Model Real Estate Development Operating Agreement from the American Bar Association

The February 2008 edition of The Business Lawyer contains a report on Model Real Estate Development Operating Agreement with Commentary [pdf. ABA membership logon required].

The model agreement was put together by a Joint Task Force of Committee on LLCs, Partnerships and Unincorporated Entities and the Committee on Taxation, ABA Section of Business Law.

Here is the fact pattern that the model agreement addresses:

The Project. The real estate project involves the acquisition of undeveloped land and the construction of an ice skating rink complex with a hotel, retail shops, condominiums, and an office building.

The Venturers. The proposed venturers are: (1) a real estate development and management company (the “Developer”), whose focus is to organize the venture, acquire the land, obtain appropriate permits, oversee construction of all the buildings in phases, manage all of the buildings, and hire the appropriate leasing agents and ancillary specialists necessary for the project; (2) the owner of the undeveloped land (the “Land”) upon which the project is to be constructed (the “Landowner”); and (3) an investor who will provide the necessary equity financing for the venture to obtain the needed debt financing for the construction and subsequent operation of the project (the “Financial Investor”).

The Entity. The venture (the “Company”) is to be organized as a manager-managed limited liability company under the Delaware Limited Liability Company Act (Del. Code Ann. tit. 18 §§ 101 et seq.) as in effect on August 1, 2007.

Debt Financing. While in many (if not most) cases, the construction financing will require guaranties or other forms of credit enhancement, it is assumed, for simplicity sake, that the construction loan, the permanent refinancing loan, and the operating capital line-of-credit will not require any credit enhancement and, therefore, will be treated as “nonrecourse debt” under applicable federal income tax regulations.

The Ownership/Membership Interests. The contributed capital will consist of the Land contributed by the Landowner (which is assumed to have a fair market value of $5,000,000 and an adjusted tax basis at the time that it is deeded to the Company of $1,000,000) and the cash contributed by the Financial Investor (which is assumed to be $10,000,000). The Developer does not contribute any capital to the Company. The Landowner and the Financial Investor are entitled to receive a preferred return on their contributed capital. Any residual profits will be shared 40% to the Developer, 20% to the Landowner, and 40% to the Financial Investor. These percentages were selected for mathematical convenience. The amount of the Developer’s “carried” or “promoted” interest and the amount of the investors’ preferred return (if any) will need to be discussed and agreed upon by the parties.

Tax Treatment of the Company. The Company is to be treated as a partnership for federal tax purposes as provided under Treas. Reg. § 301.7701-3(b)(i). For that reason, in many parts of the operating agreement and the commentary, the Company is referred to as a “partnership” and the members are referred to as “partners.” See, for example, the rules of construction in Section 11.8(b).

Cash Flow. In addition to the Developer’s carried or promoted interest, the Developer likely will be entitled to certain fees (e.g., development and management fees). Those fees, and the services to be provided in exchange for those fees, often are contained in other contracts between the Company and the Developer. Those fees will be paid “other than in the Developer’s capacity as a member” of the Company within the meaning of Code § 707(a) and, therefore, are not to be treated as “distributions” by the Company. Distributions of available cash after the Company has serviced its debt obligations and paid or made provision for its other liabilities are to be made to the members first, in the amount of their presumed aggregate, net income tax liabilities on their shares of the Company’s net income; second, in the amount of any remaining accrued, but unpaid, preferred return (i.e., net of applicable tax distributions) on their contributed capital; and the balance, in proportion to the members’ residual profits percentages (adjusted for any applicable tax distributions that they previously received on those profits). An exception to the foregoing distribution regime is made or proceeds received from the sale or refinancing of the Company’s property. Under hose circumstances, the members’ contributed capital is to be repaid before the remaining sale or refinancing proceeds are distributed in accordance with the members’ residual profits percentages.

Allocations. Capital accounts will be maintained in accordance with applicable Treasury Regulations. Allocations of the Company’s income, gains, losses, and deductions are to be made in a manner that allows all distributions to be made as described in the preceding paragraph while complying with applicable Treasury Regulations.

I will put up some future thoughts on the model agreement. My initial reaction is that I am not used to running into a situation where there are three parties. Usually, there is the Financial Investor and the Developer. The Landowner throws a different curve into the agreement.