Boutique Hotel - Partnership LLC structure

[Gordon Middleton]

Hey everyone,

I've read a ton of posts surrounding the subject of LLCs and quite of a few of them with specificity to hotels, motels, etc. That said, most involve single owners so that's why I'm creating this thread. 

I am a part of partnership (Let's call it Partnership A) that owns several holding LLCs and that is about to go into a partnership (Call this Partnership B) to buy a boutique hotel. Partnership B will be 10% Person A, 10% Person B, 80% Partnership A. I'm at a full understanding that best practice with hotels is to separate the property from the business by establishing a separate operating LLC (Operator). The trouble I'm having is what the ownership structure of Operator should be. If ownership is the same as Partnership B, then we're looking at two separate K1s which is a pain. If ownership is a single member (me), then one of two things happens. 1) we go with the lease agreement option and then Partnership B is receiving passive income that is much lower than what is expected; or 2) we go with a management fee option and then all the profit flows to Partnership B, but the expenses unequally benefit me as the single owner.

I'm trying to determine if the solution is to make Operator an (s) corp or if that still unequally benefits the single owner because I'll have to pay myself an acceptable wage. 

Any insights welcome here and feel free to blow up my structure because I know I've got a pretty loose grasp on all the concepts here. Just want to get it right now so we can focus on the important work of actually running the hotel!

[Chris Seveney]

Quote from @Gordon Middleton:

Hey everyone,

I've read a ton of posts surrounding the subject of LLCs and quite of a few of them with specificity to hotels, motels, etc. That said, most involve single owners so that's why I'm creating this thread. 

I am a part of partnership (Let's call it Partnership A) that owns several holding LLCs and that is about to go into a partnership (Call this Partnership B) to buy a boutique hotel. Partnership B will be 10% Person A, 10% Person B, 80% Partnership A. I'm at a full understanding that best practice with hotels is to separate the property from the business by establishing a separate operating LLC (Operator). The trouble I'm having is what the ownership structure of Operator should be. If ownership is the same as Partnership B, then we're looking at two separate K1s which is a pain. If ownership is a single member (me), then one of two things happens. 1) we go with the lease agreement option and then Partnership B is receiving passive income that is much lower than what is expected; or 2) we go with a management fee option and then all the profit flows to Partnership B, but the expenses unequally benefit me as the single owner.

I'm trying to determine if the solution is to make Operator an (s) corp or if that still unequally benefits the single owner because I'll have to pay myself an acceptable wage. 

Any insights welcome here and feel free to blow up my structure because I know I've got a pretty loose grasp on all the concepts here. Just want to get it right now so we can focus on the important work of actually running the hotel!

 Talk to an attorney

[Gordon Middleton]

@Chris Seveney Appreciate the advice. I have spoken with my attorney about this and he generally feels like I should not use the operating company structure at all. I respect his viewpoint and am considering it, but was hoping for more input from the community as a whole. 

[Stuart Udis]

@Gordon Middleton Curious to hear your reasoning for wanting to separate the management from the real estate in this case? From a liability standpoint it's a pretty clear case of an alter ego entity structure which any good attorney will be able to fight through and will add a redundant layer of insurance you have to pay for. I previously served as counsel at a Hospitality REIT where management was separate but the management was a viable business that managed REIT owned as well as 3rd party hotels. It's not uncommon to see this, but not in the context of your situation.

*Communication of information through this website (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation to create an attorney-client relationship to provide legal services as to any particular matter, and (3) is not intended to convey or constitute legal advice, or to provide a substitute for obtaining legal advice from a qualified attorney. You should not act upon any such information without seeking qualified legal counsel on your specific needs.

[Gordon Middleton]

Thanks @Stuart Udis. 

From my research and connections, it seems like this is a fairly common structure in the hotel world. Obviously the main reason is to separate the liability of business dealings from the property itself. I believe the other reason has to do with the fact that hotels are often run by hospitality management companies.

That said, I tend to agree that if the Operator company of built solely for the hotel, then it wouldn't really make a strong case for actual separation. I have a management company for my other pieces of real estate though and thought I could use it for the same purpose with the hotel and that would provide a much more durable case. This would also allow me to use my virtual employees and services across multiple ventures.

[Stuart Udis]

@Gordon Middleton  Remember, if the intent is merely to create separation for liability purposes, you are creating the clearest alter ego case imaginable. This truthfully offers no additional liability protection. Keep in mind any good plaintiff's attorney is going to bring all parties incidentally related to the legal claim in as an additional defendant. There is nothing you can do to stop this first chess move on their part. Remember they are first and foremost chasing the insurance dollars and they are going to take inventory of anyone connected that has insurance. This would certainly mean the management company as well as the deed holder.  The other reason you mentions is accurate, it tends to be more operational rather than liability driven.



*Communication of information through this website (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation to create an attorney-client relationship to provide legal services as to any particular matter, and (3) is not intended to convey or constitute legal advice, or to provide a substitute for obtaining legal advice from a qualified attorney. You should not act upon any such information without seeking qualified legal counsel on your specific needs.

[Gordon Middleton]

What if ownership of the property holding llc and the management llc are different? Wouldn't that effectively shunt the alter ego case?

[Kory Reynolds]

I work with a significant number of hotel entities, I can address this from a tax perspective, I'll leave the liability issues to the attorneys.

The lessee / lessor entity structure can be used for a few different tax reasons:

1) There is a REIT investor - in which case they can only have "Rental" type income, while hotel operations generates "Ordinary" income. Thus they split out the Rental, and use a C-Corp blocker to eat up the Ordinary.

2) The activity would generate self employment income.  In which case, splitting out the rental portion of the activity from the operating portion would help reduce the exposure to self employment tax

3) One is a qualified real estate professional for tax purposes...but wouldn't be a material participant in the hotel activity.  By splitting out the rental, voila, now you have rental losses which are automatically aggregated with all your other rental activities and are non-passive, even if you don't materially participate on it's own.  This is a rather narrow set of circumstances, but it is out there.

For your situation, sounds like you would just be considering items 2 and 3 for tax purposes. The barrier is the additional complexity - now you are operating two sets of books, and filing two tax returns, and have more operating agreements, more state registrations, etc, need to manage cash better, need to keep in constant mind that your rents need to be a supportable FMV, which may require getting third party certification on your rents so that in the event of an IRS audit, what you have done is supported.

In short...the size of the project, and the taxable income, need to be of enough scope to make all the additional costs and annoyances worth it.  My inclination on a smaller boutique hotel, not likely worth it.

[Gordon Middleton]

Thank you @Kory Reynolds. That is a very helpful explanation. 

As far as bonus depreciation goes though, is there a need to separate the operations from the property? Whether the active income is separate from the rental portion doesn't affect how we can use the depreciation correct? 

[Kory Reynolds]

Quote from @Gordon Middleton:

Thank you @Kory Reynolds. That is a very helpful explanation. 

As far as bonus depreciation goes though, is there a need to separate the operations from the property? Whether the active income is separate from the rental portion doesn't affect how we can use the depreciation correct? 

 There is no need to separate out the operations from the property just as it relates to bonus depreciation - the same amount of bonus can be claimed with either structure, and grouping elections if needed can lump it all together for addressing any passive / active splits.

If it is a relatively small hotel, I would lean towards keeping it simple and just doing a single entity. The only ones I am involved in that they do these types of structures are typically 7 figures of NOI annually. Having an additional $5k/year in compliance costs, having additional costs to maintain two sets of books, more registration fees, getting leases set up and maintained...it can be expensive to split it up so one needs to be sure the tax costs are worth it.