Phantom Leases: The Best Occupancy Structure for An Owner-OccupantBrian A. OpertPhantom Lease, Owner-Occupant, Protection Against Law Suit Liability, real estate Traditionally, closely held businesses that also own and occupy their real estate properties are dealt with as one entity--the owner of the business, often a sole proprietorship, is usually the owner of the real estate as well. This individual owns the operating business and the building that the business occupies in their name, which makes a significant impact on how both the business and real estate are valued. For example, a marina that operates the boats slips, repair shops and a boat supply store is dealt with as a boat maintenance business that also occupies its real estate. The manufacturer, who is the sole occupant of the office/warehouse, is valued-based on the business earnings, plus the value of its overhead cranes, manufacturing equipment and inventory, rather than as a tenant in a commercial property. A pizza parlor that owns and occupies most of the small strip center is valued as a business, with the real estate as an asset of the business. A funeral home that owns the building and land it occupies, is valued as a business with the real estate as an asset of the business. In each situation, the real estate, which may have significant value in its own right, is often booked as a depreciating asset by the accountants and often appears on the balance sheet as negative. Phantom Lease Perhaps there is a better way to structure and value these types of businesses that are associated with the real estate that they occupy. This structure changes the primary focus from a business operation that occupies real estate to owned real estate that is leased to the business. This different approach uses a "phantom lease." This is a phantom insofar as the relationship between property owner and tenant is not arms length. This concept is not new, especially for major U.S. corporations that seldom, if ever, own the real estate in the same name as the corporate parent. It may be a recent evolution impacting the small business and small real estate owner, which needs to be further examined. The Lessor Under this proposed scenario, the land and improvements (buildings) are acquired and owned by a single asset and special purpose entity, whose function is to own and manage the real estate and buildings. The entity can be an limited liability company (LLC), corporation, partnership or any other special purpose entity that makes legal and financial sense to the principal(s). Under this plan, this entity becomes the lessor. The Lessee The principal(s) of the company who owns the real estate can and should be the same principal(s) as those who own the business, which then becomes another separate entity or continues to be an individual proprietorship. Thereby, the business becomes the tenant--also called the lessee. The business can become or remain as an LLC, corporation, partnership, sole proprietorship or other entity that it has always been. It can also become a new corporate entity to better differentiate between the two. The Lease The lessor leases the real estate and improvements to the lessee, under a lengthy lease, at market rent, usually on a triple net basis. In form, this may not be different than what actually has transpired in the past. The manufacturing company, retailer or other business owner continues to occupy, manage, maintain and operate the property. The major difference is that instead of the business being required to obtain a mortgage directly and paying the debt service directly and the costs to maintain and operate the property, the lessee now pays rent to both the lessor and to maintain the property. Under this plan, the business does not own the real estate. It may still own the equipment, inventory, goodwill and customers of the company, and is responsible for hiring all employees. The business continues to pay for the utilities, insurance, repairs and maintenance and even the real estate taxes--similar to the past. On the other hand, the lessor, who owns only the real estate asset, is able to borrow money pursuant to a mortgage, and, therefore, is responsible for the debt service payments. The funds derived for these mortgage payments are obtained from the rent payments made by the lessee. To some individuals, this appears as taking money from one pocket and putting it into the other and appears to require additional overhead and cost with little or no benefit. However, this is not necessarily the situation. Advantages Let us take a look at some of the benefits. 1. Real Estate Ownership. It has been demonstrated over recent years that an ownership structure that is a single asset and special purpose entity has an easier time in securing financing and is simpler to track financially. 2. Protection Against Law Suit Liability. The real estate, to some extent, is protected against suit in the event of a liability claim against the tenant, which in this example is the business, as well as visa versa. A dispute that involves the business operation does not inevitably tie-up the real estate. There is some additional security derived from this separation of owners. 3. Furniture, Fixtures and Equipment (FF & E) Ownership Oftentimes, lenders who lend on real estate as collateral have minimal interest in FF & E as additional collateral. Accordingly, a lender may have no requirement to also file a lien and tie up the equipment, inventory and receivables of the business. This frees up this other collateral for the business to obtain additional operating capital and financing independently. 4. Real Estate Value. The real estate has its own value in the marketplace, unrelated to its value in the tenant business. This asset is valued by examining the market independently of the tenant, using market rents and comparable sales. Such rents and sales have no specific relationship to the tenant, the tenant's creditworthiness or its operating profit. If a lease is established between the tenant and the property owner, based on market rent for similar properties with similar occupancies in the area, the value of the building can be established accordingly, outside of the scope of the tenant's business enterprise. When the two are valued separately, this may result in greater total value than if valued as one enterprise combined. 5. Off-Balance Sheet Financing. The debt on the building is not necessarily a debt on the operating business. The company may have a more healthy balance sheet as a result. It may find greater flexibility in seeking other operating financing, such as factoring, equipment financing and leases. 6. Freedom to Relocate. In the event that the business grows or dies, it can relocate without disposing of the real estate. Alternatively, if the business alone does not survive, it does not automatically imply the loss of the real estate as well. The real estate can be leased to another tenant or tenants and survive independently. 7. Financial Independence. In the event of financial distress, the real estate can be sold with a sale-leaseback agreement, permitting a large infusion of new non-leveraged cash into the business, without the need to simply shut down. This is completed through an immediate sale of the real estate, with a recoup of equity as new capital. 8. Income Tax Shelter. The ownership of real estate can be used as a tax shelter in certain circumstances, with real estate losses used to shelter other passive income by deferring personal income taxes. This special purpose entity of owning the real estate may be the correct vehicle to take advantage of such a special situation. Disadvantages The following are the few disadvantages: paying the necessary fees to establish the new separate entity to own the real estate; the requirement to maintain two sets of books and records--one for the business and one for the real estate; the requirement to file tax returns separately; and the possibility to have two income tax burdens. Furthermore, to convert an existing business situation into the two entity structure, the real estate must be "quit-claimed" to the new entity without incurring a taxable event. If the principals remains unchanged, this should not present a problem. Conclusion Small business owners may maximize the financial benefits of also owning the commercial real estate that the business occupies by establishing a phantom lease between the real estate owner separately from the business operation. It is good business planning for the short-term and offers a wide range of capital and financing options for the long term. Brian A. Opert is a partner with Sterling Partners Capital LLC. He may be reached at (203) 256-9068, fax (203) 256-9564 or e-mail [email protected].