10 Reasons NOT to Use Corporations for Real Estate Ownership
One of the big questions often asked on real estate forums, especially by new investors, is do I need to incorporate to buy real estate? There are plenty of compelling reasons to use a corporation when going into business, but buying and owning real estate may or may not be one of them.
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The use of a corporation will often come down to personal preference and risk tolerance. It is unfortunate that today many investors are scared into the need of a corporation after listening to speakers at real estate events or their local real estate investor clubs. They are often pitched do-it-yourself kits or options to have company set up all of your legal entities for you. Fear should never be an underlying reason to incorporate.
Any real estate investor choosing to incorporate and operate as a business should carefully consider all of the pros and cons and should definitely consult two legal opinions at a minimum. Make sure you are clear on why or why not you would want to use a corporation.
Here are 10 good reasons to avoid using an entity when making your decision!
BONUS Reason #1: Don’t do it out of fear.
I am going to address this right off the bat as a bonus and then lay out 10 practical business-related reasons below. For as long as I can remember, fear has been the number one reason for investors to incorporate and use complicated strategies to operate their businesses.
Why? Because fear sells! And those who propagate fear usually have something for sale. It simply helps to boost the bottom line numbers when you can scare the crap out of everyone.
Investors should never operate and make decisions from a standpoint of fear. Real estate is a logical business that can be profitable when investors are slow, methodical, and take the time to listen to good advice.
With that being said, fear is always used to entice investors to make irrational and quick decisions: fear of being sued, fear of losing everything, fear of going to jail. Each of these fears is used to sell investors on why they need to use corporate structures to invest in real estate. Oftentimes, as you will see below, that is not the best strategy, and the real estate investor has very little to actually be afraid of. It is certainly nothing that cannot be mitigated in other ways without making the mistake of using a complicated strategy.
If you feel yourself being sold on fear, stop and think. Get the advice of tax professionals who have nothing to sell. Those whose only motivation is to answer your questions will always be your best guide.
So, now that we cleared that up, here is the list.
10 Reasons NOT to Use Corporations for Real Estate Ownership
Corporations are more audited than partnerships.
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).
This reason alone should be enough to make any real estate investor think twice before deciding to use an S or C corporation, which are both very popular choices by investors.
Dealer status can be costly.
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.
In layman’s terms, there are additional taxes and fees and possibly even licenses that must be obtained if you are categorized as a dealer.
Corporations are subject to more 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!
The IRS may scrutinize “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.
In reality, this is minor and not one of the top line items that is going to garner IRS scrutiny. That is, unless — and this is where it gets tricky — they see a company trying to play with the income they are reporting to improve their numbers.
Whether a company is or is not, this is simply one more area of scrutiny that comes with choosing a structured corporation like a C or S corp.
There are 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.
Keep a close eye on this reason and use a trusted advisor and CPA to help you get the right answer based on how you are going to file. Realize that depending on the type of investing you are doing, this could play a key role in how you structure.
Example: Assume a property is held in a C-corp, and it 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!
Your corporation could make a refinance taxable.
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!
For many investors, the use of structured debt is a strategy to enable an investor to buy, renovate, refinance, and repurchase. Under certain scenarios and with certain structures, each time you refinance could become a taxable event, leading to waste.
Your corporation could make distributed property taxable.
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.
Again, for some, the point of purchasing real estate is to build assets. If those assets are distributed to shareholders, even though no cash has traded hands and there is no actual cash advantage to the investor/shareholder, that distribution creates a taxable event. Not ideal!
Your corporation could make corporate liquidation taxable.
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.
Your corporation could make conversion to an LLC taxable.
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.
Hopefully, you are starting to see the pattern here. There is much, much more to think about than just “should I or should I not incorporate?”
Your corporation could make property transfers to another corporation taxable.
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 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. Therefore, they are 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 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 a SMLLC or Multimember LLC, the $100k will be subject to self-employment tax
I have been asked several times when speaking to investor groups how I hold my personal property. The questions almost always have the slant of fear. They come from investors who are mostly fearful of being sued rather than from the point of tax preparation.
For taxation, I have always relied on the professionals on my team. When I first got started, I held everything in my personal name and used layered insurance for my protective strategy. For my tax strategy, I eventually migrated my thinking with the advice of my CPA and have used an LLC to hold my investments.
I only have one LLC to hold my properties, and as they are paid off, I have a strategy laid out to put those properties into a trust. My strategy is as my investments become more valuable, my reliance on corporate structure grows.
However, as a long-term, buy and hold investor, I have shied away from using a C or S corp for my entity structure for the above reasons. From a simplicity standpoint, this has made sense for my strategy and served me well.
Investors: Do you use corporations in your real estate business? Why or why not?
Let me know with a comment!