S-Corp’s versus LLC’s for Holding Real Estate
One of the most frequently asked questions I get from new investors is what type of business structure I think they should set up before they begin purchasing properties. Well, obviously, everyone’s situation is unique. And, I’m not an attorney or CPA. But, I do have some knowledge that may help, based on my own experiences and businesses structures I’ve used.
About five years ago, when I’d read everything I could get my hands on related to real estate investing and was ready to dive in head first, I consulted a local attorney who gave us some pretty bad advice for our situation at the time. He recommended that we set up a C-Corp with multiple LLC’s (Limited Liability Corporations) underneath, one LLC per property. For those of you “in the know”, I’m sure you’re slapping your foreheads right about now! I didn’t know any better, though. And–like so many new investors–was willing to believe what my so-called esteemed attorney was telling me. The bill?-Oh, of course, there was a fat bill for setting up the C-Corp and the LLC. But, with that, I got lovely, thick, black 3-ring binders for each entity with our corporate seal and stock certificates. Later on, I came to know that these items were just from a kit that he’d purchased that included standardized Articles of Organization and Operating Agreements. Embarrassingly enough, a VP at a local bank pointed it out when I was applying there for financing.
About six months went by before it was time for tax preparation. I located a qualified, real estate related CPA and met with him for the first time. He asked me what type of business structure we had. I told him. He made me repeat myself. Then, he called our attorney and left a voicemail (like I had to do every time I needed him) asking, “Um, hi, yes, this is [Trisha Allen's CPA] calling about the C-Corp containing LLC’s you created for her. I just wondered if you could give me some insight on your thought process behind this type of structure. As you may know, it’s terrible for owning real estate, tax-wise. You can reach me at 918-555-lala.” Of course, the attorney never returned that call.
Our CPA clued me in about “double taxation”, which happens with C type corporations because they are taxed first on any profits. Then, when the stockholders receive dividends from those profits from the C-Corp, they are taxed again as regular income. Thus, the same funds are taxed twice, or “double taxation”. There aren’t many C-Corps around any more, from what I understand. It seems to be an unfriendly corporate structure for any type of business.
He recommended we take immediate action to file the paperwork to elect to change the C-Corp to an S-Corp. He explained that an S-Corp allows “pass through”, which means that the S-Corp’s losses are passed down to the stockholders to use as deductions in their personal taxes. Likewise, profits are passed down to the stockholders to appear on their tax statements. The caveat is that an S-Corp has limitations as far as how long they can show net losses, which I believe is determined by your basis in the company. In other words, let’s say that you have properties in an S-Corp (in LLC’s under your S-Corp). You have so many business deductions that you are able to show a net loss and not pay business taxes that year and even pass through those losses to offset income in your personal taxes. The next year’s the same way. But, then, perhaps the following year, you’re cut off! Even if you have legitimately lost money during that year, you’re no longer able to show a loss. You’re forced to show a profit from that point on-and pay taxes accordingly! In fact, it may work against you in that you’re never able to use all the business deductions that can be carried over from year to year because you never make enough of a profit!
At this point, I know you must be wondering-jeez, after three years, why wouldn’t your business be making a profit??? Well, it’s not exactly that you’re not making a profit. The truth is, when you have a really good CPA and you, yourself, are good at tracking business expenses (mileage, business-related travel, business-related meals/entertainment, depreciating appliances in rental properties, depreciating improvements on rental properties, advertising, business-related phone and automobile expenditures, utilities on your investment properties, professional and filing fees, etc) you may end up with so many deductions that they add up to more than you made! These are called “paper losses”.
I do not save every little receipt. But, I do save most of them. I find it’s just too stressful to be that uptight! I do have a business-only credit card (two cards on the same account-one for me and one for Michael in case he needs to get an oil change for the company vehicle or go to Lowe’s for materials on our latest project when I’m not with him). I also keep at least one bank account for each business specifically. I DO NOT CO-MINGLE PERSONAL AND BUSINESS FUNDS…EVER. Additionally, at the end of every month when the bank statements come in the mail, I sit down in front of Quickbooks and enter everything. When I’ve had to loan the business some funds to make it past a tight month, or when the business had to come up with the downpayment for House 17, I called it a loan. For all intents and purposes, that money was transferred as a loan and must be paid back. In fact, I can produce loan paperwork to support that if needed. When I made that entry into Quickbooks, I showed “Loan from Trisha Allen” as the source of the money-and it shows as a debt that must be paid. I will even charge our business a reasonable amount of interest on the loan, which will be reported as interest income on my own personal taxes next year.
I have an investor/Realtor friend who REALLY keeps track of every little business expense. I think he needs to, actually, because he has many businesses to manage. At the end of every year, he tells me he has more deductions than he can use. So, he carries them forward to the next year when he hopes he can use them. But, the next year’s always the same-too many deductions. He has an S-Corp, too. In his case, he chose an S-Corp structure because he can limit his personal income. Keep reading-I’m going explain that further.
Alright, so I’ve explained why an S-Corp wasn’t so great for us to get started. The C-Corp structure we originally had was worse. I’ve even since built an entirely new real estate business with a Series LLC. But, if I had to do it all again, I would just start out with one simple little LLC. A simple LLC should only cost about $500 to have an attorney put together. I’ve even heard there are kits to do it yourself online for less. But, personally, I would want to make sure my LLC was defensible in court and could not be seen as an “alias” of myself. In addition, you’d be surprised how many lenders ACTUALLY READ through your Articles of Organization and Operating Agreement. I have one lender that has required me to update mine with amendments occasionally. So, I would seek out a qualified real estate attorney for help.
LLC’s do not have limitations on the numbers of years a net loss can be shown. They still offer legal protection for my properties-as long as I keep a separate bank account and separate records for our business. As I said before, I don’t make the mistake of co-mingling my business and personal funds, even occasionally. Because, guess what!-If I have a rental property in that LLC and a tenant sues, it’s a short leap back to me personally and our personal assets if I failed to keep everything separate and hold yearly shareholders meetings (I keep detailed minutes of those meetings in our corporate files). The business is then called an “alias”. And, that tenant’s attorney may request to see those files and bank accounts, just to see if they can make that connection and access my personal assets!
Investors who keep their rentals in their own names have exposed themselves legally. I can understand it when they do so just when they’re getting started. They may not have many assets to protect. But, I’m totally perplexed when I see an apartment building in the owner’s personal name! I’m just not that optimistic about tenants or people in general, I guess.
It turns out that, although the S-Corp and multiple LLC’s were way overkill for us when we first started investing, they’re about to come in handy! I thought I would just sell all the houses out of that business structure and move on with my new Series LLC. But, when I met recently with our CPA to discuss how our business will be moving forward with more flips, he said, “You know what? I think it’s actually a good thing you kept that S-Corp after all! I was on board with you closing it down until you just told me your new strategy!”
For rentals, our Series LLC (which is an “umbrella” LLC with multiple sub-series underneath that act as mini-LLC’s and separate business entities in themselves-one per property, for instance) is perfect. We can show a net loss every year with all the deductions we can use for rentals. We only have one rental right now, House 16.
But, for flips, the S-Corp is great! Let’s say we churning out one flip per month. Right now, we’re not ready for that. But, this is just an example. On each flip, let’s say we’re profiting $20,000. So, at $20K per month, we’re bringing in $240K a year. Do we want to pass through $240K in profits to ourselves? No way! We want to limit the amount of personal income we receive to minimize the amount we pay in taxes. So, let’s say we only take $50,000 a year in income. We can do that with an S-Corp, which pays regular W-2 income and a set salary. With regular W-2 income, we can still qualify for mortgage lending, new car loans, and anything else we want to purchase! It’s just like having a normal job in corporate America with insurance and tax withholding, direct deposit, and everything! So, once we’re set to do more flips (when Houses 4, 8, 13 are out of my hair and House 17 is refi’d), we can set up payroll through our CPA and get some regular income up in here!
Income from an LLC is not regular W-2 income. It’s 1099 income, which is harder to use (and harder to prove) when it comes time to qualify for new lending.
There are other business entity types that I’ve never tried. For instance, there are LLP (Limited Liability Partnerships), which I believe are similar to LLC’s. There are also Syndications, which would be useful when a group of investors wants to purchase a property together one time, but do not want to form a long-lasting partnership. A Sole Proprietorship would occur when an investor holds a property in a business name of their choosing, but without a formal Certificate of Corporation or partnership with another investor.
As you can see, this answer was far too lengthy to be a response in a comment. And, I do not want to advise someone what the optimal business structure would be for his or her situation. They need to seek out professional help in the form of a qualified real estate attorney AND a real estate friendly CPA! They should be able to get a free consultation from both. I can only tell people what my own experiences have taught me and let them learn from that if it applies. And, in that respect, I hope this post has been helpful!
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I have been following your development for at least 1 (maybe 1.5 years). I always look forward to your posts. It’s almost like you have come full circle.
Your latest post (as to the entity structure) was sad. advisers will recommend over-kill which cost much more than necessary.
As to the coffee, email me and I’ll send you a Starbuck’s or whatever gift card. I prefer not to go through the hassle of Paypal for this amount. Provide a P.O. Box is fine.
I like your new site. Nice picture.
Regards,
Bob
PS: I still think multiple unit is the correct direction.
I had a friend who went to the “traveling Trump show” last year and this is what he got from the seminar (note: general investments and not RE-specific) … Create a “Managing” entity which is an LLC. I can’t remember if he said the managing member is a C-Corp or not (my notes are scribbly). For each investment vehicle, you then create a Limited Partnership (LP), for example, one for stocks & cash, one for 1-3 rental properties, etc. I’m sure this can be an LLC or even an LLP given the varying circumstances of each individual, the state they reside, etc. Also create a Living Trust so there is no probate issues. Additionally, create what is called a CRT (Charitable Remainder Trust) to avoid your heirs from paying capital gains. Again, my notes are very poor, but this is what I can decipher/remember. Just some things to run by your CPA/attorney to clear up.
Good thoughts.
A couple things to remember: An S-corp election is good, but the IRS strongly suggests you not take advantage of it. Effectively, you can take a salary and a distribution from an S-corp. Your salary is taxed twice, once through the company and once as personal income. The distribution is only taxed at the personal level. So you only pay half the tax on the distribution that you do on a salary.
However, the IRS “suggests” that if you take a distribution, you “should” take a salary. They also check to make sure you don’t take a $1 salary and a $999,999 distribution because, let’s face it, they lose out on all that tax revenue.
Unfortunately they don’t stipulate how much of your take should be salary and how much can be a distribution (i.e. 30/70). It just has to be “appropriate”.
I use an S-corp for my oil company and it works out fairly well.
-Grant
Hey, Bob! I emailed you…..
Steve - WOW, that’s a lot in attorney fees. I wonder if they’re getting kickbacks. They basically gave the clear opposite advice that I’m giving, which is keep it simple while you’re getting started!!!!!!!!!
Grant - Thanks! And, very good info! I wonder, though–does the IRS suggest against the S-Corp election because they lose out on double taxation on all profits, which they would get if you kept the C-Corp structure? I did read about that distribution versus salary on a forum for accountants. But, since I didn’t know much about that yet, I didn’t want to include it. Hopefully, I’ll get to learn more about that this year once we start the payroll for our company and start paying me a regular salary. That’s the goal, anyway.
I wholeheartedly agree, Trisha. However, after reading posts from people who are well on their way to financial independence, this setup is very similar to their own. They have a managing entity and n-number of other business entities to isolate themselves. They further shield themselves with adequate insurance. But, again, these people are further up the wealth chain - as far as starting out, I’d just start out with an LLC or something similar and meet with my CPA & attorney once a year to see if things need to be re-worked. I did find the Living Trust and CRT to be interesting as I’ve never thought about those before.
Steve - Ooooh, OK. I totally get it now. It’s a little like us using our Series LLC for rentals and our S-Corp (with an LLC underneath) for flips. They’re two different types of activities and really a little like two different types of businesses. Also, I think I was under the mistaken impression that the Trump seminar attracted beginners.
I’ll look into the CRT thing again. I did once a while back for one of my parent’s assets.
The Living Trust thing–thankfully, that’s one good thing about being an only child. Living Trusts aren’t always necessary. I don’t have any siblings to squabble over our parents’ estates.
[...] Allen presents S-Corp’s versus LLC’s for Holding Real Estate posted at Building An Empire, saying, “Choosing the appropriate business entity type whether [...]
As I understand it your salary would be deducted against the profits of the corporation rather than taxed twice. The extra tax is the social security tax on the salary. Well, I’m remembering what I read in books for stock traders. They said the salary has to be comparable to market rates in the profession in question. Now that I live in Australia it’s not relevant to me. As far as holding property in your own name, won’t insurance help there?
Trisha,
The living trust is also for you to have for your estate (if you have children or not). The goals here are many. For example.
1 Time delays of probate are avoided.
2 Costs of probate are avoided.
3 Long lost relatives who want your kids money are avoided
4 proper ownership of insurance policies can be addressed.
5 proper planning of who owns what can greatly reduce federal estate taxes…i.e: don’t have it all in you husbands name…
Estate planning is vital to assure what you have goes to who you want to have it.
Its every bit as important as deciding what entity should own your rental property. Most people just don’t want to face their own mortality.