A limited liability company (LLC) is a simple way for small businesses and investors to structure their business. Real estate investors especially love the tried-and-true method of pairing the traditional LLC with the series LLC for anonymity and asset protection. When you do this and elect to be taxed as an S corporation, you can enjoy some great tax benefits, too.
How do you decide if using an S corps election for your traditional LLC/series LLC combo is the best route?
Basics of the LLC/series LLC combo
Under this model, the traditional LLC serves as an operating (or shell) company. It manages day-to-day activities like collecting rent and paying employees. Meanwhile, the series LLC functions as an asset-holding company. It must never interact with the world, because that’s what the operating company does.
That traditional LLC is the company a would-be litigant will target. It doesn’t own anything. The company that owns all your assets is the series LLC, which is never exposed. To maximize the series LLC’s effectiveness, you may create as many series as you have assets. Have your attorney help you make the appropriate transfers so each asset is in its own series.
How is an LLC taxed?
The IRS has default methods of dealing with every incorporated business entity. For single business owners operating under an LLC, the IRS treats them as sole proprietorship. That means the business’s income is the LLC owner’s income, and vice versa. And they have to pay self-employment taxes of 15.3%. The owner of a single-member LLC files a Schedule C on their personal tax return.
Multiple-owner LLCs are taxed as a partnership, and the company will file Form 1065. It will also provide a Schedule K-1 (Form 1065) to all shareholders. In many cases, the partners also pay self-employment taxes, just like a single owner would.
But you don’t have to operate using the default methods! Electing to be taxed as an S corporation can help you avoid a big chunk of those self employment taxes—and enjoy some other benefits too.
LLC with S corp election
S corps are “pass-through” entities. They don’t pay taxes. Instead, the company’s profits (or losses) are passed through to its owners for tax purposes. Each owner will include their portion of the company’s profits and losses on their personal income tax returns, and pay taxes based on their individual tax bracket.
Additionally, any distributions—or dividends—are not subject to Social Security and Medicare taxes as long as you’re paying yourself a reasonable salary. You can also reduce—or even eliminate—your self-employment tax. An S corporation election allows the owner to draw a reasonable salary. And the corporation itself can pay the relevant FICA taxes. That can save you a bundle.
Avoid double taxation–and save big time
Filing as an S corporation can help owners avoid double taxation. That happens when both a business’s profits and its shareholders’ dividends are taxed. Unlike C corporations, S corporations aren’t subject to corporate income taxes.
At some point, however, the S corporation election may give you pass-through benefits that can possibly save thousands in taxes. Real estate investors may also opt to tax their LLC as an S corp because asset protection for active businesses is ideal for this structure. House flippers or vacation renters are examples of active real estate businesses, for example.
An S corporation’s income is reported using Form 1120S.
Disadvantages of an S corp election
Creating a taxable entity with an S corp election may lower your tax liability, but that doesn’t mean it’s for everyone. Every tool that has benefits will naturally have drawbacks.
The S corp election is inherently more complicated from an operational standpoint and might be overkill. For example, it may be overwhelming for an investor who is starting out with their first rental property and operating with less capital, knowledge, and experience.
Electing S corporation status means you’ll need an accounting system (something like QuickBooks) and a formal payroll (even if the only employee is you, the owner). It may be time to start using a real tax accountant if you’ve relied on the DIY/TurboTax route previously.
The IRS requires companies with W-2 employees to pay an extra payroll tax called the federal unemployment tax (or FUTA). This equates to 6% on the first $7,000 in wages that you paid to an employee during the calendar year, adding up to $420 to your annual tax bill just because you’ve become an employee. In some states, you could also be subject to the state unemployment tax (SUTA).
Potential IRS scrutiny
Service companies are more likely to be scrutinized by the IRS when using an S corp because most of their earnings come from personal efforts—not that of other employees. Remember: The salary you set for a shareholder-employer needs to be reasonable or the IRS will come knocking.
Tax savings aren’t guaranteed
Real estate investors use the S corps election to save payroll taxes. However, there are cases where an S corps election won’t save money, including:
- If you have substantial personal income (your top tax rate is 40% or higher) but your corporation makes $50,000 or less. In this case, the corporation may actually save tax by operating as a C corporation. The first $50,000 of a C corporation’s taxable income each year is taxed at 15 %. The rate jumps to 25% on the next $25,000 of income.
- If shareholders live in a no-tax or low-tax state, the S corporation approach may not save enough payroll tax to pay for higher out-of-state, non-resident individual income tax on out-of-state profits.
Taxation as an S corp isn’t the best for all real estate LLCs. However, when managed properly, owners may enjoy some fabulous tax benefits. Make sure to consult with an attorney and accountant familiar with real estate law to ensure your investments are properly protected.
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