Should I use an LLC or S-Corp?
The question of putting our real estate holdings in an LLC or S-Corp comes up often. It’s a fairly lengthy discussion for every post so I’m writing an article to reference people to. Hopefully this will eliminate some confusion. First and foremost, I am not an attorney or accountant. Before any action, seek competent advice from professionals!
The first question that needs an answer is what type of real estate investing activities you are going to be participating in. I’m going to break this down into two main categories:
1. Rental Properties held for a long term
2. Wholesaling or Rehab properties held for a short term
A single member LLC or Limited Liability Company is considered a disregarded entity for tax purposes. This allows us to use IRS 1040 Schedule E to show a profit/loss from our rental properties. The money is tax-free at the corporate level and is taxed at your ordinary income tax rate on the personal level. However, any active trade or business such as rehabbing or wholesaling properties is subject to self employment tax (15.3%) in addition to your ordinary income tax rate. (Those of us making over $89,000 currently per year only have to pay an extra 2.9%.)
An S-Corporation is a pass through entity and profits are still tax-free at the corporate level and then taxed at your ordinary income tax rate on the personal level. This is true for whatever type of business you are running as an S-Corp.
The question comes up…why not always use an S-Corp then? The answer has to do with a couple of things. First, transferring property to/from an LLC is not a taxable event thus saving you transfer taxes.
The second reason has to do with something called a “Charging Order.” Let’s say that you get sued personally. For simplistic purposes, let say that you have no assets other than a separate entity with 1 property in it. In an S-corp one could sue you and the court could order the transfer of some (or all) of the shares of your S-Corp to the plaintiff. With ownership of the company (at least 51%), you could be voted out of office and they will elect themselves as president, etc. With control of the company, they can sell your real estate or do with how they please.
On the other hand, in SOME states the courts exclusive remedy is to issue a Charging Order against your LLC. This means that only a percentage of the profit distribution can be awarded; not ownership interest. Since by design, an LLC is a pass through entity, it does not normally keep any of its profit at the corporate level but rather is passed through each year to the owners. Here’s the key! The LLC can decide to retain its profit and not issue any distributions to the owners. Just because you don’t receive any money, doesn’t mean you don’t have to pay tax on it. The profit is still taxable! You have a situation now where creditors must pay tax on money it never has received! A few years like this and you should be able to settle for pennies on the dollar. With control of the LLC you can decide to pay yourself a higher salary and extract your profits out that way.
So in conclusion:
I recommend an LLC for long term rental properties because of the tax advantages and asset protection.
I recommend an S-Corp for short-term wholesaling/rehab so you can save the 15.3% self employment tax. The issue of a charging order, I feel, is not an issue because you can sell the property as planned faster than it can be awarded in a court.
frogger,
Thanks much for this article. It certainly has helped me see another way of moving money from a rehab to me.
Thanks,
OnTheWater
They key here is to use a property management company to manage the work for your s-corp. A company that simply owns an investment does not require an employee since the corporation is not doing any operational work. Thus no self employment tax!
Excellent article I wish I had found it last year. I too, am in Iowa and have struggled with this question. We went with an LLC for our first 3 rentals, unfortunately we can not find an attorney here (NW Iowa) who knows about a charging order so that was not put into our first LLC.
My question to you is, in Iowa are charging orders allowed, if so do you have an attorney or a law firm you recommend. We will be putting together another LLC in the spring for our next few properties.
Thank you
frogger,
I had just gone through some of these issues with my CPA when I saw your post. The S-corp declaration will not allow you to completely avoid the self employment tax, if at all. The first issue is that as an employee/owner of an S-corp, the IRS requires you to take a salary (and pay Soc Sec and Medicare, also known as Self Employment tax). Second, if you withhold a substantial amount of the profits in the corporation and bonus them out at the end of the year (attempting to avoid the 15.3% payroll bite), the IRS frowns on this, saying that you underpaid yourself and will assess a 100% penalty on the unpaid taxes.
This is of course if you get caught....
Molotov
The ideal balance between wages and dividends for proceeds flowing from S Corp activities is that what you personally did to make money should be paid as salary, and what was generated by capital (mere ownership of a property or properties, the lending of money, etc.) or by goodwill (the "momentum" of the business, it's longstanding phone numbers, reputation in the community, etc.) should come out as dividends.
There is a great deal of flexibility to this, but the IRS has the power to recharacterize in either direction if they don't like the balance.
As for the LLC or S Corp. controversy, I view LLCs as being like "Chicken Soup" ... can't hurt.
oh man i'm still confused. couldnt i still use a LLC if i was just retail flipping or wholesaling? i'm still confused on all the tax stuff.
What about if your LLC has two members, and is taxed like a partnership? Does this change anything?
Great Article. I am in the process of forming my first LLC to hold a rental property and am hearing varying opinions about the LLC vs. the S Corp.
With regards to charging orders, the recipient of a charging order can only receive the "interest" of the LLC member and does not automatically become a member of the LLC. This is another advantage of the LLC over the S-Corp. To gain controlling interest in the LLC, the recipient of the charging order would have to be admitted as a member of the LLC and, if the operating agreement is well written, this should prove very difficult to do.
We need more articles like this.
good article. i believe that if you are a single member llc that you do not have to pay self employment tax. Is this correct?
Thanks