Musicians know that their rehearsal time isn’t the same thing as their arrival time. They are expected to be in their seats with their instrument ready and tuned. The musician will already have warmed up and put their music on the stand. They should be prepared to play the composition they are rehearsing.
Suppose the musician wasn’t told in advance what music was to be rehearsed. Most musicians will bring their entire orchestra folder to be prepared. Many might even take a guess at what will be rehearsed and put that music on the stand.
But if the piece required a mute, wind players might not even have the correct mute with them. Even if a violinist carries a met in their case, it might not be on the instrument at the beginning of rehearsal.
Or suppose the musician wasn’t told the rehearsal would involve unique circumstances, such as playing in an orchestra pit or playing outside or in a low-light situation. Unless told in advance, few musicians would bring supplies to play outdoors.
Few musicians routinely have clothespins or clips to hold music on the stand on a windy day in their cases. Brass players rarely have coverings to protect their instruments from the rain–unless they know in advance they will be playing outdoors in rainy conditions. String players usually take their better instruments, rather than their less expensive “outdoor” instrument, to rehearsals. And musicians go to rehearsals expecting to have sufficient light to see the music. Few musicians would have lights to help see the music unless told in advance to bring lights to perform in the dark.
Businesses facing a new law or regulation are like orchestra musicians. Most businesses will plan ahead so they can comply with new legal requirements on the law’s effective date.
However, some laws are general and delegate details to a regulatory agency. Until the agency adopts regulations, business attorneys may have more questions than answers about the law. And like a musician who isn’t told they will need a mute or that a rehearsal is outdoors, a business that isn’t aware of new legal requirements in advance may guess what they need to do to prepare for the law. But if the business guesses wrong, like the musician who doesn’t know they will be playing outdoors, the business may not be able to comply with new laws on day one.
On December 11, 2020, as part of the National Defense Authorization Act (NDAA), Congress passed the Corporate Transparency Act (CTA). Although President Trump vetoed the NDAA, Congress overrode the veto. Therefore, the NDAA was effective on January 1, 2021.
The CTA is likely to have a significant impact on real estate investments and may affect small businesses. The Department of Treasury must adopt rules implementing the CTA within one year of its effective date. So, businesses and real estate investments won’t have to comply with it until 2022.
Still, real estate investments need to prepare now for the CTA’s implementation. And without regulations, like the musician who doesn’t know whether they need a mute or clothespins, real estate sponsors can’t be sure what preparation to make. This article discusses what real estate sponsors can do now to prepare for the CTA.
What Companies Will Be Subject to the CTA?
The CTA was supposed to apply to “shell companies” or companies without significant operations. However, the CTA applies to many companies that aren’t what most people think of as “shell companies.” And the CTA applies to many companies with active, thriving operations.
The CTA defines “reporting company” as any corporation, limited liability company (LLC), or “similar entity” that is created by a filing with a federal, state, or triable government or which is authored to do business in the United States. There’s an exception for entities that meet ALL of these requirements:
have more than 20 full-time employees in the United States;
report more than $5 million in gross receipts or sales to the Internal Revenue Service (IRS); and
have an operating presence at a physical office in the United States.
The CTA also doesn’t apply to entities, such as banks that are already subject to federal regulation or to entities considered “dormant.”
Many small businesses won’t fall under the exemption even though they have significant operations. A small bakery or boutique retailer is hardly a shell company. Yet, it’s unlikely to have $5 million in gross receipts or more than 20 full-time employees.
Real estate investments may own a large apartment complex or strip mall. Even if the investment generates more than $5 million in gross receipts, it isn’t likely to qualify for the CTA exemption because it won’t have more than 20 employees.
That’s because mortgage lenders require the real estate to be owned by a special purpose entity (SPE) that doesn’t have employees. The SPEs aren’t set up to conceal real estate ownership but rather to protect the lender. If the real estate owner doesn’t have employees, the mortgage lender doesn’t have to worry about the real estate being encumbered by payroll tax, workers’ compensation, and similar liens.
What Investor Information Needs to be Reported?
Beneficial owners whose information must be reported include any individual who directly or indirectly:
The CTA looks to the individual “warm body” or human owners, not to an entity that owns the business or real estate investment. Under the CTA, reporting companies will need to provide FinCEN with the following information for beneficial owners:
full legal name
date of birth
business or residential street address
unique identification number (e.g., non-expired driver’s license, state identification, or passport number)
Reporting companies must report to FinCEN upon formation and when there is a change in beneficial ownership.
Why the CTA Will Be Particularly Challenging for Real Estate Investments
It won’t be difficult for a small business to gather the information the CTA requires to be reported to FinCEN. Most small businesses have only one or a handful of owners. The owners usually all know each other and may be involved in day-to-day business operations.
However, the same isn’t true for most real estate investments. Many real estate investments are put together by sponsors. The individual owners usually are passive. They are rarely involved in day-to-day operations frequently don’t know each other.
Private REITs may not have a single beneficial owner who owns 25% or exercises substantial control over the investment. However, it’s not uncommon for real estate SPEs to have only one or a handful of owners. So, if the SPE is a reporting company under the CTA, some owner information likely will have to be reported.
Another challenge is that as the real estate fund is marketed, its beneficial ownership will change frequently. Early investors who invest what eventually will be a small percentage of the fund ownership may be 25% owners until more investors come on board. Until regulations are promulgated, there is no way to know whether every new sale of units requires a new FinCEN report or whether only changes that add 25% owners must be reported.
Real estate sponsors will know the name, address, and tax identification number for each investor. But if the investor is an entity, such as a trust, the sponsor frequently won’t have the names, addresses, and identification numbers for its beneficiaries. And even if a sponsor collects that information, it isn’t likely to have the driver’s license or passport.
Privacy is another concern. The real estate investment files tax returns, so the income isn’t secret. Real investors pay taxes on their investments, but most expect their personal information to be kept private. This isn’t because they are engaged in money laundering or other illegal activity the CTA is supposed to prevent. Instead, like most people, they consider their financial situation, including their investments, to be private.
Information reported under the CTA won’t be publicly available. But it won’t be private. The information will be available to law enforcement and to the IRS. And financial institutions can access the information for some purposes.
How Real Estate Sponsors and Investments Can Prepare Now
A musician might not know what to expect for a rehearsal. But they do know the basics–that they need their instrument and supplies, such as rosin for a string player and reeds for a woodwind player. There are ways a musician can prepare for some surprises (such as needing a mute). It usually causes no harm to be prepared for something that doesn’t happen.
The same is true of real estate investments. Until we have regulations, sponsors won’t know exactly which owners’ information will need to be reported. However, the CTA tells us what information will be required if someone’s informant must be reported.
Since we know the “what” but not the “who,” real estate sponsors should collect this information from all investors now:
Beneficial ownership back to human beings
Control of the entity (whether by a trustee or manager) back to a human being
Dates of birth for the humans
Addresses for the humans
Copies of personal identification, such as driver’s licenses and passports
For new investors, this information can be collected in the initial questionnaire/investment process. This may require significant investor communications and meetings for existing investors to explain why they need to disclose this information.
As sponsors offer new investments, they should include in subscription agreements, offering materials, and entity documents a requirement that investors provide the information required for CTA reporting. There should be built-in incentives for the investors to keep that information up-to-date. The incentive will depend upon the investment.
Real estate sponsors will need to develop infrastructure for maintaining the requested information. Since the CTA imposes ongoing reporting requirements, sponsors also will need to establish a process for investors to update the information upon ownership changes.
Sponsors also will need to monitor expiration dates on personal identification. And sponsors will need to develop and implement a process for obtaining necessary updates.
This is a good time for sponsors to review their privacy policies. Many sponsors will need to update their privacy policies to disclose that personal information may be disclosed under the CTA.
Monitor Regulatory Proposals
Through their counsel, both real estate sponsors and small businesses should monitor proposed and final regulations under the CTA. Sponsors and businesses may need to update or add to their internal policies and procedures.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.