“THE TAX SIDE OF ENTITY STRUCTURING”
There are three main aspects of entity structuring: legal, tax, and compliance.
The goal is to find one that meets all three criteria. One size does not fit all. Structures can be changed.
· Ease of compliance – What are the compliance requirements? – annual filings, fees, separate tax returns, mandatory meetings, etc.
· Tax Liability Reduction – What is my tax exposure based on my real estate or business strategy and how can a specific entity reduce that tax liability?
· Asset Protection – How does this entity protect me from Bottom-up and Top-down creditors?
There are different entities that are appropriate for different types of real estate investing. Before we look at the difference, here’s an explanation of why it is necessary for every business to incorporate.
Advantages of Incorporation
Protect yourself from liability – The most important reason to incorporate your business is to protect yourself from business liabilities.
Establish perpetual existence – Perpetual existence means that the life and continuation of the business will not be affected by the withdrawal or death of one of the owners.
Gain tax advantages – There are tax deductions for a wide variety of operating costs which will substantially cut back your company’s overall tax liability.
Enhance business image – Another essential reason to incorporate your business is that it adds credibility to its operation. The perception of a business is improved by its incorporation and use of “Inc.,” “Co.,” or “LLC” following the name of the business.
Improve Management Ability– The authority of an incorporated business is centralized, which usually means a Board of Directors.
Ease of Incorporating – Incorporating does not take time and can cost you less if you do not use a lawyer.
Main Entities for Short and Long Term Real Estate Strategies
There are about 13 REAL Estate Investing Strategies:
Real Estate Cash “Short Term” Strategies: 1) Bird dogging (Finding a property on behalf of another investor), 2) quick flipping houses, (wholesaling), 3) lease options, and 4)” Sandwich” Lease options.
Real Estate Equity “Short or Long Term” Strategies: 5) foreclosures, bank foreclosed real estate (REOs), either 6) short sales, and 7) taking title “subject to” the existing mortgage
Real Estate Advanced “Long Term” Strategies: 8) Commercial real estate such as apartment buildings, office space, mobile homes, etc, 9) Rehabbing, 10) Landlording
Other Real Estate Strategies: 11) Discounted mortgages, trust deeds, and other “paper”, 12) Tax Liens, 13) Land Investing
A “short-term” cash strategy is worried about self-employment taxes and therefore needs to choose an entity structure that will reduce S.E. taxes. With this strategy, you are exposed to self-employment taxes, federal taxes, and state taxes
A “long-term” equity strategy is worried about passive loss rules and being able to take real estate losses against active income. Also, the Long term is also concerned with when to start deductions. It is not necessarily in the year that the expenses occurred.
Advanced or other strategies (can be short-term or long term) could be worried about a combination of self-employment taxes as well as taking passive losses.
If you don’t plan accordingly for your investing goals and choose the correct entity structure, the taxes will definitely hurt your bottom line in a big way. As a real estate investor, you need to stay updated on which entities are on the IRS hit list.
Generally speaking, the LLC is the ideal entity to start your real estate investing with. If you decide to hold on to the property, stay with the LLC. If you flip or rehab and flip you will want something with S Corp tax treatment. So either elect S Corp for your LLC or start a new company. Here we’ll look at the definitions of various entities.
Entity Definitions
1. LIMITED LIABILITY COMPANIES (LLC): An LLC is an unincorporated business entity filed under state law, in which all owners (called “members”) have limited legal liability. It is a hybrid entity that combines some of the major legal advantages of corporations and the excellent tax advantages of general partnerships. The owners of an LLC are called members or managers.
Tax Status: As a separate legal entity, an LLC can be taxed as a sole proprietor, as a partnership, or as a corporation. But for real estate ownership, an LLC should elect to be taxed as a partnership and thereby be governed by the favorable tax benefits of partnership tax law.
2. PARTNERSHIPS: A partnership is an association of two or more legal persons (or entities) joined together in a business.
Tax Status: It is fairly inexpensive and simple to form a general partnership, plus there are no state filings. They can be done informally and verbally (although not recommended). General partnerships are not recommended for real estate transactions, due to the liability exposure.
3. LLC-PARTNERSHIPS: An LLC partnership is both a legal entity and a tax entity with at least two members. An LLC partnership is the ideal entity for most cases of real estate ownership. They are generally the best for real estate.
Tax status: On the tax side it is a partnership with the favorable tax benefits of partnership tax law, including a lower IRS audit profile.
4. LIMITED PARTNERSHIPS (LP): An LP is a separate legal entity formed under a state limited partnership statute with at least one general partner and one limited partner.
Tax status: On the tax side an LP is a pass-through entity, filing partnership tax forms, and has almost all of the same partnership tax advantages. Limited partners are totally subject to passive loss limits and are therefore not entitled to currently deduct rental property losses against other types of income.
5. CORPORATIONS: A corporation is a legal, artificial person that is separate, distinct, and apart from the owners.
Tax status – C and S Corporations:
(a) C-corporations – A C-Corporation has its own tax rate schedule and pays its own corporate taxes. It is taxed separately with a tax rate of about 40%.
(b) S-corporations – Unlike C-Corporations, S-corps do not have their own tax rate schedule and usually do not pay their own corporate taxes. Instead, income and losses (within certain limits) pass through to the shareholder’s individual tax returns. S-corps offer the same limited liability as a C-corp, yet do not have the disadvantage of double taxation. I recommend S Corps for Short Term Cash strategies with significant income. This way, you can pay yourself a salary that is subject to self-employment taxes, and the rest of your income will not be subject to self-employment taxes but the regular taxes.
6. Series LLC: The series LLC (SLLC) includes a master or umbrella LLC and other LLCs which are separated from each other for liability purposes
Each LLC has assets separate from the others, while the master LLC controls all the LLCs in the series. Each unit has its own owners (members) and is liable only for its own debts and obligations. A series LLC has been compared to a corporation with several subsidiaries
Here’s a question about LLCs for Landlords from my blog…
I have seen that many investors have an LLC. What are the benefits to a landlord that only has one property? Should I create one?
My Answer
I usually advise my clients to form entities based on three factors – legal protection, tax reduction, and compliance. You have already noted the difficulty of finding one that meets all three criteria. Right now, the best one I see out there to use is the MULTI-member LLC with a GOOD COMPREHENSIVE OPERATING AGREEMENT/UMBRELLA POLICY. Here are the main advantages:
1. LLCs have the least compliance requirements. No minutes, BOD meetings, even no formal agreement but I strongly suggest using a comprehensive operating agreement. I currently use a 121-page one for my clients.
2. Multi-member LLCs can help in asset protection by dealing with bottom up creditors (has a claim and/or gets a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager, or employee). It also deals with top down creditors (gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers, or employees). With a good operating agreement and an umbrella insurance policy, you can minimize (NOT MITIGATE) your exposure.
3. Multi-member LLCs can help with the reduction of IRS audit exposure since 8825 (rental property form for a partnership) is audited a lot less than a schedule e (rental property form for an individual/sole proprietorship). So while you may not have all the asset protection you want, A good multi-member LLC with a carefully drafted operating agreement and an umbrella insurance policy is the best shot out there for a Landlord.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan. Book a Free Tax Consultation with me at www.wealthbuildingcpa.com
