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The hotel venture contemplated by Bruce, Erika, and Michael presents the opportunity for some
creative planning. One problem they may encounter in making their decision is the inherent conflict
presented by Michael‟s insistence upon recognition and reasonable return for his contribution of the
land. Also, Bruce and Erika fear being unduly diluted by Michael‟s share in the face of their more than
equal contribution to the ongoing work.
One might break this logjam by looking to one of the ways of separating cash flow from equity.
Michael need not contribute the real estate to the business entity at all. Instead, the business could
lease the land from Michael on a long-term (99-year) basis. This would give Michael his return, in the
form of rent, without distorting the equity split among the three entrepreneurs. From a tax point of
view, this plan also changes a nondepreciable asset (land) into deductible rent payments for the
business. As their next move, the three may decide to form an entity to construct and own the hotel
building, separate from the entity that manages the ongoing hotel business.
This plan would convert the hotel from a rather confusing real estate/operating venture into a pure
real estate investment opportunity for potential investors. The hotel entity would receive enough
revenue from the management entity to cover its cash flow and would generate tax losses through
depreciation, interest, and real estate taxes. These short-term losses will eventually yield long-term
capital gains when the hotel is sold, so this entity will attract investors looking for short-term losses
and long-term capital appreciation. For the short-term losses to be attractive, however, they must be
usable by the investors on their personal returns and not trapped at the business entity level.
All of these factors point inevitably to the use of either the limited partnership, LLC, or subchapter
S corporation for the hotel building entity. All three choices allow the tax losses to pass through to the
owners for use on their personal returns. Among these three choices, the limited partnership and LLC
allow more flexibility in allocating losses to the investors, and away from Bruce, Erika, and Michael
(who most likely do not need them), and they provide higher limits on the amounts of losses each
investor may use.
In past years, our entrepreneurs would thus face the unenviable choice of either losing the tax
advantages of the limited partnership to preserve the limited liability offered by the subchapter S
corporation or preserving the tax advantages (and the ability to attract investors) by either accepting
personal liability as general partners or attempting to adequately capitalize a corporate general partner.
This choice is no longer necessary with the advent of the LLC, which solves the problem by offering
the tax advantages of the limited partnership and the liability protection of the subchapter S
corporation. However, the passive loss limitations will still have an impact on the usefulness of the
losses for the members who do not have significant passive income, making this project (as is the case
with most real estate investments in today‟s climate) more difficult to sell.
This leaves the entity that will operate the hotel business itself. The presence of our three principals
immediately eliminates the sole proprietorship as a possibility. Because all the investment capital has
already been raised for the real estate entity, there does not seem to be a need for further investors,
thus eliminating the limited partnership as a possibility. The partnership seems inapplicable, since it is
unlikely that any of the principals would wish to expose himself or herself to unlimited liability in
such a consumer-oriented business.