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:
- 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”.
- 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:
- 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.
- 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.