As a real estate investor it is important to choose a business structure that gives you the maximum asset protection as well as the best tax advantages. Although I can't advise you as to what type of entity you should structure your company as (you should consult with attorney) I can give you a brief overview of the different types of entities. Sole Proprietorship. A sole proprietorship is basically a one person company and is simply "you doing business". There isn't any filing requirement to start you business using this structure unless you are using a fictitious or trade name. If you a using a fictitious or trade name you must file a "d/b/a" or doing business as with your state, city or locality. The only types of fees associated with being a sole proprietor are the licensing fees that your city or state or locality charges for doing business.
Tax Consequences of a Sole Proprietorship. The income made by a sole proprietorship is income earned by its owner. In addition, as a sole proprietor, you report your income, expenses, profits and losses on schedule "C" on your federal income tax return. This income is subject to a self-employment tax.
Disadvantages of Sole Proprietorship .One of the disadvantages of a sole proprietorship is there is unlimited liability. If you got sued everything you have personally is at risk. There is really nothing shielding your personal assets. If your business goes bankrupt, you must file for personal bankruptcy protection to avoid the business debts.
General Partnership. A general partnership is an entity that is formed with two or more parties. No paperwork needs to be filed to create a partnership. In fact it can be formed with a simple handshake. However, it is better to have a partnership agreement that spells out the terms of the partnership. If there is no partnership agreement then the partnership is governed by state law. The majority of the states in the U.S. have adopted the Uniform Partnership act which consists of a set of rules of how partnerships should act if they don't have a formal agreement.
Liability of a General Partnership. A general partnership has no liability protection for partners. Partners are jointly liability for any acts of negligence. So whether or not a person in a partnership committed a negligent act he or she is still personally liable for that act.
Tax Consequences of a General Partnership.The general partnership itself doesn't pay taxes it simply files an I.R.S. 1065 form. This is only an informational form that summarizes income, expenses and profits and losses of the general partnership business.
A general partnership is treated as a "flow through entity" which means that the profits and losses of the partnership "flows through" to the partners who report their share of income or losses on schedule "E" of their personal income tax returns.
The way that this works is that the partnership would send each partner an I.R.S. K-1 form that states their share of the partnership profits or losses.
Limited Partnership. In order to form a limited partnership, the partnership must file a "Certificate of Limited Partnership" with the state in which it is organized. There are two types of partners in a limited partnership. There are the general partner and a limited partner. The general partner controls the day to day operation of the partnership and is liable for all business debt where as a limited partner is not responsible for business debts and/or claims.
Liability of a Limited Partnership. The general partner in a limited partnership have unlimited liability and if a judgment is rendered against the limited partnership and that partnership doesn't have enough assets to cover the claims, the creditor can go after the general partner's personal assets. Sounds risky doesn't it? Well it is!
Now unlike the general partner a limited partner has no liability beyond what they initially invested in the partnership. Creditors can't go after limited partners for the debts of that limited partnership. In addition, limited partners unlike the general partner are not personally liable for acts committed by the general partner unless they participate in management decisions.
Tax Consequences of a Limited Partnership.A limited partnership is also treated as a "flow through entity" for tax purposes. I must point out to you that in "flow through" entities, the owners pay individual income taxes on all net profits of the business. This is the case whether they receive those net profits or not.
Corporation. A corporation is a business entity that carries its own legal status, separate and distinct from its owners. Its' primary advantage is to provide owners with limited liability against business claims. A corporation requires a filing of an articles or "certificate" of incorporation with the state. There are two types of corporations "C" corporations and "S" corporations. An "S" corporation status must be elected.
Tax Consequences of a Corporation. A "C" corporation files an IRS form 1120 and pays taxes on its net income. The primary disadvantage of a "C" corporation is double taxation. Profits are taxed first at corporate tax rates and then again at the individual level. when owners receive profits from the corporation in the form of dividends.
An "S" corporation is taxed just like a partnership. It files an information IRS form 1120-S and the profits and losses "flow through" to the shareholders. The S corporation sends each shareholder an IRS K-1 which states the shareholder's share of profits or losses.
Liability of a Corporation. A corporation provides liability protection for its owners (the shareholders). If the corporation was sued, the owners are not personally liable.
Limited Liability Companies. A limited liability company (or "LLC)" is a hybrid cross between a corporation and a partnership. To form a LLC the requirement is that you must file an "articles of organization" with the state. An LLC is owned by its' members or partners and it is governed by its operating agreement.
Liability of a Limited Liability Company. A limited liability company provides protection for its' members. The members are not liable beyond their contributions to the company. If the LLC is not able to meet its' debts, the members are not liable for these obligations. In addition, if the LLC is sued the members are not personally liable. An LLC can be "member managed" or "manager-managed"
Tax Consequences of LLC. An LLC is also a "flow through" entity and for single member LLC the tax reporting requirements are basic. All you have to do is attach an IRS form Schedule C which is a Profit or Loss from a Business to your Form 1040 individual return. You will also have to file IRS form Schedule SE which is a self-employment tax form. On this schedule you will calculate the amount of self-employment tax owed. This self- employment tax is a combination of Social Security and a Medicare tax .If there are two or more members of LLC, then that LLC generally must file its' taxes as a partnership.
Like I mentioned previously that requires the LLC to file a form 1065. Income, losses, deductions and credits allocated to each owner for the year are reported on Schedule K of form 1065. A schedule K detail is given to the respective members of the LLC detailing their specific shares of profits and losses. They would then use this information and attach the K-1 to form 1040 of their personal tax return and use it to calculate their personal income tax owed.
Limited Liability Partnerships. LLP's are a special type of partnership designed to provide individual partners with protection against malpractice by other partners in the business. In some states this is known as a registered LLP, or RLLP. LLP's are primarily designed for professions such as doctors, lawyers and accountants.
So there you have it, an overview of the different types of business entities in which to choose from. In running your real estate business, it is imperative that you to choose the entity that works best for you. Furthermore, you should also seek the advice of a competent attorney and an accountant before choosing a specific entity.
As a rule of thumb you want the best assessment of the business structure that will allow you to keep a significant amount of income that you made from your deals while minimizing the taxes that you have to pay to Uncle Sam. It makes no sense to make the money as a Real Estate Investor and to give a great deal to the IRS just because you didn't choose the appropriate business structure.
Thank you for the valuable input, Tonnele. I want to ask you about LLC. Can a non-resident form a LLC? For example, I am Canadian; can I form LLC in Washington or another state? If yes, do I need to travel there to do this or it can be done remotely? And last but not least, if I form a LLC, do I need to become a personal tax entity with I.R.S?
Would taxing of LLC formed by non-resident be different from the local ones? Thanks.
I read your post and just had a thought. Why don't you ask JT Foxx? He's one of the newer gurus and I happen to know he's a Canadian citizen buying property in the US....
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