William Bronchick shares a few guidelines to think about when deciding what legal entity would work best for your business strategy (although you should always consult an expert on your needs specifically).
While LLCs make sense for some, a S or C Corp might work better for other investors. Listen in and find out more about the tax benefits of each type of entity.
Mike: Welcome back to the flipnerd.com REI Classroom, where experts from across the real estate investing industry teach you quick lessons to take your business to the next level. And now, let’s meet today’s expert host.
Bill: Hi. I’m attorney Bill Bronchick, host of the popular internet website, legalwiz.com, and the host of the REI Instructor Classes online. Today we’re going to talk about the type of entity that you might choose for your real estate investments.
Mike: This REI Classroom real estate lesson is sponsored by Flipnerd Investor Coaching, your blueprint to investing success.
Bill: First, I’d like to say that there’s no one size fits all. Definitely speak with your accountant and your attorney if you aren’t sure. But I can give you some guidelines to go by. Understand that if you’re choosing a corporation or an LLC, that both are limited liability entities. They have the same basic corporate protection from lawsuits. The big difference between choosing an entity in real estate is mostly a tax issue. If you discuss it with a professional, definitely your tax advisor over your attorney because most attorneys don’t know squat about taxes. I’m the exception.
There are different types of income that you’re going to earn in real estate investing. It’s generally divided into active and passive, active and passive. Active, which is also known as ordinary or earned income, would be things that you are actively involved in such as a fix and flip or a wholesale. Passive income is things like rental income, or if you do hard money loans, for example, interest income. Two different classes, two different entities that you would do your investing in.
Generally speaking, you want to use a corporation, a corporate entity, for the active or earned income and an LLC for the passive income. This is where it gets a little tricky. We have C Corp and you have S Corp. What’s the difference? I’m not going to tell you in this video. You’re going to discuss that with your CPA. When I say active or ordinary income, you’re going to do that in either one of those, a C Corp or an S Corp. Just as a rule of thumb, generally, you start out S Corp unless you’re making a bundle of money. Then you go C Corp. Talk with your CPA about that.
An LLC can be taxed a number of ways. An LLC does not have a designated tax return by the IRS. They just never came up with one. They said, “Well, there are four ways you can be taxed as an LLC and you have to choose.” The first is if you’re a one-owner LLC, single member, then you would be disregarded. What does that mean, disregarded? Meaning we’re just going to ignore the LLC for federal income taxes and you’d report income and expenses on your personal return. If it’s a rental and you’re normally reporting Schedule E rentals and you put it in a single-member LLC, nothing would change for your reporting. Likewise, if you did flips and wholesales, well, here’s the problem. You’d end up on Schedule C, self-employed person or self-employed business. And on that income, you’re going to pay self-employment tax, which is 15.3%, kind of a biggie. A single-member LLC that is disregarded is generally a bad choice for active or earned income.
However, I said there are four ways an LLC can be taxed. Two and three are S Corp and C Corp. We have an LLC taxed as an S Corp, an LLC taxed as a C Corp, a corporation C corporation and a corporation S corporation. What’s the difference between an S corporation and an LLC taxed as an S corporation? Here’s the answer to the question: nothing. They’re both treated the same for tax purposes. An LLC is still an LLC and a corporation is still a corporation, but for federal income tax purposes, they’re the same. Thus, when I said earlier you want to use a C or S corporation for active or earned income, it could be either one, an LLC as a corporation taxed or a regular corporation taxed as a corporation or S corporation.
Now that we’ve got that out of the way, there’s a fourth way you can be taxed as an LLC and it requires that you have two or more owners or members as they’re called. That would be as a partnership. A partnership is an excellent way to do passive income. Because of the way it’s taxed, everything passes through, meaning your depreciation, your capital gains and so forth. You’re not going to pay self-employment tax on those earnings because it’s passive income. It’s not subject to self-employment tax. Either an LLC as a partnership or an LLC as a single person disregarded are fine for rentals.
Personally, I prefer the partnership. Even if you’re not married or you don’t have a partner, you can form another entity and make it your partner and have a partnership. The reason I like the partnership better than disregarded is when you’re doing rentals on a disregarded LLC return, it’s going to show up all your rentals and your income and your expenses on your return. Highly audited, whereas if you do it as a partnership return, you report all your income and expenses on that return and your personal return just has the net number, positive or negative. There’s nothing in terms of information that the auditor can look at unless they audited your partnership return, which is very, very unlikely.
To sum it all up, general rule of thumb is flips, wholesales, any kind of actively earned income would be under a corporation, C or S, or an LLC taxed as a corporation C or S. Non-earned income, such as rentals and interest income, would go in an LLC either, A, taxed as a partnership, which requires two people; or a disregarded single member LLC where you report on your personal return.
This is Bill Bronchick. I hope you’ve enjoyed this fast but very exhilarating topic on taxes, choice of entity and your real estate investing. See you in the next lesson.
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Please note, the views and opinions expressed by the individuals in this program do not necessarily reflect those of flipnerd.com or any of its partners, advertisers or affiliates. Please consult professionals before making any investment or tax decisions, as real estate investing can be risky.
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