Incorporating your real estate business
A corporation or limited liability company (LLC) can be formed quickly and efficiently by filing standardized documents with the appropriate jurisdiction. A corporation that, after being formed, elects to be taxed as a “pass-through” entity under Subchapter “S” of Chapter 1 of the Internal Revenue Code is known as an S corporation.
So, why should you consider forming an S corporation or LLC to operate your real estate business? There are two principal reasons.
Protection from personal liability
First, each of these entities may protect you from personal liability for the debts and obligations of your real estate business. By contrast, a self-employed real estate agent (often called a “sole proprietor”) can be liable for damages and injuries caused by the business, such as a “slip and fall” incident.
The sole proprietor real estate agent also may be legally responsible for the professional errors/omissions or negligent acts of other agents or staff he or she employs or engages.
No liability-shielding entity, however, can protect your personal assets from debts and obligations arising out of your own professional errors/omissions or negligent acts.
Lower income taxes
Second, your overall income taxes may be lowered by choosing an entity to operate your real estate business. An LLC or S corporation, for the most part, is not subject to income tax at the entity level.
Owners avoid “double taxation” by paying income taxes on the profits of the LLC or S corporation on a flow-through basis like a sole proprietor. While an LLC with just one owner (or “member”) is disregarded as a separate entity for tax purposes (and therefore treated as a sole proprietorship), an LLC with multiple members can allocate profits/losses in any way they choose.
In an S corporation, shareholders must receive dividends in proportion to their shareholdings, regardless of the amount of time or effort they “invest” in the business.
The biggest tax advantage enjoyed by S corporation shareholders is that they pay employment taxes (FICA and Medicare) only on money received by them as wages or salary, but not on profits or dividends (a savings of up to 12.4% compared to an LLC or sole proprietorship).
LLC members typically pay employment taxes on the entire amount of LLC profits (regardless of whether or not the profits are distributed to the members).
Distinctions between an LLC and an S corporation
An LLC is not required to hold meetings or to keep formal minutes, while an S corporation may be required to do so.
Owners of an S corporation are limited to a maximum of 100 stockholders and cannot include nonresident aliens or other entities, while members of an LLC have no such restrictions.
Stockholders of an S corporation may deduct “pass-through” losses only to the extent of their actual investment in the company, while members of an LLC may deduct “pass-through” losses not only up to the amount of their actual investment in the company, but their proportionate share of the company’s borrowings as well.
If you are considering the formation of an entity to operate your business, you will want to organize the entity in the jurisdiction (i.e., Maryland, Virginia or the District of Columbia) in which you operate your business (not necessarily where you reside).
This may eliminate the need to file tax returns in multiple jurisdictions relating to the business. Lastly, an LLC is the definite choice of entity to hold your rental real estate.
Since rental income is not subject to employment tax, an S corporation is of no avail for this business purpose.
For more information on planning your business or forming an LLC or S Corporation, please contact Stephen J. O’Connor at Tobin O’Connor & Ewing.