Hello BP! This is my first post ever even though I've been reading on the site for some time. I can usually find the answers I need in old threads but on this subject I haven't found exactly what I am looking, hence the post!
After speaking with a few private equity friends along with an accountant I believe the following structure may minimize the federal tax liability on a fix and flip property and help the investor avoid a lot of SE Taxes as well as having the asset sale taxed as a sort term gain. I'm not looking for a specific calculation rather a high level consensus a deal structure like this works
Take an example where the sale of an investment property generates $500k after six months where you owned 90% and a second partner owned 10%. Therefore you would be subject to SE Taxes and have the asset taxed as ordinary income.
Take an example where the property is purchase in the Owner of House, LLC. that pays a preferred return of x% then returns capital and profit in proportion to the original contribution. The attached org chart shows an S-Corp as the Active "dealer" investor in the structure along with two limited passive investors. Using the same $500k profit example above, the S-Corp receives $50k as gross revenue which it uses to pay Ind. Investor 1 a reasonable salary. Therefore only $50k is subject to tax as ordinary income, and even less SE Taxes. The passive investors are able to claim a short term gain avoiding the SE Tax. In particular, the Ind. Investor 1 books a $400k capital gain, and say for example only $25k in ordinary income and $25k salary subject to SE Tax. Ind Investor 2 books a $50k capital gain.
Mark I have posted on this several times. You need to spend some time talking to someone specializing in real estate.
Reasonable compensation is an issue as is ownership.
SE taxes are a good thing in some cases.
Bottom line a flip is ordinary income and short term gain is taxed the same way. However the SE tax is the big issue. What is your other income? Have you considered a c-corp?
Also dealer status is based upon the transaction not the overall. It is recommended to keep both separate. Hold rentals personally or in an llc. Flip property in a Corp or llc taxed as a Corp. NEVER EVER hold RE long term in a corp.
Steve, Thanks for the quick reply! I did review posts referencing the dealer vs. investor but wasn't able to find any specific/technical examples like the one above. Would you please link me if there is another one out there to review?
On reasonable compensation - Even if the S-Corp paid 100% of its $50k as salary, the Ind. Investor #1 would still have a large ST capital gain from the passive income in the investment, correct?
What do you mean by ownership issue? The S-Corp is the managing member with full control, the individual limited investors are just 'along for the ride' with no decision making authority or control of the day to day.
I haven't looked into an C-Corp since I know they would be subject to double taxation and a seem a little more cumbersome to administer. Are there any strong benefits to the C-Corp in this instance?
Actually a C-corp is easier to administer in my opinion. Most S-corp owners don't follow the rules a they should which can cause BIG issues later on.
Bottom line personal services is what we are talking about with Reasonable Compensation. What would someone else doing that work be making.
Now, the other issue, When you flip a property is is ORDINARY income. NOT Short Term Capital gains. This is especially true in your example. You will have formed a partnership for the house LLC in which you are providing personal services. You also have a corporation that is wholly owned by yourself causing another issue. You are making it unnecessarily complicated.
Simply, create your own corporation in which you flip properties. You receive a salary or commission based upon reasonable comp for someone Flipping properties. Take on the other individual as a lender with a profit split. Or a JV between you two, which must have its own accounting and partnership return filed. A K-1 then issued to you and one to him.
I personally recommend filing the 1065 for JVs. Why, because of less audit risk. Now that is a darn good reason.
IRS Joint Venture Audit Guide (how to be a legal JV vs a partnership)I'm a fan of using both when possible.