New investors can easily get confused when they wade through the alphabet soup of entity and tax information relevant to real estate for the first time. But entities are essential to running your business and protecting your investments. Some of the most common questions we get are about the types of entities real estate investors can use, their uses and features, and their differences. Today, let’s take a closer look at the basics: LLCs, series LLCs, C corporations, and the tax status often mistaken for an entity—the S corporation.
Limited Liability Companies
There are two main types of limited liability companies (LLCs) that you are likely to use for your real estate business, although they will likely serve different purposes. These are the traditional LLC and the series LLC.
Both entities are formed the same way, by paying a filing fee and recording membership with the state of formation. Each state will have different regulations governing LLC formation, taxation, and structure—including whether the state offers a series LLC option within its borders. Both types of company offer liability protection for the LLC’s members and of the assets held within the company.
Related: The Pros & Cons of Using a New LLC for Every Property Purchase
Traditional LLCs and Series LLCs: Their Roles and Differences
Traditional LLCs are a popular choice for investors because they are universally available in every state. In our practice, we frequently recommend that investors use a traditional LLC as a shell company. A shell company can be any company that does business with the public but does not actually own anything. Having a shell company is a smart move from an asset protection standpoint because it allows you to easily separate your assets from your operations. If you use a traditional LLC as your shell company, you may choose to pair it with a series LLC for an effective two-company asset protection structure that is simple to run and effective at preventing lawsuits.
Series LLCs are also incredibly useful entities because they make extremely effective asset-holding companies. They are a type of LLC that uses a parent-child structure to allow you to easily incorporate as many assets you like into the structure’s protection. If a traditional LLC holds assets, it is holding them all in the same company “pool.” This is not the case with the series LLC, which allows you to divide each asset into its own series, where it has its own liability protections. As a bonus, the series LLC need not be more expensive than its traditional counterpart—and, in fact, is often cheaper.
To learn even more details about how traditional LLCs and series LLCs compare, check out my previous BiggerPockets article entitled Series LLC vs. Traditional LLC: Which is Better for the Real Estate Investor?
Corporations offer an alternative to the limited liability company. They differ significantly from LLCs, beginning with how they are formed. Corporations must:
- File incorporation documents with the relevant state they are based in.
- Determine shareholders and distribute the appropriate number of shares to each.
- Select a board of directors to oversee the business.
The introduction of shareholders means that ownership is technically divided among shareholders and can therefore fluctuate. In comparison, LLC membership tends to remain stable and straightforward. Finally, a corporation’s profits and losses remain within the business, while LLCs have more options (discussed in detail below). These features of corporations may be overly complex for an investor managing a couple of rental properties themselves or with local help. But they make sense for business models with executive management or where the shareholder model or tax treatment are more beneficial to your business structure and scale. High-earning investors or those with consistently high-performing profitable properties may find using a C corporation allows them to pay only 15% taxes on these profits. A previous BiggerPockets poster has elaborated on the tax benefits of C corporations for such individuals.
Related: Owning Rentals in an S Corporation Might Be a Costly Mistake: Here’s Why
S Corporation Tax Status & Its Applications
The S corporation is frequently mistaken for a different type of corporation entity, but in fact it is a tax status that may be applied to another entity, generally an LLC. When you form an LLC, you have the option to tax it as a disregarded entity or pass-through entity as a partnership or as an S corporation. The same is true of the series within a series LLC; you elect the tax status that makes the most sense for a given series. You can learn more about pass-through entities and their tax benefits from another of my previous BiggerPockets articles, but for now we want to focus on S corporation status.
The S corporation tax status may save some investors on their annual business tax bill. The reasons why these are fairly straightforward. An LLC that passes through its taxes will report all profits and losses as personal income. However, if you use an LLC, or series of an LLC that has elected S corporation tax treatment, you have the ability to deduct business expenses from your taxable income.
S corporations must also pay their employees salaries, including employee-owners. However, if your business is already paying salaries, a properly-structured business can combine with the S corporation tax designation to save you thousands of dollars annually in payroll taxes. Wondering whether the S corporation designation is best for your entire business, one or more series of your series LLC, or best to avoid altogether? That is a conversation to have with your attorney before the next tax year. This is particularly true if you are already using an LLC of some sort, as you have flexibility with changing your tax designations and selecting those that will provide you with the greatest personal benefit.
How Do I Know Which Structure is Best For Me?
The best structure for you will depend on a variety of factors, including where you live, how many properties you have, your ambitions for growth, and your operational plans and capabilities. Most investors find LLCs to be the easiest entities to use, and variations of the LLC are therefore the most common choice. But the only people who can tell you which entity will work best for your specific situation are trained professionals with experience in handling tax and legal matters for real estate investors. For these reasons, we strongly recommend having both a highly competent real estate attorney with experience forming entities and a whip-smart, seasoned CPA sensitive to investors’ tax issues on your team.
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