A common goal of any business person is to develop value not only in the business goodwill and cash flow, itself, but in the assets of the business, to build up equity in the "hard assets" owned by the business. While a laudable goal, the sad fact is that most assets in most non-industrial businesses depreciate rapidly. Inventory quickly turns over and office equipment, from desks and furniture to hardware and software, has little value after a few years and is normally sold for pennies on the dollar. Many businesses seek to develop "hard assets" from intellectual property such as trade secrets, copyrighted information, perhaps unique software or customer lists and this may have value for others in the business but the market for such "assets" is restricted to the usually small market of your competitors.
Most non-industrial businesses, however, do have and use a valuable asset that is normally desired by more than the small market of competitors...but foolishly throw that asset away by leasing rather than owning it and building up equity. That asset, of course, is the office, factory, plant or warehouse in which the business operates. Rather than paying rent (which, after all, normally pays mortgage and taxes as well as upkeep and maintenance) if a company can buy its own premises then the purchase itself, over time, creates an asset of value often entirely independent of the business itself. If your business can afford to buy rather than rent its own premises, then that investment is of critical value to the business and will over time create an asset often more valuable than the business which funds the purchase. You are in the enviable position of using rent you would pay in any event to build up an asset of independent value, you are making the cash flow (a soft asset) create real property equity (a hard asset.)
Understanding this, any wise business person will seek to buy and own their own premises as soon as possible, but the method of the purchase is as important as the decision to buy: for if done correctly, there are significant tax advantages to having the individual owners buy the premises and lease them to the business ("lease back arrangement.") As discussed below, the tax advantages may be significant enough so that the cost of the purchase is less than the cost of rental. It must be noted, however, that such lease backs can cause difficulties within the company that must be carefully considered and handled if severe drawbacks are to be avoided.
Basic Lease Back Arrangement:
The structure is deceptively simple. The owners of the business purchase property and lease it back to the business they operate, collecting rental as any other landlord. Usually, the business-tenant is a limited liability entity (Limited Liability Entity) which signs the lease with the owner who may or may not incorporate or become a limited liability company. As discussed below, our office normally recommends that both the owner and the tenant become limited liability entity for a variety of reasons, both tax and security. Depending on whether all the owners are also owners of the property, the lease may be a more or less formal affair, usually "triple net" meaning that all expenses of the property form part of the lease payments (e.g. mortgage, upkeep, taxes, utilities are paid in the rental payments.) Quite often a standard commercial lease is executed for a relatively long period with right to renew on the part of the tenant. If all the owners own the building, it is usually easy to arrange the lease since it is likely they all have identical interests. However, if only a portion of the owners are landlords, then the terms may end up being hotly contested and that is one of the dangers discussed below.
The advantages of such an arrangement for both landlord and tenant are significant.
- The business has a "friendly" landlord who will work with the business to keep the premises in good condition and grant long term rights to the premises, usually granting leases that are far longer than the typical landlord.
- The business has a landlord who uniquely understands the needs of the business and will often make improvements that most landlords would not continence.
- The landlord not only has the business making payments that build up equity in his or her own asset, but intimately knows (and often controls) the tenant and need not fear the tenant not paying rental or committing harm to the premises.
- The landlord can depreciate the value of the structure gaining significant tax advantages and, alternatively, can make improvements on the building which give added value to the building AND at the same time help the business she or he owns, a double return.
- Even if the business may not have enough income to gain tax advantage from the deduction of needed improvements it pays for, the owner may pay for those improvements, depreciating the improvement, and repay him or herself over time by agreement of the tenant to increase rental...and the use of the two entities in such a manner for tax planning is a tremendous advantage to both.
- Above all, wealth being generated by the business still goes to the owner(s) rather than to a landlord and slowly but surely creates equity in an asset that will have value independent of the fortunes of the business itself: this author has known of several companies that were sold without much profit...but on condition that the new owner continued to rent the premises from the old owner-landlord by which the selling owner-landlord made his return not on the business he sold but on the rental he was able to guaranty from the sold business.
There are disadvantages:
- The business may not be able to afford fair market rental thus the return from the leaseback may be lower than if the building was leased to a third party.
- There is the need to come up with the down payment and various other improvements and upkeep that any landlord is required to maintain.
- If things go badly for the business, the owner faces a double problem of having his or her cash flow from the business lessen at the same time the lease payments may not be made. By linking the wealth in the building to the business, one's eggs are in one basket.
- Often one can not really afford the location that is ideal for the business and one buys a location that is affordable...but a disadvantage to the business.
- And the needs of the real estate owner may not conform absolutely to the need of the business. It is not uncommon to have the owner of the building wish to sell the property during a market peak while the owner of the business...often the same person...does not want a alteration in landlord or location. The owner of the real estate may not wish a lessee to be in the premises when trying to sell it; conversely, the business may wish to move to a new location due to changes in the business and the owner may face losing a tenant during a period of few tenants being available. Other examples can easily be imagined where the needs of the property owner and the needs of the business diverge.
The single greatest disadvantage, discussed in detail below, occurs when the ownership of the building is not identical to the ownership of the business and conflicts of interest may arise when the fifth point above occurs. These must be and can be anticipated are minimized by the right contractual and lease documents discussed below.
It is important to have a good accountant assist in the structural planning of the entities that will be used for the lease back arrangement. At least one should be separate from the owner of the building, e.g. a corporation or limited liability company or partnership owns the building while another entity owns the business. This allows greater flexibility in various tax planning since two or more separate taxing entities can be used for depreciation, income tax planning, etc.
Further, such items as improvements and payment for same, what to pass on to the business or retain as an expense in the entity owning the property all have to be considered and planned for before the structures are created and the contracts and leases executed. Each owner will have individual tax problems and advantages to be considered and factored into the structure. Expert tax advice is usually required. Our office can recommend qualified accountants if necessary and the cost of such planning will seldom exceed two thousand dollars...which is deductible, of course.
The IRS will pierce through any self dealing business transaction which is inherently unreasonable and, instead, impose for tax purposes a constructive reinterpretation of the relationship. Thus, if one loans money at no interest or below a commercially reasonable rate, the taxing authorities may impose income tax on the person receiving the loan or impose constructive interest on the lender, taxing him or her on interest never actually received! Tax planning must be considered from the moment the idea is first considered of a lease back.
The Basic Documents to be Created
There are a minimum of four and often more legal documents that must be created if later problems are to be avoided. If properly drafted, the documents will stop disputes before they occur, allow advance planning for all parties, and avoid the ill will that misunderstandings of duties or obligations can cause.
- First, a good contract of joint ownership must be drafted assuming there is joint ownership of the property providing for not only division of income and power, but for what occurs if one of the owners wishes to be bought out, dies, or becomes divorced. (Consider the disaster that a bitter divorce could cause to the entire plan; a furious spouse seeking to maximize his or her bargaining power by forcing sale of the business or termination of the lease.) A valid Buy and Sell Agreement between the owners of the property is a vital prerequisite to an effective lease back arrangement and the reader is invited to read the article concerning those arrangements on the web page. (For that matter, the operating business should also have a good Buy and Sell Agreement, whether renting or not, and that need becomes even more vital in the circumstances of a lease back arrangement.)
- Second, the title documents must be carefully drafted and recorded concerning the property to conform to the ownership restrictions described above. The agreements, without proper title recordation, is an invitation to dispute.
- Lastly, an excellent and long term Commercial Lease between the business and the owners of the real estate must be carefully created since the prosperity of both and the future of the business will rest on the terms of the lease.
- Additional documents may be required due to unique issues facing the individual tax planning of the owners or the type of business being the tenant. (Various hold harmless and indemnity agreements; various agreements relating to foreign tax treatment or Trusts, etc, etc.)
- And, of course, the real estate purchase itself will have its own set of documents, discussed further in Real Estate Transactions.
Unique Issues Confronting the Leaseback Arrangement
Clearly the interests of a landlord and tenant are often at odds. The landlord wants maximum rental and minimum risk, often insisting on guaranties from the owners of a limited liability entity renting the premises. In a weak market the landlord wants a short term lease so that rentals can soon be raised. In a strong market the opposite is the case. The typical commercial lease is a very one sided document granting tremendous rights to the landlord and nullifying many of the common law or statutory protections available to a tenant.
All this can normally be easily worked out If the ownership of the building and the ownership of the business are identical. However, any differential between the ownership can create a conflict of interest which could, if extreme, result in later claims of breach of fiduciary duty. Recall that the officer, directors, majority shareholders and employees of a company, as well as the partners in a partnership all have a fiduciary duty to one another, the highest duty of care known to law. A lease back arrangement which is to the disadvantage of the company can result in later claims by other owners of the company that the owners of the building violated their fiduciary duty to the company-or vise versa if the owners of the entity owning the real property enter into a disadvantageous lease.
The most obvious solution is to have identical ownership of both the property and the business since then each person has the same interests usually (but not always if their tax situation differs.) Assuming the ownership or interest can not be made identical, however, the solution is the same for any "self dealing" involving a fiduciary. The following steps must be taken:
- Full written disclosure of the existing or potential conflict of interest is delivered to all persons involved in the transaction with each such person signing off the disclosure. Legal counsel should draft such disclosure.
- The fiduciary in a conflict should not vote on the issue as to whether to accept the transaction. As a director or shareholder, it is best for the fiduciary to abstain from voting after making full disclosure of the potential conflict of interest.
- Lastly, assuming another conflict arises as to some aspect of the lease back, again, the fiduciary must abstain from voting on the issue. (e.g. in bad times, whether to breach the lease; whether to sue the landlord for breach of the lease, etc, etc.)
- The twin tools of full disclosure and abstention of voting must be complied with religiously or the chance of conflict can arise.
- In general, a good lawyer should be consulted before any documents are executed to consider and discuss as many of the potential conflicts of interest that could possibly arise so that they may be discussed in some detail and resolved before emotions arise or before either entity is committed to the purchase or the lease back is executed. If the problems can not be resolved before execution, then that must be faced before it results in obligations which can not be avoided and enmity thus arising. Once resolved, the resolution is reduced to writing either in a contract binding the parties, the minutes of the various entities, or the lease executed by the entities.
So Complicated... Worth Doing?
If one can afford it, there is seldom a better investment. It allows payments otherwise going to rent to build equity, avoids many of the issues of leasing that can hurt a business, and makes one business venture into two business ventures: a real estate company as well as whatever else the business does.
It will probably cost between five and ten thousand dollars in various professional fees, perhaps twenty to thirty hours of your time, and the usual costs of real estate transactions-brokerage fees, title costs, etc. Under most circumstances, that cost is made up by equity appreciation in a year or two of ownership and recall that at later times the equity in the real estate can be a handy source of emergency capital for the owners of both the business and the real estate. When combined with the tax benefits, it is hard to imagine a better investment for the owner of a business requiring a place to operate.