In today’s litigious society, if you plan to invest in real estate, you should seriously consider utilizing a business entity to protect your personal assets against potential losses and liabilities.
Investing in real estate requires a bit more savvy than merely deciding to rent out your condo when you are ready to move on to a house. As a novice investor, do your homework. Make sure you know the legal requirements in your State. And how to protect yourself and your assets against potential losses and liabilities.
Well, let’s go back to that condo. Imagine that you are renting it to a lovely family. They are tidy and clean and always pay their rent on time. Everything is great. Until one winter’s day, a delivery person slips on black ice on the driveway. He hits his head, requires an ambulance, a hospital visit, subsequent doctor visits, and lost time at work. On the advice of his lawyer brother-in-law, he decides to sue for damages. You, as a property owner, suddenly find yourself embroiled in a lawsuit.
It is vital to be sure that your personal assets are completely untouchable – separate from anything to do with the rental property.
Setting up an LLC or an S-Corp can solve that liability problem for real estate investors. But without a clear understanding of the benefits and pitfalls of both entities, knowing which way to go can be a daunting task. Let’s take a closer look at both and see which one might work best for you.
Limited Liability Corporations (LLCs) haven’t been around very long. In 1977, the State of Wyoming decided to create this new business entity to alleviate double taxation. Business owners paid taxes on money they earned at a corporate level, then the funds were taxed again as income when upon distribution to the owners.
After an 11-year battle with the IRS as to how the Federal Government would handle the taxation of this new business entity, LLCs finally caught on in the 1990s. Now, two-thirds of every corporation formed is an LLC.
In simple terms, a Limited Liability Corporation (LLC) is a means of structuring a business. An S-Corp addresses how a company pays taxes.
Both entities protect the investor’s personal assets from any debts or liabilities that a business might incur. Some examples include foreclosure, personal injury, or catastrophic loss, which could financially destroy an investor if his personal assets remain unprotected. Despite readily available liability insurance, asset protection remains the number one reason for real estate investors to choose an LLC or S-Corp structure.
Both an LLC and an S-Corp allow for the separation of personal and business assets and provide “pass-through” asset distribution to owners and/or shareholders.
The most significant difference between the two has to do with their tax implications. For taxation purposes, the IRS automatically designates an LLC either as a sole proprietorship or as a partnership – depending on the number of owners. Those owners can elect the LLC to be an S-Corp or a C-Corp, depending on how they choose to distribute income and assets within the corporation.
Each individual must report income and deductions, gains and losses, as part of their personal income. Each person must also pay their own self-employment taxes based on those figures.
They are taxed on their salary – which must be reasonable – and on their dividends. However, the dividends are based on a different rate than income and do not include self-employment taxes. Depending on total income, this might be a much better tax benefit.
LLCs are extremely popular with small business owners because they are quite easy to set up and to manage. They offer a good compromise: some of the benefits and protections of a corporation, without the headaches of big administration and income reporting. LLC owners also enjoy considerable flexibility in how their money is taxed.
This includes filing fees, which vary from State to State but are typically around $500. Despite the costs, many real estate investors believe that the benefits of personal asset protection more than outweigh the cost of setting up the LLC. It’s kind of like insurance for your assets.
With an LLC, both income and expenses “pass-through” the LLC to the owner. Business owners report and file the transactions of the business as part of their personal taxes. This is much simpler than having to file corporate taxes in addition to individual taxes.
In an S-Corp, the money also “passes through” to the business owners, but in a different way. The owners or shareholders can take some money as income and some as distribution or dividends from the business. This allows owners to pay lower self-employment taxes as a different tax rate applies to the distributions or dividends.
They are required to follow a more rigid structure of meetings; they must have a payroll, and typically have to file quarterly payroll reports.
Other rules affect S-Corp businesses as well. There can only be a maximum of 100 shareholders. Those shareholders must be U.S. Citizens or Permanent Residents. All documents, such as minutes of meetings about the S-Corp, must be filed with the State. And certain States, like California and New York, have laws specifically addressing S-Corp entities.
Whether or not to designate your business as an S-Corp depends on your goals as a real estate investor.
If you just want to have some rental income from a property or two and protect your assets, you might be better off forming an LLC. However, if your goals involve purchasing, building, flipping, or sub-dividing multiple properties, an S-Corp designation would probably suit you better.
Your finances are entirely separate from business finances. The most significant savings come through the amount of personal tax you must pay. Owners may also deduct the cost of required health insurance.
This income is taxed at the individual rate and subject to self-employment taxes. However, the remainder of the profits of the company may be distributed to the owners/shareholders simply as other profits or dividends and therefore are not subject to the higher tax rates of personal income. Depending on how much the company earns and how many shareholders there are, this could prove to be a significant savings for real estate investors.
Many people don’t realize that an LLC can be set up to be taxed as an S-Corp. It provides an investor with all the benefits of an LLC combined with the tax benefits of an S-Corp. It might be the best of both worlds.
Unless a single member business owner specifically designates the LLC as an S-Corp when it is established, the IRS automatically considers it a sole-proprietorship for taxation purposes. Personal assets are still safe from losses and liabilities of the business. The main difference involves distribution and taxation.
Typically, as a sole proprietorship LLC, the income and expenses of the business “pass-through” the LLC directly to the owner who then files and reports them on their taxes. The owner can claim mortgage interest, maintenance, and other expenses of owning the property. This is particularly beneficial if, as a real estate investor, you have one or only a few rental properties and are not particularly concerned about significant self-employment taxes.
If, on the other hand, you own multiple investment properties, with varying income or potential, you may want to elect the S-Corp designation to save money on self-employment taxes. Be aware, however, that the IRS limits S-Corp shareholders to 100, and they must be U.S. citizens or Permanent Residents.
Also, taxation laws change frequently, so be sure to consult a tax specialist before making your ultimate decision on what works best for you.
This decision also depends on your long-term goals as a real estate investor. When you embark upon setting up your business, it is worth it to consider the longer-term instead of just the immediate future. In most states, business owners have around two months to decide if they want to elect to be an S-Corp.
While LLCs do have corporate structure regulations, they tend not to be so strictly enforced. If you are a sole-proprietor, it is unlikely that you will demand access to your By-Laws or have to file minutes with the State when you conduct your annual meeting with yourself.
Some investors begin with an LLC and, as they grow and take on more properties, create an LLC for each entity. In that case, if you were to purchase a property that required the specific kinds of tax benefits provided by an S-Corp, you could designate that at the outset.
You might elect to begin your entrepreneurial adventure as an LLC. Perhaps it makes more sense for you in terms of ease of organization, bookkeeping, income levels, etc. However, in a few years, you might find that financially, it is time to change to an S-Corp. In most States, you can do it easily by filing Form 8832 with the IRS. This simply indicates that you wish to change the tax designation of the entity. The actual operation of the company remains the same. Changes occur in the distribution of money and how the IRS calculates tax liability.
One of the tools that you can use to help determine how best to set up your business is an S-Corp vs. LLC Tax Calculator. This allows you to compare, in a side-by-side S-Corp vs. LLC chart, the tax liabilities for your business.
As an LLC, the total annual income for your business determines your tax level. Since the business income passes through to your income, you pay tax on the total.
As an S-Corp, calculate the salary you would pay yourself to know what your self-employment tax level is. Combine that number with your dividend for a total tax liability.
In terms of real estate investing, the question is not whether to set up an LLC or an S-Corp, but rather which to choose. Protecting personal assets should be paramount. However, it is also essential to understand the S-Corp vs. LLC tax implications of each entity as they have a significant impact on your ultimate tax obligation.
In The One Percent, we recently took a deep dive into how to make money in real estate. To learn more about the most proven wealth creation system ever in history, join us and look for the February issue, the Real Estate Edition.