What type of business entity should I form?
This is a question that many first time real estate investors don’t answer right away. Why? It’s simply because when you only own one or two properties or for that matter you haven’t purchased one yet you are thinking about how to buy the property and what to do with it. In that case one of the last things someone thinks about is whether or not they are going to place it into a business entity. In this article I want to stress to you the importance of creating a separate entity and not only that but creating the correct entity as this is equally as important for tax considerations and in some cases personal situations.
Let me first Identify the types of business entities and the basic distinctions between each:
1) LLC(Limited Liability Company
2) S-Corporation
3) C-Corporation
1. LLC(Limited Liability Company)
A limited liability company, commonly called an “LLC,” is a business structure that combines the pass-through taxation of a partnership or sole proprietorship with the limited liability of a corporation.
Like owners of partnerships or sole proprietorships, LLC owners report business profits or losses on their personal income tax returns; the LLC itself is not a separate taxable entity. Like owners of a corporation, however, all LLC owners are protected from personal liability for business debts and claims — a feature known as “limited liability.” This means that if the business owes money or faces a lawsuit, only the assets of the business itself are at risk. Creditors usually can’t reach the personal assets of the LLC owners, such as a house or car.
Who should form an LLC?
You should consider forming an LLC if you are concerned about personal exposure to lawsuits or debts arising from your business. For example, if you decide to purchase a property as a real estate investment, you may worry that your liability insurance with that property won’t fully protect your personal assets from potential slip-and-fall lawsuits. Running your business as an LLC may help you sleep better, because it gives you personal protection against these and other potential claims against your business.
How do I form an LLC?
In most states, you create an LLC simply by filing “articles of organization” with your state’s LLC filing office (which is usually part of the secretary of state’s office) and paying a filing fee. A few states refer to this organizational document as a “certificate of organization” or a “certificate of formation.” Most states provide a fill-in-the-blank form that takes just a few minutes to prepare. You can obtain the form by mail or download it from your state’s website (check your state’s secretary of state or corporations division home page).
A few states impose an additional requirement: Prior to filing your articles of organization, you must publish your intention to form an LLC in a local newspaper.
You’ll also want to prepare an LLC operating agreement, though it isn’t legally required in most states. Your operating agreement explicitly states the rights and responsibilities of the LLC owners. The main reasons to do this are to clarify your business arrangements and to decide how your LLC will be run. If you don’t create a written operating agreement, the LLC laws of your state will govern the inner workings of your LLC.
Do I need a lawyer to form an LLC?
No. All states allow business owners to form their own LLC by filing articles of organization. In most states, the information you must provide for the articles of organization is very basic — typically, you have to supply the name of the LLC, the location of its principal office, the names and addresses of the LLC’s owners, and the name and address of the LLC’s registered agent (a person or company that agrees to accept legal papers on behalf of the LLC).
Now that most states provide downloadable fill-in-the-blank forms and instructions, the process is even easier. And LLC filing offices are becoming more accustomed to dealing directly with business owners; they often allow business owners to email questions to them directly.
What are the Tax Benefits of an LLC?
No matter the size of your small business, the IRS essentially provides the tax benefit of larger companies to businesses that operate as LLCs. The term “Pass Through” relates to the fact that your LLC bypasses all of the taxes at the corporate level. In other words, as a registered LLC, you will not have to pay taxes for your company profits as a business, but you will be required to pay taxes for company profits individually. The taxes are assessed as the profits pass through the corporation down to the LLC’s owners, also called Members. These taxes are calculated by the distributive share of ownership, determined by the percentage profits allocated to each member of the LLC. Typically, these percentages are agreed upon in the LLC Operating Agreement. Each member then pays individual taxes on that amount. This is beneficial for a company, because a corporation pays taxes on profits from the business level, but at the shareholder (member) level.
2. S-Corporation
An “S-Corporation” is a regular corporation that has between 1 and 100 shareholders and that passes-through net income or losses to shareholders under in accordance with Internal Revenue Code, Chapter 1, Subchapter S.
How are S-Corporations Taxed?
An S-Corporation is not subject to corporate tax rates. “Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income,” according to the Internal Revenue Service.
Instead, an S-Corporation passes-through profit (or net losses) to shareholders. The business profits are taxed at individual tax rates on each shareholder’s Form 1040. The pass-through (sometimes called flow-through) nature of the income means that the corporation’s profits are only taxed once at the shareholder level.
The IRS explains it this way: “On their tax returns, the S corporation’s shareholders include their share of the corporation’s separately stated items of income, deduction, loss, and credit, and their share of non-separately stated income or loss.”
S-Corporations therefore avoid the so-called “double taxation” of dividends.
S-Corporations, like regular C Corporations, can decide to retain their net profits as operating capital. However, all profits are considered as-if they were distributed to shareholders. Thus an S-Corporation shareholder might be taxed on income they never received. (Whereas a shareholder of C-corporation is taxed on dividends only when those dividends are actually paid out.)
What are the Eligibility Criteria for S-Corporations?
A corporation may choose to be taxed as an S-Corporation if it meets the following criteria.
1. The company is (a) a domestic corporation, or (b) a domestic entity eligible to elect to be treated as a corporation that timely files Form 2553 and meets all the other tests listed below.
2. The company has no more than 100 shareholders. (A husband and wife and their estates are treated as one shareholder for this test. A member of a family can choose to treat all members of the family as one shareholder for this test. All other persons are treated as separate shareholders.)
3. The only shareholders are individuals, estates, certain exempt organizations, or certain trusts.
4. The company has no nonresident alien shareholders. (That is, the only shareholders are US citizens and resident aliens.)
5. The company has only one class of stock. Generally, a corporation is treated as having only one class of stock if all outstanding shares of the corporation’s stock confer identical rights to distribution and liquidation proceeds.
6. Each shareholder consents to the S-Corporation election.
3. C-Corporation
A C-Corporation, under United States federal income tax law, refers to any corporation that is taxed separately from its owners. A C corporation is distinguished from an S corporation, which generally is not taxed separately. Most major companies (and many smaller companies) are treated as C corporations for U.S. federal income tax purposes.
Generally the difference between a C-Corporation and an S-Corporation is that a C-Corporation is a completely separate entity from yourself, meaning it involves a separate tax return filing for the corporation. Also there are double taxation concerns that are attached. However on the first $50,000 your are taxed at 15% which is a very low rate. It should be noted that an LLC can also be filed as a separate return and taxed at the same rate.
Above I went into some detail regarding each of the types of business classifications now I want to clarify for you specifically which entity would best suit your needs related to Real Estate. Most Real Estate Investors end up creating Limited Liability Companies. In that case most of the time all of their properties are covered under that one entity. In some cases investors have been creating multiple LLC’s for each property they own typically using the property address as the company name. This isolates each property as it’s own entity thereby isolating that specific property in case of some type of civil suit or any other variance of that type of situation.
While an LLC is the most popular form of a business used in Real Estate many larger real estate investors utilize corporations. I myself have both a C-Corporation and an LLC. I use my LLC for a business related specifically to Rehabs and Lease Options. Within the LLC I place each property into a Land Trust using the property address. The company then is the beneficiary of that trust not on the deed. This limits the LLC’s exposure and risk. My other company is a C-Corporation as for my particular situation it is a better fit. If in the end as a new investor or even a seasoned investor your believing that you don’t need to organize it within a formal entity, I would assert that you are wrong. As I have said above no matter how you organize your assets within the business you are much better protected personally with an entity rather then without.