What Entity Type is Best When Investing In Real Estate?
What entity type to invest in real estate depends on the type of transaction you are engaging in. The two most likely candidates are S Corporations and Limited Liability Companies.
Speaking on the federal level, the S Corporation has some major advantages over the C Corporation or Corporation, as we will refer to it from now on throughout this section. A C Corporation is taxed as a Corporation and any salaries paid out to the shareholders are taxed as income on your personal tax return.
This is called double taxation, and really spells double trouble. Since the S Corporation are taxed as a partnership, the entity is not subject to double taxation.
It is usually best to flip properties out of an S Corporation.
S Corporations are much simpler than C Corporations, and therefore cheaper to operate. They are less flexible than LLCs, but have one important advantage:
S Corporation dividends are exempt from social security taxation if the S Corporation owners are paid a reasonable salary. This feature is quite important because income from flips (as opposed to rentals) would otherwise be subject to a 15% social security tax (this is subject to change as tax laws change).
LIMITED LIABILITY COMPANY (LLC)
The LLC is a relatively new type of hybrid business structure for real estate that is now permissible in most states. It is designed to provide the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. Formation is more complex and formal than that of a general partnership.
The owners are members, and the duration of the LLC is usually determined when the organization papers are filed. LLCs can be made up of one member (in some states) or multiple members. LLCs also have the flexibility of being taxed as a sole proprietorship or as a Corporation.
LLCs are generally best for rental properties. Rental properties provide many tax advantages. Specifically, rentals:
Sell at favorable capital gains tax rates
Generate depreciation deductions
Generate tax upon sale that can sometimes be paid in installments, instead of all at once
Can be exchanged for other real property tax-free (1031 exchange)
May generate low-income housing credits.
By using an LLC, you are able to capitalize on these tax benefits as much as possible.
Articles of Organization are filed with the state to create the LLC. Filing fees are typically a lot less than creating a Corporation. Corporations can restrict on how the income is earned and who is the investor. LLCs do not have these same attributes and are the most flexible of all the entities.
DIFFERENCES AND SIMILARITIES BETWEEN ENTITIES
LLCs and S Corporations Similarities:
Both are separate legal entities that are created by a state filing.
They offer the same limited liability protection; the owners are typically not personally responsible for the debts and liabilities of the business.
Both are pass-through tax entities – this means that the income or loss generated by the business is reflected on the personal income tax return of the owners.
The ownership of an S Corporation is restricted; however, a limited liability company does not possess these same limitations. a) An LLC can have an unlimited number of members (owners) while a subchapter S Corporation is restricted to no more than 75 shareholders. b) Non-US residents can be members of an LLC while an S Corporation may not have non-US residents as shareholders.
LLCs are allowed to have subsidiaries without restriction. S Corporations are not allowed to own eighty percent or more of another corporation’s shares.
Formalities: a) A corporation requires formalities, annual meetings of shareholders and directors are required each year, and meeting minutes are required to be kept with the corporation’s records. b) LLCs are not required to hold such meetings; this makes managing an LLC much easier. However, it is a good idea to document major decisions of the company.
S Corporations do have advantages. One person can form an S Corporation, while in several states do not give full protections to single member LLC’s (see associated blog on Single Member, LLCs).
A corporation’s existence is perpetual. Conversely, an LLC typically has a limited life span. Most states require that an LLC list a dissolution date in its articles of organization and certain events such as the death or withdrawal of a member can cause the LLC to dissolve. A recent trend, states are allowing LLCs also to be perpetual.
The stock of an S Corporation is freely transferable while the interest (ownership) of an LLC is not – typically the approval of the other members must be received.
An S Corporation may have advantages with self-employment taxes in comparison with an LLC. For more information on this issue, please contact your tax advisor.