Why do investors choose LLC's over S-Corp's?

[Brian Garrett]

I always see discussions where investors ask about creating an LLC for their business.

How come people never discuss S-Corps? Are they not common in the World of REI?

I currently own several S-Corps in other industries so I'm familiar with the structure of them, the requirements for them in my state, the tax benefits of them, etc.

Is there a downside to starting a new S-Corp to run all of my real estate investment endeavors through? Why are LLC's always suggested and that much more common?

Thank you in advance!

[Brian Garrett]

Originally posted by @John Woodrich:

I read a couple of the above posts but not all.  @Linda Weygant mentioned a few of the reasons but the main reason people put property in an LLC is because debt gives you basis. For example, if you purchased a property by putting in $2,000 and had a loan of $48,000 your basis in an S-Corporation would be $2,000, your basis in an LLC would be $50,000. How this matters??

Year 1 - the property is rented, you show a $3,000 loss but you cash flow $2,000 which you take home.  

    -In an S-Corporation you have $2,000 deductible loss, $2,000 capital gain on the distribution in excess of basis, and a $1,000 suspended loss.

-If you were in an LLC/Partnership - you would have a $3,000 deductible loss and not have to pickup any gain.

Fast Forward

Year 5 - your property has appreciated from $50k - $100k, your current loan is $30k and let's say your stock basis/capital account are at $0. You refinance the loan on the property to $75, pulling out $45k in cash for your next investment and deposit into your new LLC.

    - In an S-corporation there is a $45,000 taxable gain.  

- In a LLC/partnership there is no gain recognized.

Last - if you for some reason decide to convert the property from investment to personal the S-Corp is deemed to sell it to the shareholder at FMV paying tax on the gain. A member of an LLC/Partnership doesn't have to pay tax on any appreciation and assumes the property at the adjusted basis.

S-corps are good for operating entities. 99.9% of the time rental real estate should be in a LLC/Partnership structure.

 Great information John. What about if you are flipping and not holding for rentals?

[Colleen F.]

Very informative thread-makes me wonder why I can't vote for threads.... I can see why for rental income an S-corp would not be advantageous. Since an LLC can elect to file as a S-corp what would the advantage be of having an S-corp alone?

Now I know LLCs may be chosen for reasons other then taxes. LLCs I have seen touted for liability protection, does an S-corp offer that same advantage?   Is it identical I  don't know since it is not a structure I am familiar with.    

[Linda Weygant]

@Colleen F. - this was a good discussion a few days ago about the subtle nuances between LLCs and S-Corps....

https://www.biggerpockets.com/forums/51/topics/430130-s-corp-or-llc-for-flips

[John Woodrich]

@Colleen F. LLCs and S-Corporations are substantially the same when it comes to liability protection.  An S-Corporation is a C-Corporation that has filed an election to be taxed under subchapter S of the internal revenue code.

@Brian Garrett Many people who have a flipping business or a construction company will operate under the S-Corp structure. The main reason for this is to limit the amount of self-employment taxes (social security and medicare) paid. For example, if you operated a flipping company under an LLC, all of the income is subject to self-employment taxes. If you were an S-Corp and made $120,000, you could take a "reasonable" wage, say $70,000, and only pay self-employment taxes on the $70,000. This effectively would save around $6,000 in self-employment taxes.

Tax strategy is very important, if you read my post above an LLC is very tax advantageous for that example. If you follow this post an S-Corporation is very tax advantageous. If you are unsure it definitely pays to pay a professional who knows what they are doing.

[J. Martin]

@Brian Garrett,

The main advantage of the S Corp is to only pay a portion of the total profits from an ACTIVE business as salary income. So you only have to pay the self-employment tax (Social Security and Medicare) on a fair and reasonable salary, and don't need to pay self-employment tax on the profit portion above and beyond your reasonable salary. If you had an ACTIVE business in a pass-through LLC, you would have to pay self-employment taxes on the entire profit of the LLC.

https://turbotax.intuit.com/tax-tools/tax-tips/Sma...

"The tax rate for self-employed individuals is a combination of the social security tax rate (12.4) and the Medicare tax rate (2.9), which equals 15.3%."
https://www.paycor.com/resource-center/2016-social...

If you have passive income in a pass-through LLC (like Schedule E income from passive real estate investment), you don't have to pay any self-employment taxes anyway, because it's passive - not active. LLC's are a bit cheaper and easier to run. So most use pass-through LLC's if it is not an active business.

Brian, you said, "The part I don't understand is how rentals are not considered self employed income when I'm the sole owner of the properties and that income is paid directly to my LLC and ultimately me."

Read this article from BP below on passive vs active income. If you do not materially participate in the operation of a business and are just an investor, it is considered passive income. Passive income from real estate is what schedule E is for - and that's not taxed as self-employed income. It is Uncle Sam's gift to you for buying dirt in the good 'ol US of A, along with depreciation :)

https://www.biggerpockets.com/renewsblog/2013/11/0...

Hopefully these links help clear things up!

@Alex Shaughnessy, is this your understanding? @Linda Weygant? 

I am not a lawyer, but did some research and will be incorporating my active real estate business as an S-corp (furnished rental business).  Also makes it easier to sell shares later in some ways. The properties will continue to stay out of the S-corp and remain passive income on Schedule E. 

[Steven Hamilton II]

First of all @Brian Garrett, it is not polite to be so dismissive to someone going out of their way to help you understand a concept. This is especially true when you ask a tax question on the tax deadline.

LLCs are far as the IRS is concerned DO NOT EXIST. So we will often say S-corp, C-corp, partnership etc. INSTEAD of saying "LLC taxed as a" every time we speak. Whether or not your entity should be an LLC is an attorney question. @Jerry W. might be able to answer that.

Here is some information as it pertains to rentals and LLCs.

. Are there any significant differences between a LLC taxed as a proprietor vs a LLC taxed as a S-corp? Both are flow through but I have heard a lot of conflicting information about which is better for real estate.

First we need to know what you plan to do as an investor. Are you going to continue to have rental property only or engage in flipping activities? If you plan to only engage as a landlord I recommend keeping the LLC taxed as a disregarded entity. This means that you will not have to file an extra tax return. You also could find that you lose some benefits by this scenario. Simple put: Disregarded LLC is best; however, if you are operating with a partner either a C-Corp or partnership are usually best.

This is only pertaining to rental income. Other income can be a significant factor.

And LLC taxed as a _______.
Disregarded entity: Reports on Form Schedule E attached to the personal 1040 pays no self employment tax. Default if there is only one LLC Member.

[b]Partnership:[\b] Reports on Form 1065 which issues a k-1 to each partner who must report on their personal 1040. The general partner may be subject to Self-Employment Tax on their earnings. Increased costs in accounting and reporting. Default if there is more than one LLC Member.

S-corporation: Reports on Form 1120S which issues a K-1 to each shareholder to report on their personal 1040. A "reasonable salary" must be paid. Social Security and medicare will be incurred upon any salary issued. Increased costs in accounting and reporting.

[b]C-Corporation:[\b] Reports on Form 1120. No reporting is done on the personal 1040. Good for high income individuals in the 28% tax bracket and higher. Increased accounting costs and reporting costs. No salary must be paid. Taxed at 15% on first $50,000 of income. Good for long-term investing in which funds will be reinvested.

2. Taxation rates? So let us assume that we maximized our deductions and still end up with an annual net rental income of $1000. Do we pay a self employment tax on this? No right? We pay federal and state at the personal bracket level?

And LLC taxed as a _______.

Disregarded entity(Single-Member LLC) you will only pay ordinary income tax rates on your rental income. No self emloymeny tax will be paid on rental income.

[b]Partnership:[\b] You will pay at the Ordinary Income tax rates on income passed to your 1040. The general partner may be subject to Self-Employment Tax.

LLC taxed as an S-Corp you will pay ordinary tax; however, once you have an established income the IRS likes to see that individuals are paying the operators a "reasonable salary" for the work being done. That means there will be Self-employment Tax.

[b]C-Corp[\b] you will not have to worry about paying Self-Employment Tax except for any salary that the corporation decides to pay. There are no salary requirements and if you plan to keep the income in the corporation for a very long time you will not be subject to any double taxation.

For flipping purposes:

Reasons for using an entity taxed as a corp are so you can pay Wages and SE tax is not a bad thing and the IRS WILL go after you if you're not paying enough. 

Paying those wages is a very important factor as you may qualify to put additional funds into a retirement account AND there are deductions you will qualify for that you didn't already.

[Linda Weygant]

@J. Martin - I was with you up until your statement towards the end about material participation.

Active participation doesn't make your passive rental income suddenly become regular earned income.  Rental income is passive unless you are a real estate professional.  Those rules are different than active participation rules.  

Active participation just means you can write off your losses (subject to income limitations, etc).  

But yeah, you're 99.9% there.

[Frank Grigus Jr]

...

[Albert Bui]

Originally posted by @Brian Garrett:

I always see discussions where investors ask about creating an LLC for their business.

How come people never discuss S-Corps? Are they not common in the World of REI?

I currently own several S-Corps in other industries so I'm familiar with the structure of them, the requirements for them in my state, the tax benefits of them, etc.

Is there a downside to starting a new S-Corp to run all of my real estate investment endeavors through? Why are LLC's always suggested and that much more common?

Thank you in advance!

One big reason is that properties held in S corps or LLC's taxed as scorps (wait whaa, yeah LLC's can be taxed as partnerships, S corps, and C corps) when transferred have to leave at market value which might be a problem if you bought it for 100k and now its worth 180k because, thats a 80k gain you got on your hands when this property is transferred (unless if you transfer or sell it to yourself at cost basis).

The other reasons is like most people said regarding self employment taxes and avoidance of them in totality.

Another reason is you may not want to comingle your liabilities of your buy and hold properties with your active business (wholesaling, flipping, consulting, etc) which may compound your risk for lawsuits.

However, to the contrary I see tons of S-corps with investors or LLC's taxed as scorps for flippers or people who use their scorps for active businesses like hard money lenders and flippers.

The benefit of Scorp is that us conventional lenders like to see income surrounded by a veil of s-corp legitimacy even though its only a couple pieces of paper filed with the state. Magically your income within or flowing from an scorp is somehow more usable or legitimate in a lending context. (hint hint)

[Albert Bui]

Originally posted by @John Woodrich:

I read a couple of the above posts but not all.  @Linda Weygant mentioned a few of the reasons but the main reason people put property in an LLC is because debt gives you basis. For example, if you purchased a property by putting in $2,000 and had a loan of $48,000 your basis in an S-Corporation would be $2,000, your basis in an LLC would be $50,000. How this matters??

Year 1 - the property is rented, you show a $3,000 loss but you cash flow $2,000 which you take home.  

    -In an S-Corporation you have $2,000 deductible loss, $2,000 capital gain on the distribution in excess of basis, and a $1,000 suspended loss.

-If you were in an LLC/Partnership - you would have a $3,000 deductible loss and not have to pickup any gain.

Fast Forward

Year 5 - your property has appreciated from $50k - $100k, your current loan is $30k and let's say your stock basis/capital account are at $0. You refinance the loan on the property to $75, pulling out $45k in cash for your next investment and deposit into your new LLC.

    - In an S-corporation there is a $45,000 taxable gain.  

- In a LLC/partnership there is no gain recognized.

Last - if you for some reason decide to convert the property from investment to personal the S-Corp is deemed to sell it to the shareholder at FMV paying tax on the gain. A member of an LLC/Partnership doesn't have to pay tax on any appreciation and assumes the property at the adjusted basis.

S-corps are good for operating entities. 99.9% of the time rental real estate should be in a LLC/Partnership structure.

 Very good explanation John, heavy info, facts are great though and well explained.

[Albert Bui]

Originally posted by @John Woodrich:

@Colleen F. LLCs and S-Corporations are substantially the same when it comes to liability protection.  An S-Corporation is a C-Corporation that has filed an election to be taxed under subchapter S of the internal revenue code.

@Brian Garrett Many people who have a flipping business or a construction company will operate under the S-Corp structure. The main reason for this is to limit the amount of self-employment taxes (social security and medicare) paid. For example, if you operated a flipping company under an LLC, all of the income is subject to self-employment taxes. If you were an S-Corp and made $120,000, you could take a "reasonable" wage, say $70,000, and only pay self-employment taxes on the $70,000. This effectively would save around $6,000 in self-employment taxes.

Tax strategy is very important, if you read my post above an LLC is very tax advantageous for that example. If you follow this post an S-Corporation is very tax advantageous. If you are unsure it definitely pays to pay a professional who knows what they are doing.

 Most accountants use the rule of the net income (in my experience) as follows 1/3rd wage income to 2/3rds K1 income from an S-corp.  The more conservative accountants I've seen use 50/50 between W2 and K1 net profit split to save the SE(self employment) taxes. Whats your take on this split theory above and if you'd like to share is your preference on W2/Profit split for your clients? 

The max income for social security/payroll tax withholding went from 118,500 in 2016 to 127,200 in 2017 this year before the tax payer is no longer required to withhold their portion of this 12.4%. Does this mean that a person with a net profit of 254,400 - 381,600 within the S-corp no longer has a benefit from the W2/profit split since he/she is in effect will be paying payroll taxes up to the maximum amount of W2 portion in 2017 income anyway? 

After the higher income brackets mentioned above, what would the other benefits of a scorp be when the tax payer is at a tier where the W2/profit split no longer holds benefit?

[David Ho]

Starting a LLC checking off the "S" corp to be taxed as so.... Hiring the kids and pay into the 539 Education and Flipping houses in the LLC... I would then create series LLC in the state of Illinois to put the rental properties in......

[John Woodrich]

Originally posted by @Albert Bui:

Originally posted by @John Woodrich:

@Colleen F. LLCs and S-Corporations are substantially the same when it comes to liability protection.  An S-Corporation is a C-Corporation that has filed an election to be taxed under subchapter S of the internal revenue code.

@Brian Garrett Many people who have a flipping business or a construction company will operate under the S-Corp structure. The main reason for this is to limit the amount of self-employment taxes (social security and medicare) paid. For example, if you operated a flipping company under an LLC, all of the income is subject to self-employment taxes. If you were an S-Corp and made $120,000, you could take a "reasonable" wage, say $70,000, and only pay self-employment taxes on the $70,000. This effectively would save around $6,000 in self-employment taxes.

Tax strategy is very important, if you read my post above an LLC is very tax advantageous for that example. If you follow this post an S-Corporation is very tax advantageous. If you are unsure it definitely pays to pay a professional who knows what they are doing.

 Most accountants use the rule of the net income (in my experience) as follows 1/3rd wage income to 2/3rds K1 income from an S-corp.  The more conservative accountants I've seen use 50/50 between W2 and K1 net profit split to save the SE(self employment) taxes. Whats your take on this split theory above and if you'd like to share is your preference on W2/Profit split for your clients? 

The max income for social security/payroll tax withholding went from 118,500 in 2016 to 127,200 in 2017 this year before the tax payer is no longer required to withhold their portion of this 12.4%. Does this mean that a person with a net profit of 254,400 - 381,600 within the S-corp no longer has a benefit from the W2/profit split since he/she is in effect will be paying payroll taxes up to the maximum amount of W2 portion in 2017 income anyway? 

After the higher income brackets mentioned above, what would the other benefits of a scorp be when the tax payer is at a tier where the W2/profit split no longer holds benefit?

 We don't use a rule of thumb, it depends on the facts and circumstances of what services they are providing to the company.  We try to determine what a reasonable wage is by estimating what it would cost to pay someone to do the same job the owner is.  If you could pay someone $70k to do the job, that may be a reasonable number.  If it is a larger company maybe you are past the social security limits.  The IRS has mostly attacked people abusing the system and taking no wage.

As far as your other comment, the wage limit you mentioned only applies for the social security portion of self-employment tax.  You still have the medicare portion that is paid on all wages so there still is savings with someone who has a wage over the social security limits.

[Albert Bui]

Originally posted by @John Woodrich:

Originally posted by @Albert Bui:

Originally posted by @John Woodrich:

@Colleen F. LLCs and S-Corporations are substantially the same when it comes to liability protection.  An S-Corporation is a C-Corporation that has filed an election to be taxed under subchapter S of the internal revenue code.

@Brian Garrett Many people who have a flipping business or a construction company will operate under the S-Corp structure. The main reason for this is to limit the amount of self-employment taxes (social security and medicare) paid. For example, if you operated a flipping company under an LLC, all of the income is subject to self-employment taxes. If you were an S-Corp and made $120,000, you could take a "reasonable" wage, say $70,000, and only pay self-employment taxes on the $70,000. This effectively would save around $6,000 in self-employment taxes.

Tax strategy is very important, if you read my post above an LLC is very tax advantageous for that example. If you follow this post an S-Corporation is very tax advantageous. If you are unsure it definitely pays to pay a professional who knows what they are doing.

 Most accountants use the rule of the net income (in my experience) as follows 1/3rd wage income to 2/3rds K1 income from an S-corp.  The more conservative accountants I've seen use 50/50 between W2 and K1 net profit split to save the SE(self employment) taxes. Whats your take on this split theory above and if you'd like to share is your preference on W2/Profit split for your clients? 

The max income for social security/payroll tax withholding went from 118,500 in 2016 to 127,200 in 2017 this year before the tax payer is no longer required to withhold their portion of this 12.4%. Does this mean that a person with a net profit of 254,400 - 381,600 within the S-corp no longer has a benefit from the W2/profit split since he/she is in effect will be paying payroll taxes up to the maximum amount of W2 portion in 2017 income anyway? 

After the higher income brackets mentioned above, what would the other benefits of a scorp be when the tax payer is at a tier where the W2/profit split no longer holds benefit?

 We don't use a rule of thumb, it depends on the facts and circumstances of what services they are providing to the company.  We try to determine what a reasonable wage is by estimating what it would cost to pay someone to do the same job the owner is.  If you could pay someone $70k to do the job, that may be a reasonable number.  If it is a larger company maybe you are past the social security limits.  The IRS has mostly attacked people abusing the system and taking no wage.

As far as your other comment, the wage limit you mentioned only applies for the social security portion of self-employment tax.  You still have the medicare portion that is paid on all wages so there still is savings with someone who has a wage over the social security limits.

 Right but no other benefits on the tax end from an S-corp once you're passed the social security limits? Since the purpose of getting the scorp was to reduce the the 15.3% on the earned wages (12.4% social security + 2.9% medicare portion = 15.3%)

Also Obama care tax of .9% above 200k of earned wage income.

[Steve Vaughan]

Originally posted by @Albert Bui:

The benefit of Scorp is that us conventional lenders like to see income surrounded by a veil of s-corp legitimacy even though its only a couple pieces of paper filed with the state. Magically your income within or flowing from an scorp is somehow more usable or legitimate in a lending context. (hint hint)

This is a great point, Albert. One of the advantages of having an s-corp vs an LLC taxed as one. My wife has a small w-2 job, and I have been 'self-employed' forever yet we qualify to buy our single-families individually to not over-burden our FICOs and double the number of loans we can get. Couldn't do it without her receiving almost half of all our S-corp income thru a k-1 as 'earned' income. Same for me. LLC stuff passes through as investment or passive income. Diversity helps.

One other reason I like my s-corp (for actively earned income, not rentals) is for the opportunity to have a defined benefit retirement plan.  Essentially a pension.  Contributions (up to $30kish/yr) reduce income for that year.  I also have solo 401k options where my qualified plan contributions can buy more RE.  Double bonus.  Cheers!

[John Woodrich]

Originally posted by @Albert Bui:

Originally posted by @John Woodrich:

Originally posted by @Albert Bui:

Originally posted by @John Woodrich:

@Colleen F. LLCs and S-Corporations are substantially the same when it comes to liability protection.  An S-Corporation is a C-Corporation that has filed an election to be taxed under subchapter S of the internal revenue code.

@Brian Garrett Many people who have a flipping business or a construction company will operate under the S-Corp structure. The main reason for this is to limit the amount of self-employment taxes (social security and medicare) paid. For example, if you operated a flipping company under an LLC, all of the income is subject to self-employment taxes. If you were an S-Corp and made $120,000, you could take a "reasonable" wage, say $70,000, and only pay self-employment taxes on the $70,000. This effectively would save around $6,000 in self-employment taxes.

Tax strategy is very important, if you read my post above an LLC is very tax advantageous for that example. If you follow this post an S-Corporation is very tax advantageous. If you are unsure it definitely pays to pay a professional who knows what they are doing.

 Most accountants use the rule of the net income (in my experience) as follows 1/3rd wage income to 2/3rds K1 income from an S-corp.  The more conservative accountants I've seen use 50/50 between W2 and K1 net profit split to save the SE(self employment) taxes. Whats your take on this split theory above and if you'd like to share is your preference on W2/Profit split for your clients? 

The max income for social security/payroll tax withholding went from 118,500 in 2016 to 127,200 in 2017 this year before the tax payer is no longer required to withhold their portion of this 12.4%. Does this mean that a person with a net profit of 254,400 - 381,600 within the S-corp no longer has a benefit from the W2/profit split since he/she is in effect will be paying payroll taxes up to the maximum amount of W2 portion in 2017 income anyway? 

After the higher income brackets mentioned above, what would the other benefits of a scorp be when the tax payer is at a tier where the W2/profit split no longer holds benefit?

 We don't use a rule of thumb, it depends on the facts and circumstances of what services they are providing to the company.  We try to determine what a reasonable wage is by estimating what it would cost to pay someone to do the same job the owner is.  If you could pay someone $70k to do the job, that may be a reasonable number.  If it is a larger company maybe you are past the social security limits.  The IRS has mostly attacked people abusing the system and taking no wage.

As far as your other comment, the wage limit you mentioned only applies for the social security portion of self-employment tax.  You still have the medicare portion that is paid on all wages so there still is savings with someone who has a wage over the social security limits.

 Right but no other benefits on the tax end from an S-corp once you're passed the social security limits? Since the purpose of getting the scorp was to reduce the the 15.3% on the earned wages (12.4% social security + 2.9% medicare portion = 15.3%)

Also Obama care tax of .9% above 200k of earned wage income.

Incorrect - you still save the 2.9% medicare portion on wages which you don't on S-corp profits.  You are correct that you can run into the additional medicare tax however you only pay the medicare portion on wages.  

Set the S-corp wage at a reasonable amount and appropriate taxes will follow.

[Gord Stevenson]

When I researched it in 2009 (first property) the general advice was that both income tax and capital gains tax would in most cases be less expensive if taxed as personal income rather than corporate income.

This could be accomplished by holding the property in an individual's own name...or by holding the property in an LLC and choosing partnership tax treatment. Between the two choices, the LLC added the advantage of liability cap protection.

To verify this is still true you would need to check the current marginal tax rates for personal versus corporate income.

My guess is that it is still true...but I believe Donald Trump has stated plans to reduce corporate tax rates so the story may change.

Another question that I do not know the answer to is whether corporate entities are more complex or costly to maintain.

[Joshua Seeley]

I learned a lot about the benefits of the S Corp from Mark on his podcast "Refresh Your Wealth". I would check it out. Goes a lot more in depth on what Natalie and Linda are saying and explains why its beneficial, even though you may not have heard about it. I myself am just getting started, but definitely plan to have two separate entities, an S Corp for my wholesaling, and an LLC for my rentals once I get to that point.

[J.C. Martel]

@Joshua Seeley, thanks for that reference. I'm holding my rentals in my S corp too because as a real estate licensee my rental income is considered active, not passive. Just adding another point to this discussion that tax status is really dependent on your individual situation. If I weren't a licensee then my rentals might be passive income, if I weren't actively managing them, and then they'd be better off in an LLC.