Are you planning to invest in real estate? One of your main decisions will be choosing the right tax entity structure for your business. The type of entity structure you choose depends on various factors. These include the amount of legal protection you need, the way the entity is capitalized, payroll, tax implications, and the tax consequences of forming and terminating the structure. Here are seven different tax entity structures, along with some considerations and warnings.
Under IRS rules, the C-corporation is the default or the standard corporation. A C-corporation pays its own taxes and is taxed under Subchapter C, which gives this entity its name. The shareholders who’ve bought stock in a company not only own the corporation, but they also have limited liability protection. In other words, they aren’t personally liable for the debts of a business, which is a huge selling point for corporations.
An S-corporation is a corporation that doesn’t pay direct taxes on its net income. Instead, this type of corporation allows income to be passed on to its shareholders and is taxed under IRS Code Subchapter S of Chapter 1. It isn’t a separate taxable unity. An S-corporation starts out as a C-corporation but can become an S corporation, following the company electing it to be so.
If you flip real estate, you need to form an S-corporation. This prevents the dealer from getting a self-employment/social security tax on part of the profit he or she earns from real estate flipping.
3. General Partnership
A general partnership is similar to a sole proprietor because there’s no action needed to start it, other than having at least two people to run your business. Some of the benefits include flow-through taxation and management flexibility. A drawback is that a general partnership has unlimited personal liability for the actions of your business partners. If one of your partners makes a bad decision or has a problem, it can hurt your finances.
An LLP (limited liability partnership) is a partnership where all or some of the partners have limited liabilities. With an LLP, each partner isn’t liable or responsible for the negligence or bad behavior of another partner. This entry structure has elements of both corporations and partnerships.
An LLC (limited liability company) is an ideal choice for long-term real estate investors. It’s also a good option for rental properties. Besides being affordable and simple, LLCs don’t entail much paperwork. They’re so named because they limit the liability of an investor. What’s more, LLCs are easy to manage as the earnings and losses are passed on to an investor’s personal income tax return.
However, if you choose an LLC, just be sure you don’t mix your personal and business expenses because this can make you personally liable. Furthermore, consider that an LLC dissolves in the event of bankruptcy or death.
6. Single-Member LLCs
Just as their name indicates, single-member LLCs are limited liability companies with only one owner. The IRS collects business taxes through an owner’s personal tax return single-member because LLCs are not regarded as entities.
7. Sole Proprietors
A sole proprietor is an entity structure for real estate investors who run their businesses by themselves without forming any entity. One of its main perks is not having extra tax returns. Also, there are no legal fees for forming an entity. A major disadvantage is not having any liability protection with your personal assets being exposed. This may eventually cost you more when facing a lawsuit.
The Bottom Line
- Failing to set legal safeguards for your real estate investments can mean putting your home, vehicles, savings and other personal assets at risk if you get sued or have accumulated debts.
- Because every situation is different, there’s no “one-size-fits-all” solution.
- When choosing an entity, consider factors, such as the business cycle, legal tax, and financial situation changes.
- If later you need to change your entity structure, please note that although usually owners can move up through the entity hierarchy without tax consequences, they can’t move back down without incurring significant tax concerns.
- Also, if you need more information about business structures and its tax implications, you can go to IRS.gov.
We can help you decide your choice of entity and develop a customized package of accounting and tax services for your business. Contact us or request a complimentary online consultation.