Many rental property owners begin their real estate investment journeys as sole proprietors. However, as their portfolios start to grow, they eventually decide to convert their rental businesses into LLCs or S-Corps for liability and tax purposes.
Establishing your rental business as an LLC or S-Corp protects your personal and business assets from common liabilities, such as credit issues and lawsuits. LLCs and S-Corps also enjoy certain tax benefits that lower your tax responsibilities, allowing you to keep more of your rental income.
Whether you own and operate a series of multifamily units or lease office space, it’s important to understand how the legal structure of your rental business impacts your liability and tax obligations. In this blog, we’ll discuss why you need to convert your rental business into an LLC or S-Corp, the pros and cons of each, and how to decide between the two legal structures.
Why convert your rental business to an LLC or S-Corp?
When scaling a rental business, it's important to consider how different business structures can protect your real estate assets and minimize your liabilities as a property owner. Most real estate investors transition from a sole proprietorship business structure to an LLC business structure to protect their assets and minimize personal liability.
Investors can also choose to be taxed as an S-Corporation or another tax classification, depending on their needs. It's important to note that an S-Corp is not a business structure, but rather a tax classification that requires businesses to operate in a certain way. We'll explore the requirements for an LLC and S-Corp in more detail below. Let's first touch on some of the pros and cons of sole proprietorship.
Tax benefits of sole proprietorships
Sole proprietorships make sense for property owners who have just started their real estate investment journey and have one or two properties in their possession. The main reason rental owners operate as sole proprietorships is the capital gains exclusion provided by the IRS.
The capital gains exclusion states that if a sole proprietor, (in this case, the rental owner) has lived in the home for at least two of the last five years before selling it, they can benefit from a $250,000 tax exclusion if a single and $500,000 if married.
Rental owners are also exempt from self-employment tax as long as the income generated from the property is passive. This means that you wouldn't have to pay taxes on the rental income you generate from short-, mid-, or long-term tenants. However, you would have to pay taxes on the home if you were to renovate it and sell it to a new owner. Self-employment taxes can eat up as much as 15.3% of your income, so it’s best to avoid them whenever possible.
However, it’s not advised to stay as a sole proprietorship for too long. Rental owners with a sole proprietorship have much less liability protection than owners with an LLC or S-Corp classification.
Liability concerns of sole proprietorships
Sole proprietorships operate under a rental owner’s individual Social Security Number, making you responsible for all liabilities incurred on your properties. Since there’s no separation between your finances and the finances of the real estate business, a tenant can sue you directly as opposed to your real estate business, which puts your financial stability and the future of your rental business at risk.
Most real estate investors eventually decide to move away from a sole proprietorship and towards an LLC business structure and/or S-Corp tax classification. This allows investors to establish their rental businesses as individual entities, helping them keep their personal and rental finances separate. LLCs and S-Corps also come with their own set of tax advantages.
What is an LLC?
An LLC (Limited Liability Company) is a legal business entity that protects a business owner’s assets from their company’s debts and liabilities. LLCs can be owned by a single member or multiple members depending on how many people own the business. As an LLC, your rental business enjoys more liability protection than sole proprietorships and less profit-sharing restrictions than corporations. It’s a convenient way to structure a small to medium-sized rental business because it offers asset protection, flexible tax options, and anonymity.
What is an S-Corp?
An S-Corp (Subchapter Corporation) is not a legal business entity but rather a specific tax classification that exempts business owners from double taxation. Double taxation occurs when company profits are taxed at both the corporate and shareholder level. Property owners with an S-Corp tax classification do not need to pay corporate income tax. Instead, their company profits pass through an owner’s tax returns. You can establish your rental business as an LLC and classify it as an S-Corp for tax purposes. This allows you to become a company employee, potentially lowering your taxable income.
What are the key differences between an LLC and an S-Corp?
Before establishing your rental business as an LLC or an S-Corp, you’ll want to understand what the key differences are between the two classifications. LLCs and S-Corps mostly differ based on taxes, ownership, business operations, and fees. We'll break down each of these differences below.
Taxes
As mentioned above, an LLC is a legal business structure and an S-Corp is a tax classification. Qualifying rental owners can establish their rental business as an LLC and elect S-Corp taxation with the IRS. All you would need to do is fill out a form and follow the rules associated with S-Corp taxation.
Unlike S-Corps, LLCs don’t have their own IRS tax category. Instead, LLCs are taxed as sole proprietorships, partnerships, or S-Corps. An LLC with one owner is usually taxed as a sole proprietorship and an LLC with multiple owners is taxed as a partnership.
However, regardless of how they’re classified, LLCs benefit from pass-through taxation. This allows for rental income, losses, deductions, and credits to “pass through” the business and be taxed at the owner’s or owners’ personal income tax rate instead of having to pay corporate taxes. As a result, LLCs avoid double taxation and can keep more of their rental income.
Ownership
LLCs are allowed to have an unlimited number of owners, commonly referred to as “members.” These members may be U.S. citizens, non-U.S. citizens, and even non-U.S. residents. S-Corp ownership is much more regulated.
The IRS doesn’t allow S-Corps to have more than 100 principal shareholders or owners. Additionally, S-Corps cannot be owned by individuals who are not U.S. citizens or permanent residents. Lastly, S-Corps cannot be owned by any other corporate entity, whether that be an LLC, sole proprietorship, partnership, or C-Corp.
This means that if you classify your LLC as an S-Corp, that LLC cannot be acquired by a larger rental company without losing its S-Corp tax classification.
Business operations
LLCs and S-Corps also differ greatly in terms of how they are managed. LLCs can be managed by either their owners or designated managers. S-Corps, on the other hand, are required to have a board of directors and corporate officers, such as a CEO, CFO, and CMO. S-Corps are also legally required to adopt corporate bylaws, conduct initial and annual shareholder meetings, produce company meeting minutes, and follow extensive stock issuing regulations.
LLCs are only required to adopt an LLC operating agreement, which can be set up however its owners prefer. There’s no need to hold shareholder meetings or record meeting minutes. While LLCs are encouraged to follow the same business guidelines as S-Corps, they aren’t legally obligated to do so.
Fees
Lastly, LLCs and S-Corps pay different incorporation fees. It costs about $500 to set up an LLC, which includes:
- Articles of Incorporation fee.
- Annual reporting fees.
- Attorney fees to draw up legal documents.
Incorporating an S-Corp is usually more expensive because of its complexity, and set-up costs can range from $800 to $3,000, depending on your state. In addition to the fees required to set up an LLC, S-Corps also require:
- Financial reporting fees for accounting and taxes.
- Insurance costs.
How to decide between an LLC or S-Corp for your rental business
As you can see, you don’t necessarily need to choose between an LLC or an S-Corp for real estate. Many real estate investors establish rental businesses as LLCs and claim S-Corp taxation if their businesses meet S-Corp taxation requirements. However, if you’re just starting out as a rental owner or plan to keep your rental business within the family, an S-Corp classification may not be necessary.
While the S-Corp classification provides greater tax benefits, it’s also more expensive to establish and requires the outsourcing of professional services via lawyers and accountants. This may not be worth it for a real estate investor with just a couple of properties under their belt.
An investor with a sizable property portfolio and multiple employees, however, are far more likely to reap benefits from S-Corp classification. Chances are the money they would be saving as a result of their S-Corp status would far exceed the money they'd be spending to incorporate.
Establishing your rental business as an LLC is the simplest and most cost-effective way to protect your personal assets as a property owner. Whether or not you declare your LLC as an S-Corp will ultimately depend on the size of your company, its management structure, and how much money is being generated through rental income.
Important Note: This post is for informational and educational purposes only. It should not be taken as legal, accounting, or tax advice, nor should it be used as a substitute for such services. Always consult your own legal, accounting, or tax counsel before taking any action based on this information.
