Understand LLCs and S corporations
Before we compare LLCs and S corporations, you should understand the basics of each business structure.
What is an S corporation?
By definition, an S corporation is a type of federal tax designation, rather than a formal business structure.
Your S corp business will exist as a separate legal entity, shielding you from being held liable for business debts and obligations. It also means your business will be subject to pass-through taxation and avoid double taxation.
What is an LLC?
A limited liability company (LLC) is a unique cross between a partnership and a corporation. It offers personal liability protection while also allowing owners to choose how the company is taxed.
LLCs may also be taxed flexibly as sole proprietorships, partnerships, C corporations, or S corporations according to their specific circ*mstances.
Now that we’ve covered the basics of LLCs and S corporations, let’s look at how each option would work for a real estate company.
Forming a real estate business as an LLC
For a business structure, LLCs are typically favored by small business owners who want to limit liability risks and protect personal property. And real estate companies are no exception.
How does an LLC benefit you?
An LLC provides several advantages to real estate business owners, including:
Liability protection
Protecting personal liability is the top priority from the very beginning of starting a real estate business.
Real estate agents can be held liable for damages resulting from business negligence. If you are a realtor and fail to disclose a material defect in a home you are selling, the buyers may sue you for damages.
In the event of a lawsuit, your personal liability will be limited if your real estate business is an LLC. The assets held by the LLC would be the only thing at risk.
Get your LLC incorporated seamlessly with BBCIncorp company formation services. From incorporation, business banking, company secretary, accounting services, etc., we got you covered!
Tax flexibility
A real estate LLC can choose to be taxed as a sole proprietorship, partnership, C corporation, or S corporation. Therefore, you can choose the most advantageous tax structure for your business.
To benefit from the lower tax rate, you might want to tax your real estate business as a sole proprietor if it’s relatively new and not making a lot of money.
Once your company is established and earning a substantial amount of money, you may wish to be taxed as a partnership to avoid double taxation.
Some drawbacks to consider
There are, of course, some disadvantages to LLCs:
Less flexibility in profit distribution
An LLC must have a formal operating agreement in place that outlines how profits will be distributed among members. This can be rigid, particularly if the business is struggling and members want to change the profit-sharing arrangement.
More expensive to set up and maintain
The formation and maintenance of an LLC can be more costly than other business structures. This is because LLCs must file additional paperwork and may be subject to different state taxes.
What is the best state for an LLC?
A Delaware LLC for real estate can be a powerful asset. While they are more expensive to set up and maintain than other structures, the benefits outweigh the costs
Difficult to transfer property
Transferring property to an LLC, whether you have a mortgage or not, may result in transfer taxes. This varies by state, as not all states levy transfer taxes. Make sure to research the requirements in your state before making a decision.
Forming a real estate business as an S corporation
S corporations possess several distinct advantages over LLCs in the real estate industry. To begin, S corporations are exempt from self-employment tax.
Not only are S corps exempt from corporate taxes, but their profits are also exempt from Social Security and Medicare (also known as Self-Employment) tax.
Those who generate active income in areas such as property flipping, real estate development, brokerages, and other areas in which self-employment taxes play an important role may find this beneficial.
What is self-employment tax?
Self-employment tax, currently 15.3%, is paid by self-employed individuals.
Generally, this tax aims to ensure that individuals pay their Social Security and Medicaid taxes, which their employers would otherwise withhold.
An individual is considered self-employed if they conduct a trade or business as an LLC, sole proprietor, or partnership.
How an S corp minimizes self-employment tax
Self-employment tax can be a significant burden for real estate professionals, eating into profits and making it difficult to save for retirement. Fortunately, S corporations can be used to solve this problem.
Practical example of this case
Buying a property to sell within a few months will subject the profits to both self-employment tax and ordinary income tax.
Using a partnership, you will owe $6,200 in self-employment taxes if you sell the property for $50,000 and earn a 12.4% tax rate.
However, if you structure your real estate business as an S corporation, you will only be liable for self-employment tax on your salary (which is subject to payroll taxes). You may also distribute the remaining profits without being subject to self-employment tax.
This can result in significant savings, one of the main reasons why real estate professionals choose to incorporate as an S corp.
What about the drawbacks?
There are a few factors that might influence your decision, and why you might not choose an S corporation for your real estate business:
Limited number and type of shareholders
You must have fewer than 100 owners who are either:
- U.S. citizens;
- U.S. resident aliens; or
- U.S. grantor.
Furthermore, S corp owners are not permitted to be corporations, partnerships, business trusts, or IRAs.
This restriction prevents you from bringing in an investor or two to help with a down payment on a property, which is common in real estate. You will most likely need to establish a new entity or restructure your business to accomplish this.
Risk of revoked status
Your business status may be revoked if you fail to comply with the requirements of being an S Corporation. This encompasses holding initial shareholder meetings, adopting bylaws, issuing stock, and recording stock transfers.
This means you would be taxed as a C Corporation and subject to double taxation. The good news is that your status is unlikely to be revoked as long as you remain compliant.
LLC vs S corp for real estate: Which one to choose?
A variety of factors influence your choice of business structure for your real estate venture. Let’s take a look at a few key considerations:
Key reasons to select an LLC
- You are the sole owner of the real estate and have no plans to bring in any outside investors.
- You don’t want to deal with the hassles of issuing stock, holding shareholder meetings, and producing reports.
- You want the ability to create different classes of membership interests, which will allow you to distribute profits more freely.
Key reasons to select an S corp
- You want to reduce your self-employment tax liability.
- You intend to bring in additional investors and want the ability to issue stock to them.
- You can handle the responsibilities of running an S Corp, including the legalities involved.
- You intend to buy, flip, and sell properties rather than simply purchasing and holding one or two properties for passive income.
For some real estate investments, it is highly recommended to use an LLC and an S corporation at the same time, with the LLC holding the property and the S corporation managing the business.
This strategy shall offer real estate investors both the asset protection of an LLC and tax benefits from an S corporation.
Still unsure about which structures to choose?
Take our US Business Entity Selection quiz for better reference. You can use this tool to make the right decision on your real estate business structure!
Conclusion
The LLC business structure offers more flexibility than an S Corp, but an S Corp can save you money on self-employment taxes. The final decision comes down to the crucial benefit you aim for in your real estate business.
Remember that you can always change your business structure if your needs or goals change. However, you should always consult with legal experts on the matter before making any vital changes.
In case of any further inquiries, don’t hesitate to contact us through our chatbox or leave a message at service@bbcincorp.com. Our support team is ready to help!
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
Share this article
