the syndication, etc. Others use only a simple memorandum of the salient facts.

4

Leading syndicate managers have registered their offerings with the Securities and Exchange Commission under the Securities Act of 1933 as well as under State securities laws. Others take the position that registration is not required by reason of specific exemptions contained in the act.

Throughout this entire period, the syndicate manager is the entrepreneur. He bears the complete risk of loss of his deposit and the expenses he has advanced, if his syndication is not successful.

The syndicate manager's reward for his efforts has taken many different forms. Some charge a fee for their services which becomes part of the cost of acquiring the property. Others retain for themselves a participation in the syndicate on terms more favorable than incoming members. Still others, share in the annual income from the property after the participants have received a fixed return or share in the proceeds of sale or refinancing. Invariably complete disclosure is made to investors. Usually, too, the syndicate manager invests in the syndicate.

After the purchase has been completed the syndicate manager directly, or through a real estate management agent continues to supervise the investment, usually on a fee basis. This requires periodic physical inspection of the property, supervision of insurance coverage, negotiation of leases with new and old tenants, review of expenses, arrangement for refinancing when necessary, preparation and filing of reports and submission of information to participants. Syndicate purchases are usually intended to be long term investments-but if the property is to be sold or refinanced, it is the syndicate manager who makes the recommendation to his group. However, as a general rule a syndicate manager does not have the right to sell the property without the concurrence of a substantial majority in interest of the participants.

Most syndicate managers seek a cash return of 12 percent per annum to their investors.5 No attempt should be made to equate this with the yield on securities since the terms involved are not comparable. Cash return is not equivalent to net income or taxable net income. The real estate investor ignores depreciation as an expense and substitutes, as a deduction, amortization which must be paid to liquidate the mortgage indebtedness on the property. Depreciation is deductible for income tax purposes, amortization is not. Thus, a 12 percent cash return includes not only income derived from the property but also to the extent depreciation exceeds amortization cash ordinarily accumulated for depreciation reserves and to that extent, a return of capital. In addition to the cash return, the participant's equity in the property increases annually as the mortgage indebtedness is liquidated. Thus, when the mortgage is paid off, the cash return increases substantially.

A return of 12 percent is not always available to the syndicate manager. Sometimes the property must be refinanced to achieve the desired return. Some syndicate managers favor the creation of a

See Kroll, "Syndication and Regulation," 14 The Record of the Association of the Bar of the City of New York 74 (1959). Helmsley, ibid., fn. 2.

lease position and sometimes will organize a syndicate to take a lease of the entire premises. The lessee pays the fee-owning syndicate a rental which may return 12 percent to the participants in the fee. The lessee takes greater risks and initially may get a smaller return. Its hope of greater profit, however, stems from the possibility of increasing the income from the property. It may be noted parenthetically that prime properties returning 12 percent per annum are currently not available; indeed, it is extremely difficult at this time to purchase good properties which will yield a 10 percent cash return per annum. There has been, in recent months, a decided slackening in new syndicate activity.

There is no particular significance to 12 percent as a cash return. It is the rate which has been developed in the marketplace by numerous buyers and sellers of real estate. It is the rate at which an investor is willing to take the greater risks inherent in any investment which is not readily marketable. It may vary with the location of the property, the margin of safety (excess of income over charges), the credit standing of the tenant, the length of the lease, etc. It competes with every other type of investment.

Some syndicate managers confine their participants to limited groups, clients, friends, relatives and do not solicit or invite anyone with whom they do not have a close acquaintance or working relationship. Others solicit investors through brokers or advertise in the newspapers or by sending brochures to persons on their mailing lists. The average participant is content to rely on the ability and integrity of the syndicate manager. This reliance may at times be compelled because the individual investor may lack the ability to judge the merits of a prospective offering, the resources to purchase alone a desirable parcel, or the time to make the thorough investigation required in the purchase of real estate. He is or must be aware that his investment is reasonably permanent and that he gives up a substantial measure of control over the property. Nevertheless, he knows he will receive periodically his proportionate share of all of the available cash income.

The number of participants in a syndicate vary. Some have less than 10, others in the hundreds, perhaps thousands. The average cash investment of a participant varies from $5,000 to $10,000. However, in many syndicates there are participations of $2,500 or less and, in contrast, there may also be occasional participations of $100,000 to $150,000. The beneficial interest of a participant may vary from a fraction of 1 percent to 25 or 35 percent.

Properties acquired on a syndicate basis are located, as would be expected, in commercial and industrial areas. They are not, however, confined to one particular location. Syndicates have invested in properties in California, Maryland, New Jersey, New York, Pennsylvania, Tennessee, and Washington, D.C. The list is by no means complete.

II. THE LEGAL ENTITY ADOPTED BY SYNDICATES

In adopting the form of entity which is to own and operate the syndicate property, the syndicate manager is motivated primarily by

Greenblatt, "Real Estate Syndication: Some Basic Considerations," 14 the Record of the Association of the Bar of the City of New York 68 (1959).

the necessity of avoiding the corporate income tax. The very essence of a syndication is that the cash income will be distributed periodically to the participants and they will report in their personal returns and pay a tax on their pro rata shares of the net taxable income of the property. Thus a form of entity must be adopted which will be construed as a conduit for Federal income tax purposes. The imposition of a tax on the entity on the ground that it is an association taxable as a corporation, will invariably make it impossible to pay the desired and, at times, promised return to the participants. A tax on the entity plus the further tax levied on the participants on distributions, would serve, effectively, to discourage, impair, and probably destroy syndicate investments.

8

The Treasury Department's income tax regulations have for 20 years held that a limited partnership will be deemed an association taxable as a corporation if it is not interrupted by the death of a general partner or by a change in the ownership of his participating interest, and if the management of its affairs is centralized in one or more persons acting in a representative capacity. Both conditions must be present. Acting in reliance on these regulations, syndicate managers have used such forms as general partnerships, limited partnerships, joint ventures and trusts, in each case being careful to avoid the conditions which will subject the organization to taxation as a corporation. Many syndicate managers submit their forms to counsel for an opinion regarding taxability and inform their participants of the substance of the opinion rendered. The regulations under the 1954 Internal Revenue Code have not at this writing been promulgated or proposed. It is an open secret that they are presently under consideration and will probably impose more stringent requirements than heretofore.

The many different types of noncorporate forms adopted by syndicate managers are unnatural and at times unwieldy but stem from the need of avoiding the corporate tax. Yet, incorporation is the natural form for these enterprises.

Personal liability of a participant of a real estate syndicate may usually be limited without too much difficulty. The principal creditor is the lending institution which has placed a mortgage on the property. In most cases it is usually simple to limit liability on such debts to the property itself by an exculpatory clause in the mortgage or use of a nominee to execute the bond. Liability on long-term leases may be limited by a clause permitting transfer without any continuing obligation on the original lessee. Other debts of a real estate syndicate are relatively insignificant.

The desirability of the corporate form stems not so much from a need to limit liability as from ease of operation. It is simpler for a corporation, rather than a large group of individuals, to buy property, to sell property, to refinance property, to make leases, to hold title, etc. For example, a lending institution may be completely willing to make a mortgage loan on a particular property but be reluctant to

At least one syndicate manager has incorporated all his syndications. This may not be costly taxwise, if the allowable depreciation exceeds or approximates net income thus resulting in little or no income tax. There are many corporations, publicly and privately held which own real estate. These usually, however, were not created with the view to distribution of all income to shareholders.

T.D. 4894, 1939-1 C.B. 79; see also sec. 3797-5 of Regulations 103, 111, 118.

deal with a hundred, or 50, or even 10 tenants in common. A company which insures title would normally insist on proof that all the tenants in common were alive as of the moment the transfer of title takes place. The lessee of a long-term lease could insist that each owner sign its lease.

Death of a shareholder does not interrupt the continuity of a corporation. In a noncorporate form it may lead to protracted probate proceedings, introduction of a widow and minor children, and invariably uncertainty regarding clear title to the property.

Our Federal income tax law hampers syndicates in the selection of the form of organization which is most suitable to their purposes and denies them the advantages of the corporate form.

III. FAIR AND EQUITABLE TAXATION OF INCOME DERIVED FROM REAL ESTATE INVESTMENTS

It is all too easy to adopt the pat phrase that our Federal income tax system should be fair and equitable. But as we measure any particular tax provision against this concept, we are beset by an even greater problem than the one we seek to solve the necessity for setting standards by which we can determine what is fair and what is equitable.

Is an income tax system fair and equitable only if a tax is imposed on income at the corporate level and again at the shareholder level? Should it make any difference whether the corporation is actively engaged in a trade or business or passively standing by receiving only one rent check a month from a tenant who has taken a long-term net lease on the corporation's property?

Let me refer back to the office building owned by A in his individual capacity before he became a syndicate manager. Suppose he enters into a net lease with X corporation for the entire premises. X undertakes to pay all operating expenses such as salaries and wages, repairs, insurance, etc., and real estate taxes and, in addition, to pay A a specific sum monthly as rent. X subleases space in the building to various tenants and collects the income. X's profit or loss is dependent upon the extent to which it can sublease the premises. A's income is assured so long as X corporation pays its rent. He reports his income in his income tax return and deducts mortgage interest and a reasonable allowance for depreciation. A is sometimes described as a passive investor. By every imaginable standard, the imposition of an ordinary income tax on such income at progressive rates is fair and equitable.

Modify the situation and assume that A decides not to enter into a lease with X but to enter directly into leases with tenants, collect the income, pay operating expenses and other charges, etc. In such circumstances, A is said to be engaged in the active conduct of the trade or business of operating the building. Nonetheless, the same ordinary income tax is imposed on his net income at progressive rates and it has not been suggested that the tax imposed was not "fair and equitable."

The amount on which A must pay an ordinary income tax is not dependent in any manner on the disposition of the taxable net income.

Thus A may use the net income to build a new addition to his building, or to make payments on account of the principal of a mortgage against the property. He may purchase securities or use it to support himself and his household. The amount subject to tax and the tax remains the same.

I submit that a tax imposed at progressive rates on the income derived by an owner from the operation of real estate is fair and equitable.

Should a greater tax be imposed upon A if he is only a "passive investor" or, conversely, should a greater burden be imposed if he is deemed engaged in the active conduct of a trade or business? I can perceive no reason why the tax burden should be different and our present income tax laws do not recognize such a distinction.10

I now turn to the situation where B has joined with A in the purchase of a second property. A and B are tenants in common, each owns a one-half interest in the property and each reports one-half of the income in his tax return. Each pays an ordinary income tax at progressive rates on his share of the net income. The tax imposed is no less fair and equitable than if each owned a separate parcel of property which produced an amount of income equal to their onehalf share.

As the number of persons who participate with him in his purchases increases, A begins to use different forms. He may elect a joint venture, a general partnership, a limited partnership, a trust, or some combination of these. He cannot incorporate. Should an added tax burden be imposed on the operation merely because it adopts a form similar to a corporation or in fact incorporates?

I suggest that fairness and equity do not require a double tax on the income from operation of real estate regardless of the form of entity adopted, the number of participants or the nature of the operation, provided, the parties retain such control over the income as to make them in substance the owners thereof." This is the rule today of the unincorporated entity which is not taxable as an association. It should also be the rule applicable to corporations and associations taxable as corporations. Our courts have often admonished us not to exalt form over substance.12 In his budget message of 1954, the President said that small firms should be able to operate under whatever form of organization is desirable without being influenced by tax considerations and then recommended "that corporations with a small number of active stockholders be given the option to be taxed as partnerships." The concern for small business is commendable but no logical reason requires discrimination against real estate investments.

• One writer has suggested that a taxpayer does not receive preferential treatment if his savings and personal consumption are financed solely by money received in the form of ordinary income. Blum, "The Effects of Special Provisions in the Income Tax on Taxpayer Morale," hearings before the Subcommittee on Tax Policy of the Joint Committee on the Economic Report, 84th Cong., 1st sess., p. 251. Presumably the tax burden is fair and equitable if the taxpayer has not received preferential treatment.

10 I am not unaware of the policy of conferring limited tax exemption to earned income; however, I do not believe it has application to the situation discussed.

11 Tax equity is achieved when the same load is placed on different persons who are in similar economic positions. Blough, "The Federal Taxing Process," p. 48 (1952). 12 Weiss v. Stearn, 265 U.S. 242 (1924); Gregory v. Helvering, 293 U.S. 465 (1935).