C Corporation: The Active Real Estate Investor’s Preferred Choice of Entity

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A common question among many real estate investors I meet is “should I form a C corporation or an S corporation for my short term investing (short term investing is commonly viewed as fix and flips, wholesaling, or just about any investing that does not have an investment intent.)?  My standard answer is almost always a C corporation.

I am sure many of you are thinking that an S corporation is preferable because, according to some myth, it will lower investors’ taxes.  The arguments in favor of an S corporation are persuasive.  Two of the most common are as follows:

  1. The S corporation does not get doubled taxed and are flow through entities. 

All income or losses of the S corporation flow through to the shareholders’ return each year based upon ownership percentages of the shareholders.   The recipient shareholder pays tax on his share of the flow through income.  A C corporation, in contrast, must pay taxes at its own rate on its net income.  Any after-tax profits distributed to shareholders will be taxed again as dividend income to the shareholder – hence the “double tax”.

  1. The S corporation will save on social security taxes. 

Each individual must pay 15.3% employment taxes on their first $106,800 in active earnings.  On amounts above $106,800, the tax drops down to 2.9% for the Medicare portion (technically, your employer pays one half of the tax, but when it is your business, it is still your money whether it comes from your business or from you individually).  The savings in an S corporation are achieved when you split your corporate earnings between salary, which is subject to employment taxes, and distributions, which are not subject to employment taxes.

Given the potential tax savings, why would anyone choose C corporation tax treatment?

   
Consider two arguments in favor of a C corporation:

  1. The IRS has been given the green light from congress to actively audit S corporations that do not pay salaries. 

It has been a longstanding thorn in the side of the service when taxpayers avoid paying employment taxes by utilizing an S corporation to split income between salary and distributions.  By some estimates, the vast majority of S corporations pay no salaries to owners and completely avoid all employment taxes.  As a result, a bill was introduced this year to repeal the availability of S status to business with less than 4 owners.

  1. C corporations keep your business affairs private and eliminate many hassles when purchasing real estate. 

As an active real estate investor, I abhor the day my CPA convinced me to convert my business to S corporation tax status.  The small amount of savings I receive by avoiding the 2.9% Medicare tax on my earnings above $106,800 in no way makes up for the hassles I experience as an investor.  Whenever I apply for a loan, I am forced to endure multiple document requests by inexperienced underwriters who believe that through the collection of additional information, their ignorance will culminate in understanding.  The document requests I am referring to were brought on by my S corporation and other entities I participate in that show up on my individual tax return as a K-1s.

Here is how it typically works for me when I apply for a loan:  Initially I am asked to turn over the last 2 years of individual tax returns.  After 3 to 4 weeks, I will receive a 2nd request from the underwriter to produce 2 years of tax returns for every business that shows up on my 1040 in which I own a greater than 20% interest.  After I provide the returns, I am usually contacted in another 2 weeks for a current profit and loss for each business.  In another 2 weeks, I typically receive a follow-up request to explain certain changes in my business from one year to the next.  The process continues until enough paperwork is generated that the underwriter is satisfied they have killed enough trees. 

I have given you the condensed version.  My point is that S corporations can create more problems for the real estate investor than they solve.  Borrowing money is an important aspect to investing and I have found that the more information you provide to an underwriter, the greater chance you will be denied or delayed.  Many of my real estate deals have been delayed because of hang-ups in underwriting.  I typically request 120 days for closing if I am dealing with a lender with whom I have not had dealings.  If the underwriter does not understand your business, then the safest course of action for them is to deny your loan.  You will not have this problem with a C corporation.

With a C corporation, you do not receive a K-1, so nothing shows up on your 1040.  As far as everyone is concerned, you are just a W-2 employee.  I do not want an inexperienced underwriter looking through my business and making a judgment call if my business will pose a risk to the loan.  Some of my business decisions in certain businesses are made to lower taxable income.  From the underwriter’s point of view, this is a negative.  For me, it is a positive.  What you want to avoid is making it an issue that necessitates further inquiry.

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25 Comments

  1. Clint –

    Thanks for the great article!

    You mention two reasons for considering using a C-Corp instead of an S-Corp. The second reason is for simplicity, especially when dealing with lenders — in my opinion, this is BY FAR the best reason to use a C-Corp. Because an S-Corp will flow through income, the tax returns at the end of the year will — at first glance — indicate a very small (if any) profit. Many inexperienced underwriters/lenders will assume this means that the business produced little profit, without bothering to noticed that the profit was paid out to you as salary or dividends.

    My question is about the first point. While it’s true that if you try to claim all S-Corp profit as dividends instead of salary, you’ll set yourself for an audit. But, even if you are completely conservative and pay yourself 100% of the profits as salary (I don’t think this is necessary, but let’s be really conservative), you’ll still pay less in taxes through the S-Corp than you would being taxed twice by the C-Corp, correct?

    So, it’s not clear how that first point indicates a benefit to have a C-Corp. Am I missing something?

    Btw, do you have any preferences of a C-Corp over a multi-member LLC taxed as a C-Corp? Seems that the less management overhead of an LLC is a great benefit without much downside.

    • J Scott,

      The taxes would be the same if you paid out all of the corporate profits as salary. The double taxation occurs when a “C” corporation does not expense out all of its income. The “C” corporation will pay taxes on its profits which then become retained earnings. When the retained earnings are later distributed they will be taxed to the recipient hence, double tax trap. Through good tax planning this can minimized so I do not see it as a real issue.

  2. Interesting article Clint.

    Just a couple of comments:

    The “green light” from congress to which you refer, is nothing new. There has been a “reasonable salary” rule for the owners of S Corporations for years. If your S Corporation does not pay you a salary it is definitely a red flag for an audit.

    If your business is incorporated you should be paying yourself a salary, period. This is true irrespective of the C or S tax status of the corporation. Why, then, should this be a an argument in favor of a C Corporation?

    Too, I see the double taxation problem as very real. Unless you are taking 100% of the profits of your business as salary any distributions from your C corporation will be taxed a second time when distributed. This is a substantial tax burden on small business owners and a compelling reason in and of itself to consider S Corporation election.

    I’m not saying that C Corporations do not have their place – they most certainly do. Just not as the BEST or first entity choice for real estate investors.

    • Bill,

      My main point is “S” corporations increase the amount of scrutiny a person will receive in underwriting. It is extremely frustrating when I must explain to an underwriter why certain business decisions were made to reduce taxable income. Example — investor defers 15% of his income into 2009 to avoid recognition in 2008 when he didn’t have the losses or expenses to offset the income. In 2010 investor has a slow year and generates 15% less revenue from operations. When investor applies for a loan in 2011 the underwriter comparing 2010 to 2009 will become fixated on a 30% drop in gross revenue (15% real drop and 15% change from pushing income from 2008 into 2009). In my opinion the 2.9% in savings by taking a distribution versus a salary or the full 15..9% on amounts under $106,800 may not benefit the investor in the long run if loans are denied based upon business decisions.

      I agree that “S” corporations can provide benefits in certain situations but in my investing it has shown to be more of a detriment.

    • Andy,

      A LLC works for short term investing if it is taxed as a corporation. However, in some states LLCs are subject to higher state taxes and should be avoided. California one such state that has a gross receipts tax that only applies to LLCs.

      • Thanks Clint. SO, now, this brings me to my next question. Why would my accountant tell me to form an LLC for wholesaling houses with my future going to future buy and holds and some Flip’s?

        • Andy,

          Not sure. Do you know how it is taxed? Where are you conducting your investing? Do you have a lot of start up expenses, e.g., education, equipment?

  3. I disagree with the points in this article. Solutions:

    1. Point 1 – Just take a reasonable salary and pay FICA taxes on the reasonable portion. Why let the IRS intimidate you into more taxes?

    2. Point 2 – Find a better lender. If you are dealing with a lender that doesn’t understand your business find a new one that does. Why pay increased taxes for your lender’s ignorance?

    To me it is not a good idea to pay 15.3% taxes AND corporate taxes to avoid hassle from the IRS and banks you shouldn’t be doing business with anyway. S-Corps are the way to go!

  4. for real estate investing, i’d prefer a LLC with S Corp election and take a reasonable salary, etc. you get the flexibility of a LLC under CO law, while at the same time the ability to take a reasonable salary and pay no tax on distributions above & beyond the salary, etc.

    if you have a LLC and someone sues the entity (and wins), you as the manager still retain complete management control of your LLC…this is a nice feature of having a LLC. Admittedly, the jury is still out on how Colorado case law will honor the LLC going forward. For now, it’s a good choice, in my view. if your c corp gets sued and the lender takes 51% or more of the entity’s stock as payment, they now have management control over the entity.

    i agree with previous comments regarding simply getting a better lender, etc. this is a straightforward solution to what seems to be your point issue.

    caveat: to advise someone who may read this article to form a C Corp may be a disaster waiting to happen, particularly if the investor doesn’t want to deal with all of the REQUIRED reporting for C Corps. To me, the required management reporting for C Corps is a much bigger (and ongoing) hassle than dealing with lender requirement that can be handled by choosing a different lender…just my humble opinion.

    if a real estate investor is savvy enough to start up & manage a C Corp, i’d strongly recommend that the person actually start a partnership with another investor or family member rather than a C Corp. There’s MUCH more flexibility in pulling earnings out of the partnership completely tax free, in a variety of situations. Serious investors who engage in real estate activities on a regular basis would likely agree with me that partnerships are far more desirable than C Corps. It’s just that you’ll likely need an accountant to manage the books and give you solid tax advice. Also, you can write into the partnership agreement anything that you want to protect your interests, etc.

    Generally, I’d only recommend C Corp if you’ve got several shareholders who want to invest in the company, AND you’ve got the management and accounting support, etc.

    Respectfully,
    Keelan

    • You said, “There’s MUCH more flexibility in pulling earnings out of the partnership completely tax free, in a variety of situations. Serious investors who engage in real estate activities on a regular basis would likely agree with me that partnerships are far more desirable than C Corps. It’s just that you’ll likely need an accountant to manage the books and give you solid tax advice.”

      There is most certainly more flexibility with a partnership, but absolutely no legal protection. The whole point of the entity should be legal protection. Tax benefits are secondary.

      The only partnership a “serious investor” would consider is a limited partnership. A limited partnership requires a general partner who does not get legal protection (same as above). “Serious investors” form an entity (LLC or C Corp) to be the general partner. Now, you have multiple entities to keep track of. Make sure your business requires this type of complexity. One C Corp (or S Corp) would take care of it.

      Speaking as an accountant, C corporations are easier to account for than partnerships. Partnerships are the most complex entities to keep records for an accountant. (Did you think all that flexibility made it easier?)

      C corporations pay tax at 15% on first $50,000 of net income. The rules change, but a C corp can carryback losses to the preceding two years and claim a refund for overpaid taxes. You can’t do that on your 1040 with partnerships and S corps. Did you know your C corp can have any year end? This allows some powerful deferral strategies not available with any other entity.

      Talk to a real estate attorney with a firm grasp of real estate taxation for the best setup for your personal situation. Make sure YOU understand it before you do it!

  5. Pingback: C Corporation: The Active Real Estate Investor’s Preferred Choice of Entity « Clint Coons Blog

  6. I have 4 duplexes and my own single family home in which I live. If I pay off one of the duplexes and then put it in a C corporation, will it stop counting against me as far as the Freddie Mac 4 property limit. (I know Fannie Mae has a 10 property limit, but a local bank that does only Freddie Mac is offering an unbelievable rate. I stand to save $5000 per year in financing if I can get under the 4 property rule, and I don’t really want to sell.)

  7. Joseph McElyea on

    I like the c corp for another reason and that is benefits. If you own more than 2% of an s corp you are taxed on benefits. In a c corp all of those perks are non taxable like healthcare for employees, car expense, paid trips to conventions, furthering education paid to make a better employee, etc. a c corp also has a lower corporate taxation rate on the first 50k if I remember right. But yeah you have to pay tax twice on dividends so just minimize those. Make your corporation work for you.

    • Valid points Joseph. And, as the old adage goes “time and taxes change all things.” Many investors are beginning to look more favorably at C-corps since the Tax Payer Relief Act of 2013. The amounts passed through disregarded entities are now taxed at higher rates than before. For some of my clients the tax bite is now less if the income is taxed at corporate rates instead of individual rates.

  8. I’m a real estate investor and my company is a C-corp.

    I’m in the middle of precisely the underwriting nightmare you outline in your article. The worst part is that these underwriters are asking me for K-1 info on my C-corp. I was stunned, flabbergasted, astonished! Do underwriters not understand the difference between S and C?!

    Absolute double facepalm… when one facepalm just isn’t enough.

  9. Lauren Sands on

    I work as a ‘Loan Coordinator’ for a high volume lender. The documentation requirements that a self-employed person endures, whether self-employed through dividend and interest income, or their own business, is challenging.

    In the weeks leading towards close, I typically must gather anywhere from 250-500 pages of documentation. I would guess that the self-employed person ends up producing anywhere from 500-700 pages of documentation on average when including pre-approval.

    I see the frustration borrower’s deal with on a daily basis and can see how you’re drawing the conclusion you are. Especially when you’re in a business that relies on lending.

  10. Does anyone have advice for finding reasonable insurance when purchasing an investment home in a c-corp? I find that for homes held in the c-corp the home insurance premium is about 4x if I were to buy it personally and not in the c-corp. This is for average priced single family homes. I have tried all sorts of brokers, etc.

  11. Steph – Why would you EVER own an investment property in a corporation? C-corps are great for active/earned income transactions such as flips, rehabs and assignments – but NOT for a property purchased for investment purposes.

  12. I consider some of the comments in the above article offensive. I am a mortgage loan underwriter. I am not a CPA, however, we are required to review a borrowers income and make a judgement call on if the borrowers income is supported. The article makes comments that inexperienced underwriters review their financials which is completely untrue. I have 25 years reviewing mortgage loan requests and I am a college graduate. I am FAR from inexperienced. The reason we have to request additional documents is because we rarely get complete tax returns. I have to squeeze complicated self employed borrowers into programs designed for W2 borrowers and first time homebuyers. If you don’t want your financials reviewed then take the easy route and go with in-house financing from your bank. Their decision is based on your relationship with the bank. You will not be eligible for the long term financing with extremely low rates with the in-house program. Conforming loans have to “CONFORM” to rules and regulations set up by government entities and Fannie Mae. If I make a poor decision and your loan goes into default, I could loose my job and even more, my reputation. The only thing you are loosing is a little time. Not exactly fair wouldn’t you say? You are a little short sighted….

  13. Typically the loan application is taken by a loan officer who is not paid to understand financials. They are paid to get loan applications. The loan is then passed to a loan processor who prepares the required paperwork, orders an appraisal, ect. The loan is never seen by a mortgage loan underwriter until the loan is complete and ready for review as a total package. It may take 2-3 weeks for this process to be completed. Once the loan goes into underwriting, the underwriter will review the borrowers taxes and if anything is missing request additional information. I have reviewed borrowers who have 1, 2, 3 all the way up to 33 businesses. The paperwork is astronomical. We have to consolidate all of this information into a yes or no decision. It is extremely time consuming and complicated. Each business must be reviewed individually. If you are getting multiple requests for additional documentation, these requests are probably coming from the loan officer and/or loan processor who is trying to anticipate what is needed. Underwriters are not allowed to go back and request additional information multiple times. We request conditions one time, unless what is submitted is not satisfactory. Many times, loan officers will downplay what is being requested as to not ‘bother’ the customer and make them upset. When what is provided doesn’t satisfy the original request, they will have to buckle and ask the customer for the originally requested documents per the underwriter. I see it every day. No one wants to make a customer upset. With complicated customers, if all the required documents are not received, it will take additional requests. Fannie Mae requires 2 years tax returns on all customers + 2 years on each business that the borrower owns more than 25% (not 20%). If the tax returns are have not been filed…..which MANY customers do not file by April 15th, then the year ending P&L Statements are required. If the first quarter of the next year has passed, current year P&L statements are also required. This is something which Fannie Mae requires. It is not set up to upset customers. We are only fulfilling what is required. There are also overlying conditions required by each investor that acts as intermediate investors which pool the loans to sell to Fannie Mae. These overlays can be different from investor to investor. If all these conditions are not met, the loan will not be sellable to them and could result in a substantial loss to the individual bank. It is difficult for the average lay person to understand these complicated processes. All it takes is a little understanding and tolerance from people. As an underwriter who has reviewed financials for 25 years, there is rarely a loan that I make a mistake on, but I am human.

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