One of the first decisions you have to make when starting a real estate business, regardless of size or scope, is how to structure your venture.
While many real estate agents operate as sole proprietorships, this is not always the best long-term option because it does not protect your personal assets from potential litigation consequences.
Two other common business structures for real estate agents are the LLC and the S corporation. Let’s dig deeper into each option to see which is best for you.
Understand LLCs and S corporations
Before we compare LLCs and S corporations, it’s important to understand the basics of each business structure.
What is an S corporation?
An S corporation, by definition, is a type of federal tax designation rather than a formal business structure.
Registering as an S corp means your business will exist as a separate legal entity from you personally, 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, offering its owners personal liability protection while also allowing them to choose how the company is taxed.
LLC members can choose to be taxed as a sole proprietorship, partnership, C Corporation, or S Corporation for tax purposes, with the option to switch back at any time.
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
As a business structure, LLCs are typically used by small business owners who want to limit liability risks and protect personal property, and real estate businesses 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 structured as an LLC. The assets held by the LLC would be the only thing at risk.
- Tax flexibility
As an LLC, your real estate company can be taxed as a sole proprietorship, partnership, C corporation, or S corporation. This means you can select the tax structure that is most advantageous to your company.
For example, if your real estate business is new and not yet making a lot of money, you may want to be taxed as a sole proprietor to take advantage of the lower tax rate.
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
Of course, LLCs are not without their drawbacks. These include:
- 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 due to the fact that LLCs must file additional paperwork and may be subject to different state taxes.
A Delaware LLC for real estate can be a powerful tool that you should consider. 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 have some distinct advantages over LLCs in the real estate industry. To begin, real estate businesses structured as S corporations are exempt from self-employment tax.
Not only are S-Corporations exempt from corporate taxes, but their profits are also exempt from Social Security and Medicare (also known as Self-Employment) tax. This can be a significant benefit for real estate professionals who generate active income in areas such as property flipping, real estate development, brokerages, and other areas where self-employment tax plays a significant role.
What is self-employment tax?
Self-employment tax, which is currently 15.3%, is paid by self-employed individuals.
This tax is designed to help ensure that individuals pay the required Social Security and Medicaid taxes, which would otherwise be withheld by their employer if they were classified as employees.
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.
For example, if you buy a property with the intention of sprucing it up and flipping it within a few months, the profits are subject to self-employment tax and ordinary income tax rates. If you sell the property and make $50,000, you will owe a self-employment tax of $6,200 (assuming a 12.4% tax rate) if you operate as a partnership.
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), not on the entire $50,000. You may also distribute the remaining profits without being subject to self-employment tax.
This can result in significant savings, which is one of the reasons why real estate professionals frequently choose to incorporate as an S corporation. The structure is beneficial to not only real estate flipping, but also to real estate developers, agents, brokers, and management companies.
What about the other side of the coin?
Here’s why an S-Corporation might not be the best option for your real estate:
- Limited number and type of shareholders
You must have fewer than 100 owners who are either:
(1) U.S. citizens
(2) US resident aliens
(3) US grantor
Furthermore, S corp owners are not permitted to be corporations, partnerships, business trusts, or IRAs. This restriction is problematic if you want to bring in an investor or two to help with a down payment on a property, which is common in real estate. To accomplish this, you will most likely need to establish a new entity or restructure your business.
- Risk of revoked status
Your business status may be revoked if you fail to comply with the requirements of being an S-Corporation, such as holding initial shareholder meetings, adopting bylaws, issuing stock, and recording stock transfers.
This means you would be taxed as a C-Corporation and would lose the benefits of being an S-Corp. The good news is that your status is unlikely to be revoked as long as you remain compliant.
LLCs 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 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 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 are capable of handling the responsibilities of running an S Corp, including the legalities involved.
- You intend to buy, flip, and sell properties as opposed to 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 can give real estate investors the best of both worlds: asset protection from an LLC and tax benefits from an S corporation.
Unsure which structures to choose?
How about taking a simple US Business Entity Selection quiz and deciding for yourself?
Overall, the LLC business structure offers more flexibility than an S Corp, but an S Corp can save you money on self-employment taxes. Ultimately, the decision comes down to what’s best for your real estate business.
Be sure to consult with our expert consultants to ensure your choice. And remember, you can always change your business structure down the road if your needs or goals change.
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.
- Understand LLCs and S corporations
- Forming a real estate business as an LLC
- Forming a real estate business as an S corporation
- LLCs vs S corp for real estate: Which one to choose?
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