Ch.8 Financial Statements

Sole Proprietorship

-a business enterprise owned by a single individual

-the owner is personally liable for all of the debts incurred by the proprietorship

-unlimited liability: If the proprietorship is unable to pay its debts, the proprietorship’s creditors may collect from the personal assets of the owner.

-not regarded as a separate legal entity and does not pay income taxes.

-the profits of the proprietorship accrue to the owner (whether or not the owner withdraws all of the profits from the proprietorship) and are taxed as part of their personal income.

General Partnerships

-a form of organization in which two or more persons carry on a business with a view to profit

-Usually the parties will agree to form a partnership by means of a contract, known as a partnership agreement, egistered under the Partnership Act.

-The partnership then takes on a personality of its own, although whether it becomes a distinct and separate legal entity is a matter of debate.

-not a taxable separate legal entity; it is a conduit through which any income flows through to the partners according to their partnership agreement.

-The income is not taxed at the partnership level, but as part of each partner’s personal tax return.

-each general partner becomes personally liable for all the debts incurred in the ordinary course of business regardless of whether the partner approved of what was done.

-E.g., if a junior partner signs a contract with a supplier who believes the junior partner has authority to enter contracts on behalf of the partnership, the contract is binding on all general partners. In such an instance, however, the other partners could seek to recover their losses from the junior partner who exceeded their authority.

Limited Partnership

-a form of organization similar to a general partnership, consisting of one or more general (managing) partners and one or more limited partners

-The general partners actively carry on the business of the partnership and have unlimited liability (the same as the partners in general partnerships). The limited partners are passive investors.

-They may receive income from the partnership, but as long as they do not take part in the day-to-day operations of the partnership, their liability to creditors is limited to the amount of capital that they have contributed to the partnership

-If a limited partner becomes active in the management of the firm, they risk being deemed a general partner and thus becoming exposed to unlimited liability.

-both partnerships have the same income tax status. For real estate investment, partnerships offer some tax benefits that are not available to corporations,

Limited Liability Partnership (LLP)

-a variation of a general partnership, where the partners are actively involved in the business and have limited liability

-often used in professional services firms.

-Each limited partner in an LLP can make management decisions for the enterprise

-each partner’s liability for the overall debts of the LLP and the wrongful actions of other partners is limited to their investment, with two caveats:

1. Each partner remains personally liable for their own negligent or wrongful acts or omissions, beyond their investment in the LLP; and

2. Any partner may lose this limited liability and be held personally liable for the acts of another partner or an employee of the partnership if they had knowledge of these acts and failed to take reasonable actions to prevent them.

-two main reasons for the use of LLPs:

1. Partners are accountable to their clients or customers; and

2. All partners have the ability to be active in their business without exposing themselves to personal liability for the acts of their other partners (beyond the value of their investment in the partnership).

-has primarily been used in BC for law, notary, and accounting firms

-Overall, partnerships are less common than corporations in real estate professional services firms.

Corporations

-a business entity that is owned by shareholders who decide on the general policies of the company through their elected Board of Directors; a separate legal entity with the rights and liabilities of an individual

-created by a Certificate of Incorporation issued by the provincial or federal government.

-A company whose shares are traded on a stock exchange is referred to as a public company, whereas one whose shares are not traded on an exchange is classified as a private company.

-The shareholders have input in the general policies of the company to the extent that they elect the directors, but the board of directors manages the company in accordance with the Canada Business Corporations Act and their company’s Articles, free from any shareholder interference whatsoever.

-The directors are primarily liable to the company rather than to the shareholders

-shareholders are liable only for the value of the shares purchased or agreed to be purchased.

-A corporation is a separate legal entity; it has its own personality separate from the shareholders or owners, and its own income tax status.

-may then pay out the income to shareholders in the form of dividends, which have a beneficial tax treatment compared to personal income.

-or may choose to withhold income as retained earnings, deferring further taxation for owners.

-Perhaps one disadvantage of corporations, as an investment vehicle to purchase real estate, is that they may somewhat limit the potential for tax sheltering

-since the shares pass from one owner to another, the company exists until it is terminated by an act of those shareholders.

Personal Real Estate Corporations (PRECs)

• Limited liability: the licensee’s personal assets are protected from many business liabilities; however, an important exception for PRECs is that the licensee remains personally liable for actions related to provision of real estate services (though these may be covered by errors and omissions insurance).

• Business taxation: the PREC may facilitate more deductible business expenses, plus payment of corporate tax rates that are lower than personal tax rates.

• Income splitting: the PREC may issue non-voting shares to the spouse and children, reducing taxes payable by spreading income to family members.

• Tax deferral: income may be retained in the corporation, with personal taxes only paid once dividends are distributed.

• Lower tax rate: earnings are subject to a lower corporate tax rate up to a pre-determined threshold; earnings after this point are taxed at a higher corporate business tax rate, though still lower than the highest marginal tax rate for an individual.

-Despite numerous benefits, there are accounting costs for both establishing and maintaining a PREC; as well, the PREC requires double the real estate fees, as both the licensee and the PREC must be licensed and carry errors & omissions insurance.

Trusts and REITs (Real Estate Investment Trusts)

-not a form of business operation, but can serve as a means for people to collectively invest

-a trustee holds assets in their name (“in trust”) for the benefit of the investors (beneficial owners).

-The trustee manages the assets, as agreed upon by the individual participants, and any subsequent profits or losses are passed onto the beneficial owners.

-REITs are an example of using a trust to collectively invest in mortgages and real estate assets.

-The assets are placed in trust and beneficial interests/trust units are sold to investors who share in the annual income from those assets.

-As long as the trust meets Canada Revenue Agency’s (CRA) rules, the income earned by the trust is not taxed

-income distributed to the beneficial owners of the trust units is included as part of their individual taxable income and subject to income tax.

-the beneficial owners are generally liable only for the amount committed to the purchase of the trust units

-offers the same liability protection of the corporation, but also potentially the tax advantages of a partnership

-offer excellent liquidity, with listings on major public stock exchanges.

-simple, advantageous way for smaller investors to get involved in commercial real estate ownership.

Joint Venture

-consists of two or more legal entities (e.g., individuals, corporations) that decide to cooperate in carrying out some undertaking.

-risks and costs of some undertaking can be shared between two or more established legal entities

-Money is put into the venture (which may be to explore or develop an area) and separate accounts are maintained, with profits or losses being apportioned to the participants.

-The legal form of the joint venture could be that of a partnership or that of a corporation.