how you pay people if you want to save on taxes by holding the property, well, how are people going to get paid back, put in the operating agreement and and go from there? Double figure tax avoidance. Fica taxes are employment taxes that fund Social Security and Medicare. They're split between employers and employees. If you're a dealer, though, meaning you sell so many properties within a year, then you're a fix and flipper, basically, and you're considered self-employed. And then you owe both the employee and employer part of FICA taxes. So one way to avoid this dealer status is to demonstrate investment intent. You have to prove that you sell properties to generate capital for other investment projects. Um, and you might also consider a legal entity that changes how investors are taxed. So just something to think about when you're drafting these operating agreements about how to structure your business, which is actually why I love LLCs and drafting operating agreements, because these issues, they're way more dense than you can, you know, imagine about how to deal with certain situations. To your property ownership. So we talked about the one year property ownership, but sometimes people do a two year plan and if you make upgrades for over two years, then sell the property, you could save a lot in taxes. So the first 250,000 of capital gains is tax free for singles limits, 500,000 for married couples. I know that's different for LLCs, but again, pass through taxation that actually comes into play. The LLC also can take advantage of real estate business deductions. It's also something to keep in mind when you're thinking about losses in the operating agreement, how to account for them and how to account for distributions. Again, because these are all well recognized real estate business deductions for real estate, LLCs, mortgage interest insurance, property taxes, maintenance costs, property management fees, advertising expenses, software tools, support expenses, legal fees, travel mileage, you name it. I mean, this is a real legitimate business. And, you know, when you have real legitimate businesses, the IRS approves of these real estate business deductions. And so holding a property in an LLC, you know, allows you to maximize this and then pass on profits and losses to your individual member owners. So it's really cool, actually. Um, depreciation is another tax benefit that can be utilized by the LLC. You know, the IRS sets a lifespan of a residential structure at 27.5 years. So then owners can deduct 127 fifth of the property's building value each year. It's a way to avoid taxes and also and legally. Right. So this is all recognized by the IRS. Also, tax tip. If you die, the property you own passes to your heirs. The first 11.18 million of your estate is tax free. Your heirs can sell the property and keep the proceeds tax free. Now, this is a very common thing. And operating agreements is, well, what happens if somebody dies? And so I've seen them all over the place, whether it be passes through their estate, there's a buy sell. You know, the entity has a right to buy it back. But these are situations that you really should think about when you're drafting these agreements. I only have about 1 to 2 minutes left, but I was just going to talk real quick. You know, these operating agreements, one of the requirements that either I'll put in there or I'll advise the manager is to get insurance for your building, make sure you get the right type of insurance. Um, and then, you know, just structuring the asset and the drafting the operating agreement in a manner, um, where your, your just protecting yourself, um, is so important. So for example, if I have, um, numerous properties all under an LLC, you know, sometimes I'll have a, they call them series LLCs, but basically the concept is I'll have a master LLC that then, you know, there's the members are all LLCs, and then those members are LLCs. And basically there's, you know, imminent levels of sophistication you can put into real estate holding companies or companies that lease where the individual owner to get at the individual owner is so complicated. And probably as long as you're following corporate formalities not even allowable, that you can really use the LLC and the operating agreements to protect your assets. And just lastly, protection by debt. If there's no equity, there's nothing to take. A lot of times what I see people do and and allow you know, you put in the operating agreement, this is allowable behaviors. You take out equity and reinvest in more real estate with little or no money down. Obviously, you open yourself up to, you know, defaulting and not being able to pay back all of your your loans and whatnot. But if you're smart about how you do this, then you protect yourself through the LLC. The only recourse is the property itself. And then you have cash flow to buy more properties. And, you know, the sky's kind of the limit when you structure these things in a right way and you have solid operating agreements. Um, so anyways, I'm out of time for the day. Um, I really appreciate getting the opportunity to work with you guys and always remember, always go to other people's funerals, otherwise they won't come to yours. And that's by the great, the late, great Yogi Berra. Um, you have my contact information. Just be advised I'm not a tax attorney, but, you know, I know some about taxes, and I know a lot about real estate and real estate operating agreements. So feel free to give me a call or shoot me an email. Sometimes it takes me a little bit to get back to everyone. I get a do a lot of these talks and get a lot of questions, but I will get back to you. Just be patient. I really enjoy giving these presentations and like to hear from you, so feel free to reach out with, you know, to me if you have any questions. Thank you so much.

Presenter(s)

NO
Nathan Osborn
Equity Shareholder
MONTGOMERY LITTLE & SORAN, PC

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