31 Jul Early Stage, Step 13: The advantages of leasing real estate
Editor’s note: This is the 13th in a series of articles on developing start-up companies in the technology or biotechnology sectors.
Madison, Wis. – So far we have discussed several ways to finance a business entity: raising equity through securities offerings; debt financing through banks; through sale and leasebacks; and leasing assets. For many businesses, real estate is the most expensive asset to finance.
Some companies purchase their own real estate. If they do so, most professionals recommend that they own the real estate outside of the operating entity, particularly if the operating entity is a corporation. An operating entity is the entity that actually owns the active business. For example, the operating entity of a grocery store is the entity which owns the inventory, employs the workers, and runs the store.
There are a number of reasons that we advise business owners to own their real estate outside of their operating entity. One reason is to insulate the assets of the operating business and the real estate from the potential liabilities of each other. If the operating business has a liability to a creditor, the assets of the real estate entity are not subject to the creditor’s claim, and vice-versa.
Another reason is that real estate usually appreciates in value, and it may be sold as the business grows to acquire larger facilities or is sold as part of the sale of the business, itself. If the real estate was owned by a corporate operating entity, particularly a C Corp, there would be increased tax burdens on this sale. So most business owners own real estate outside of the operating entity and lease it to the operating entity. This lease is at a fair market rental rate consistent with going rents in the local market. Otherwise, the IRS can attack the rent as being either too low or too high and a gift by one party to the other.
Nonetheless, if a business owner leases real estate from a separately owned entity to the operating entity, the owner may earn income on the rental income, which after expenses, is taxable income to the owner. This income is subject to income tax, but not social security and FICA taxes, which is a substantial tax benefit and planning opportunity for a the owner of a company that owns the real estate and then leases it to the operating entity.
Leasing at will
Companies that do not own their own real estate and lease it from third parties enter into lease agreements of varying durations with various terms. The shortest-term lease is an at-will, month- to-month lease in which the landlord and tenant have an extremely short-term arrangement. This is fairly common for mini-warehouse units but not in most business circumstances. At a minimum, most businesses lease real estate from year to year or for substantially longer periods of time.
The longer the lease term is, the more the lease will likely shift ownership risk and costs from the landlord to the tenant. That is, expenses such as repairs, maintenance, capital improvements and the like would more likely be borne by the tenant than would be by the landlord. The landlord’s rent would be established at a level that would allow it to recoup enough cash to pay its mortgage and related expenses. So, in any business leasing situation, the key terms of the lease will include: the rental rate, the term, and other expenses of the real estate that the tenant will pay, such as utilities, insurance, property taxes, maintenance and repairs and the like. These terms need to be negotiated between the parties and worked out to a mutually satisfactory result.
Finally, it could very well be that the tenant wants the option to purchase the building should the tenant anticipate spending a long duration there. This purchase option could be in one of two forms. First, is a first right of refusal. This right gives the tenant the right to be offered to buy the property before it is offered to any other third party. This typically does not come with any specific terms and conditions – merely that the tenant has to be offered the right to buy it on the same terms as a third party is offers.
The tenant option
The more definitive approach is an option for the tenant to buy the property. A tenant option provides specific purchase terms, including how long or when the option can be exercised by the tenant, the purchase price, whether the landlord will allow installment payments, and details of closing the purchase. This is much more detailed and sometimes more problematic to determine but once it is determined, it is much more certain for the tenant going forward.
Now that we have covered many of the financing means for small business, we will turn to discussing strategic partnerships, franchises, and dealerships.
Previous Early-Stage articles by Joe Boucher
• Joe Boucher: Early Stage: Step 12 – Alternative forms of business finance
• Joe Boucher: Early Stage: Step 11 – Other forms of finance
• Joe Boucher: Early Stage 10: The nuances of federal laws
• Joe Boucher: Early Stage, Step 9: Raising capital in the securities landscape
• Early Stage, Step 8: Misclassifying workers brings risk
• Joe Boucher and Bonnie Wendorff: Early Stage 7, Part I: Just what is an employee?
• Joe Boucher: Early Stage: Step 6 – Taxes, taxes, taxes!
• Joe Boucher: Early Stage: Step 5 – Forming the entity
• Joe Boucher: Early Stage, Step 4: Cautionary trademark tales
• Joe Boucher: Early Stage, Step 3: Naming the entity
• Joe Boucher: Early Stage Step 2: Choosing a domain name
• Joe Boucher: Starting a tech business? Step 1 is minding the intellectual property
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