I often have clients, both experienced and new, come to me asking for entity structuring advice. Entity structuring is a ton of fun. There are so many unique ways entity structuring can benefit your business. We mix long-term strategy with present financial facts, a real estate CPA’s dream!
Today, I’m going to talk about the most flexible and tax efficient way to structure a partnership. I’m not an attorney, and I always tell my clients that they need to speak with an attorney prior to ever going through with an entity strategy. However, as a CPA, I can advise all day on the tax side.
Everyone wants (needs) entity structuring advice. Most commonly, I receive requests to review partnership structuring. Real estate is expensive, after all, and often requires pooling money together to pick up an asset.
As these requests became more frequent, I realized I needed to come up with something better than the standard “create an LLC and own everything 50/50” advice. I needed something that was going add immense value to my clients, as well as to differentiate me from all of the other standard CPAs.
So I started a massive research project. I interviewed successful investors, attorneys, and even other CPAs practicing in real estate (who are way smarter than me!). I believe I’ve found an optimal entity structure for partnerships. It’s nothing spectacular or complex; you may even *facepalm* and say “duh!” It’s just a different way of running a partnership that provides for optimal flexibility and tax benefits.
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Each Partner Has Their Own Entity
Have you and a potential (or current) partner ever argued about entity structure? Are you the partner who simply “lets it go” and cringes come tax time? If so, this simple fix will add a ton of value to your business and life.
My proposal is this: In any partnership, you should consider the idea of having each partner invest in the partnership through their own entity, rather than their personal name.
The reason for this is simple. If I need to be utilizing an S-Corp but my partner needs to be utilizing a C-Corp, we shouldn’t be jointly owning an LLC or any other type of entity through our personal names. An LLC can be taxed as an S or C-Corp, but not both. It has to be one or the other. So if partners need to be utilizing different entity structures to maximize their tax efficiency, someone is going to lose.
If I partner with someone on a flip and I need our shared entity to be an S-Corp to maximize my personal tax position, what happens when my partner disagrees? Even in partnerships, all parties should attempt to maximize the benefits of their own situation.
The workaround here is that I create my own entity, my partner creates their own entity, and we each invest (through our entities) into a shared company. This allows me to have my personal entity be taxed as a partnership, S-Corp, or C-Corp. And regardless of what I choose, my partner can choose a tax structure completely different via their own personal entity.
Again, this is because we each have our personal entities, which are subsequently taking a 50/50 stake in the shared entity.
A Shared LLC Creates Ultimate Flexibility
What should the shared entity, the partnership be? In most cases, a simple LLC will do. This will provide you with plenty of flexibility in divvying up profits between owners (more on that later) and will ensure that the administrative burdens of entity management remain low.
This partnership LLC will be your parent, or operating, company. It will become the owner of all subsidiary entities you open up per your normal entity strategy. Whether you open a new entity per flip or rental property, the partnership LLC will “invest” in the entity that owns the property.
Profits will flow from the subsidiary entities to the partnership LLC, and then the partnership LLC will distribute profits to the partners’ entities per the operating agreement.
How Entity Selection Affects the Distribution of Profits
The type of entity you select will greatly affect your ability to distribute profits in a tax efficient manner. This is why many different entities and subsequent tax strategies exist.
Related: How to Know When It’s Wise to Place Your Rentals in a C or S-Corporation
Out of all the entities, the LLC is the most flexible in the profit distribution category. The reason for this is that your percentage share of capital, debt, and profits and losses can all be different. A partner who has a 50% stake in an LLC can also have a 10%, 25%, 75% (or whatever number) share in the profits. The split does not have to be the same.
Why would you ever do this? Perhaps both partners bring an equal amount of money to the table to open the partnership, but one partner is going to be the operating partner and will spend significantly more time running the business. That partner should be compensated for his extra effort.
With an S or C-Corp, the “partners” are really shareholders. They own shares of the corporation and profits (dividends), which are divided up on a per share basis. So if each partner owns 500,000 shares (totaling 1M outstanding), then each partner owns 50% of the capital, debt, AND profits.
If the corporation nets $100,000 after all expenses and owner salaries have been paid, how do we extract that profit? We’d issue a cash dividend to the shareholders (partners). But it would be on a per share basis, and if each partner owns 50% of the shares, each partner receives 50% of the issued dividend. We can’t distribute 75% to one partner and 25% to the other. Corporations lack flexibility in profit splitting.
There are other measures of extracting profits from corporations. For instance, we can compensate the partners for their work via a W2 salary or 1099 pay. Or if one partner performs significantly more work, we provide them with a bonus. But then we have to worry about payroll tax issues, which reduces tax efficiency. Dividends, on the other hand, avoid payroll tax; so issuing a dividend would be optimal but not flexible.
This leads me back to why LLCs are the best choice for partnerships. The profit splitting flexibility is priceless. The ease of management only further augments the pro-LLC argument.
As with any tax strategy ever, there are drawbacks to opening personal entities and then having it take a stake in a shared operating entity. Most notably is the cost of upkeep, in both monetary and time terms.
If cash is short, this entity strategy may not be a good idea for you until you’re able to generate sustainable income. Setting up a personal entity, if you do it right (i.e. not via LegalZoom), is expensive. I’d budget at least $1,000. You’ll then have to share on the cost of setting up the partnership entity and paying an attorney to draft legal documents showing that you company owns the partnership entity. All of that costs money, of which your share is likely going to be another $1,000.
On top of that, you will also have increased tax compliance. That’s code for “more tax returns,” which subsequently means more expenses. If your personal entity is an S or C-Corp, go ahead and budget another $700 to $1,500 depending on deal volume and complexity. The partnership entity will also need returns prepared, which will likely cost between $600 and $2,500, again depending on complexity.
Accounting and bookkeeping fees will remain relatively the same, but payroll fees are another item you’ll need to budget for. If you use a third party software solution, you’re likely looking at $30 per month.
Then we have the “value of your time” issue. This is a more complex entity structure, meaning it will take more of your time to ensure it operatives effectively and meets compliance requirements on both the state and federal levels. Corporate board meetings, maintaining minutes, logging expenses, submitting expense reports, and issuing refunds to yourself all take time.
But the great news? It will all be completely worth it, as you’ll save a significant amount of money from taxes alone by operating on this manner.
As always, don’t try this yourself. You need a team of licensed and experienced professionals to walk you through each step.
Disclaimer: This article does not constitute legal advice. As always, consult your CPA or accountant before implementing any tax strategies to ensure that these methods fit with your particular situation.
How do you have your partnership structured?
Let me know your thoughts with a comment!