Why use an LLC partnership instead of a Corporation?
LLC partnerships avoid the following corporate disadvantages by default (automatically); by election; or by planning. When referring to a partnership the term “partner” includes a member of an LLC or more specifically of an LLC partnership. Such reasons not to use corporations pertain to both rental keepers and resale flippers.
1. IRS AUDITS: Corporations (C and S) are audited more than partnerships and corporate audits are on the rise. For instance, corporations are fairly frequent targets on the issue of reasonable compensation (discussed in number 4 below).
2. COSTLY DEALER STATUS: Corporations are designed for active (ordinary income) businesses. Thus, using a corporation (C or S) for quick-sale flips is a blatant admission of costly dealer status and impairs dealer-avoidance planning.
3. PAYROLL FILINGS: Corporations (C or S) are subject to more payroll filings because corporate shareholders are employees and must receive a reasonable W-2 salary. In the case where there are annual tax losses in the corporation, a W-2 salary could cause unnecessary taxable income to shareholder-employees. How costly!
4. IRS SCRUTINY OVER “REASONABLE COMPENSATION” TO “C” OR “S” CORPORATION SHAREHOLDER-EMPLOYEES. Reasonable compensation essentially means that the combined amount of wages and fringe benefits cannot be disproportionate in relation to the value of the work being performed.
5. LIMITS ON DEDUCTING LOSSES: One of the unique, magical virtues of real estate investments is that a property can be showing a “paper” tax loss, yet still be financially profitable with positive cash flow. Corporations (C or S) have limits on fully deducting rental property tax losses.
EXAMPLE: Assume a property is held in a C-corp and generates $20,000 of bottom-line tax losses. If the owner is in a 31% tax bracket, they would lose $6,200 of tax savings!
6. TAXABLE REFINANCING: S-corporation distributions of tax-free borrowed money to shareholders could end up being taxable income because of the above basis limitations of not including third-party debt. That is, the rule in number 5 above could make a tax-free refinance, taxable!
7. TAXATION OF DISTRIBUTED PROPERTY: With corporations (C or S) there is taxation on distributions of appreciated property deeded from the corporation to the shareholder even though no cash is realized.
8. TAXATION ON ENTIRE CORPORATE LIQUIDATION: With C or S corporations there is taxation on the liquidation of the entire corporate entity (with appreciated real estate) even though cash may not be realized. With real estate, you need tax-free exit strategies. You will not get this with C or S corporations.
9. TAXATION ON CORPORATE CONVERSION TO AN LLC: With C or S corporations, conversion of the corporation (with appreciated assets) to an LLC will result in tax liabilities even though cash may not be realized. You, therefore, need to plan your tax-free exit strategy in advance by not putting real estate in corporations in the first place
10. TAXATION ON PROPERTY TRANSFERS TO A CORPORATION: Transfers of appreciated property to a corporation (C or S) is taxable if the contributing shareholder is not in control of the corporation immediately after the transfer. This could be a tax dilemma where there will be a more than 80% change in owners after the incorporation.
WHEN TO USE S CORPORATIONS
I would think of using S corporations if my real estate strategy is wholesaling, flipping, rehabbing, or any real estate strategy that gives you money, without you holding the property for investment. These types of strategies typically are considered active real estate strategies and generate active real estate income and are therefore subject to self-employment tax. The benefit of an S corporation is that you can pay yourself a salary on a portion of your income from your real estate strategy and the rest of it will not be subject to self-employment tax. Only Salary is subject to self-employment tax.
For example, If I purchased a property and rehabbed it for a $100k profit, I can pay myself a reasonable salary of $50k with an S corp LLC. The other $50k will not be subject to self-employment tax. However, if I earned this income through an SMLLC or Multimember LLC, the $100k will be subject to self-employment tax
Here are a couple of recent questions I received regarding LLCs:
Q. “I read a business plan for multi-family properties and I had a question on the use of LLCs. It recommends you have one LLC for the PM and then a separate LLC for each property. If so, I’m wondering to you handle that practically. Sounds like a lot of costs are associated with such an arrangement. I have 5 properties (4 duplexes and a single). I own everything individually now. I have an LLC but it doesn’t own the RE. I was thinking about biting the bullet and paying the transfer tax but I’m trying to think through the structure as well as the cost/benefit analysis.”
I usually advise my clients that they can pretty much use equity stripping and insurance to address the above issues without having to create multiple LLCs. Right now, the lawyer I work with in MD charges $450 to put a lien on a property and it can be the same lien put on multiple properties. It makes sense to have a management LLC and then a holding LLC that puts liens or notes on all the properties. The other alternative is to get a good umbrella insurance policy. I always tell my clients, that we worry a lot about lawsuits depleting our funds but pay little attention to TAXES, which are guaranteed to deplete your funds EVERY year without proper planning. Just food for thought.
How about LLCs for Landlords?
Q. I have seen that many investors have an LLC. What are the benefits to a landlord that only has one property? Should I create one?
I usually advise my clients to form entities based on three factors – legal protection, tax reduction, and compliance. You have already noted the difficulty of finding one that meets all three criteria. Right now, the best one I see out there to use is the MULTI-member LLC with a GOOD COMPREHENSIVE OPERATING AGREEMENT/UMBRELLA POLICY. Here are the main advantages:
1. LLCs have the least compliance requirements. No minutes, BOD meetings, or even no formal agreement but I strongly suggest using a comprehensive operating agreement. I currently use a 121-page one for my clients.
2. Multi-member LLCs can help in asset protection by dealing with bottom-up creditors (have a claim and/or get a judgment against the LLC arising from the acts or omissions of the company rather than from the acts or omissions of a member, manager, or employee). It also deals with top-down creditors (gets a judgment against the member because of the member’s acts or omissions, rather than the acts or omissions of the LLC, its managers, or employees). With a good operating agreement and an umbrella insurance policy, you can minimize (NOT MITIGATE) your exposure.
3. Multi-member LLCs can help with the reduction of IRS audit exposure since 8825 (rental property form for a partnership) is audited a lot less than a schedule e (rental property form for an individual/sole proprietorship)
So while you may not have all the asset protection you want, A good multi-member LLC with a carefully drafted operating agreement and an umbrella insurance policy is the best shot out there for a Landlord.
I address many of these issues in my Wealth Building Plan. Make sure you are getting the best tax advice. Let me evaluate your financial and tax situation, then develop a customized tax strategy just for you. Together, we will come up with a strategic plan designed to answer your questions as you build your own customized wealth-building plan.
