How Pass-Through Entities Help Real Estate Investors (& Which is Right for You)

by | BiggerPockets.com

A pass-through entity is a business structure, such as an LLC, series LLC, or S corporation. We use the term “pass through” because you can claim the income of these types of businesses on your personal income tax returns. Ordinarily, you would have to file a separate return for your business (or businesses).

The chief benefit of using a pass-through entity is that you won’t be taxed twice. Nor will you end up paying a CPA thousands of dollars to file a business tax return. Typically, other types of business structures will be obligated to file such a business return. We’ll talk more about the best entity for real estate investors below.

Some of you may be starting to think this doesn’t apply to you because you file a return jointly with your spouse. Well, you can relax. This poses no problems, and all the benefits described above would still apply. But there are some instances where you will have to file a separate return, despite using a pass through entity. The main case for this is if you’re using a partnership return.

The Partnership Return and Taxes

Some states require at least two members to form an LLC. So let’s say you file your LLC in one of these states and have another partner in it besides yourself.

In this scenario, you’re going to have to file a document called a partnership return. A partnership return is a separate return for your business itself. By separate, we mean separate from your personal taxes. Due to the complexity of a partnership return and its filing process, you would be wise to recruit somebody to help you prepare it. I suggest you hire a CPA, ideally one who is also a real estate investor, to assist you in preparing your return.

And now, onto the bigger concern for real estate investors.

Which Pass-Through Entity is Best for a Real Estate Investor?

I so love when the answers to complex questions like these are simple. This one can be answered in three words: the series LLC. Hands down. I’ve given some of the basics below, but if you want to learn more, check out my recent BiggerPockets article that compares the series LLC to the traditional LLC.

Related: Maybe You Shouldn’t Start an Entity. Consider 4 Alternative Asset Protection Strategies Instead.

The series LLC offers unbeatable asset protection, easy tax filing, and is the foundation of a solid asset protection plan. To illustrate how this works, play along with the following example.

Say you own six properties. Instead of holding all six properties in one LLC, with a series LLC you can create a “series” within your LLC. Each series will hold a single property. So you’ll have seven companies total: the parent company, and then six individual series for your assets. But you don’t have to separately account for all seven come tax time, thanks to the fact that you’re using a pass-through entity. Of course, this is only true if your series LLC was formed properly. You also will have to do your part to ensure your entity is compliant. You can look forward to a future article on what “doing your part” entails, but the basics are:

  1. Follow the advice of your professionals. This applies to attorneys and CPAs who help with your entity.
  2. Keep assets separate from operations. Let the series entities hold your assets, and run all of your business with the public through a separate company or person.

How The Series LLC Prevents Lawsuits & Saves Money

The benefit of the series LLC structure from a lawsuit prevention standpoint is clear. If someone sues one of your series and wins, only that one property in that individual series will be vulnerable to costly judgments. That means the remainder—and likely the vast majority—of your wealth and assets would be protected. The series LLC’s structure protects those other assets and isolates them from the one in the line of legal fire.

Related: 6 Mistakes to Avoid When Setting Up Your Real Estate Entity

Another great benefit is that no matter how many “series” you have within your LLC, they can all be filed on the same income tax return. This is a huge money-saver that you won’t receive with a traditional LLC, let alone multiple traditional LLCs. When you couple these savings with the lawsuit protection capabilities of the series LLC, it’s easy to see that using entities like that saves you time and money in multiple ways. If you want to learn more, read my previous post about the role of LLCs in protecting real estate investments.

Congratulations! You’re now better informed on pass-through entities and the benefits of the series LLC for real estate investors.

Feel free to keep the conversation going by adding any questions or comments below. If you have experience with pass-through entities, feel free to share that as well.

Thanks for reading, and good luck out there in the real estate industry.

About Author

Scott Smith

Scott Smith helps clients nationally and internationally from his office in Austin, Texas. With over 5 years experience in the litigation, Scott works on proactively building defense in anticipation of future lawsuits for real estate investors. Scott is one of the few attorneys in the nation that structures companies for maximum protection with minimum taxes.

What You Want the Text to Say

12 Comments

    • Scott Smith

      It sure is! Anyone in the country can take advantage of the Series LLC. You do not have to get one in the state that you reside in. I set up Texas and Delaware SLLCs for clients in many states regularly. It’s a tool available to everyone. (Note for those reading: yes, it’s available for everyone, but California is “special” in this regard. California investors are generally better served by the Delaware Statutory Trust).

      In your case–go for it. Talk to your CPA. Even better, talk to your CPA and an attorney.

    • Scott Smith

      Hey Jacob,

      Yes the price is far lower. Roll with me for a moment. A Texas series LLC has a one-time filing fee of $300, and then you can create as many as you like. No matter where you live, each time you create a new LLC, you will be expected to pay taxes on that entity (or in the case of states like mine, file “no taxes due” for each and LLC. So now we’re talking filing fees + annual taxes (possibly) for each LLC. Not to mention the legal fees you’d be paying to establish many LLCs. Managing multiple LLCs can also become a banking nightmare. There are ways to manage a Series LLC with a single business account.

      On balance, it’s going to be far cheaper to use a Series LLC. It’s also less demanding on your time. If you acquire a new asset, you can incorporate it into your structure by creating a child series in minutes on the computer. Sign, get a copy to your attorney, and bam–you have a new LLC. No need to repeat the entire process with new operating agreements, EINs, unnecessary time with lawyers, etc. Most of the investors I work with (myself included) find this to be the most cost-effective solution, particularly compared with multiple LLCs. It may not be difficult to juggle 3 LLCs, but if you scale up your property to 20 assets and follow the “one asset per LLC” guideline? Well, that’s going to create a headache for you and your chosen real estate professionals.

      • Scott Smith

        I’ll also add that the SLLC better protects your assets because it compartmentalizes them into series. If someone sues your Traditional LLC and it has multiple assets, they are all on the line in an lawsuit. This is not the case with the Series LLC, particularly if you use it in conjunction with a shell company. Someone could in theory sue a Series, but they would only be able to seize the property within that series if a judgment is issued against you. Your other assets would be secured in their own series.

    • Scott Smith

      Insurance can work a number of ways. An LLC can be added as an additional insured to an existing policy. For newer entities, you may have to take out a new policy in the name of the SLLC. An LLC is not a substitute for appropriate insurance, and all rental properties should be appropriately insured.

      I’d suggest speaking with your attorney and coming up with a list of questions to ask your insurance adjuster on this subject. Often the mere mention of an LLC will lead to immediate pressure for commercial insurance. Don’t be afraid to get multiple opinions on that matter.

      As for property management or any other types of businesses that actually interface with the public, using a shell company is ideal. A shell company is typically a traditional LLC that acts as your face to the world. It should not own anything–that’s the Series LLC/asset-holding company’s job. By the same token, you don’t want any of your Series entities doing business with the public such as collecting rent, etc. Their job is to simply hold the assets. The shell company owns nothing–in fact, it’s the company we would *want* a potential plaintiff to sue, as there is nothing to recover in judgment. Does that make sense to you? The short version is you want a Series LLC structure that holds assets and does no business, and a Traditional LLC that conducts business but owns nothing. I hope that helps answer your questions.

    • Scott Smith

      Hi Steve,

      This is a common question. Just because there is no case law does not mean that the Series LLC hasn’t been tested in the court/lawsuit context. The Series LLC has been involved in thousands of lawsuits yet nobody has challenged the validity of the structure. There is no case law because case law can only exist when there is ambiguity in the law itself. Case law only interprets the law; the law itself is what is passed by the legislature. When it comes to the Series LLC, the laws creating it are very clear and there is nothing left to interpret.
      If a litigator were to challenge the Series LLC and win, it would mean a big pay day. So, the people who have the greatest incentive to challenge it, including those who have had the opportunity thousands of times to challenge it, have decided that challenging is not legally defensible. A lack of case law, in the case of the Series LLC, is actually a reflection of its powerful deterrent effect.

    • Scott Smith

      Hi Vlad,

      Are you referring to a Canadian Investor with assets inside of the U.S.? In such cases we generally form limited partnerships, but the LLC can serve as a general partner. When I personally serve Canadian investors, I work with cross-border CPAs to carefully evaluate that investor’s situation and tax obligations. Each situation is unique, and I don’t want to give you information that will confuse you about your own situation. If you’re looking to set up asset protection, I highly recommend creating a formal relationship with an asset protection attorney. Your attorney need not be Canadian, but it’s good if they have served investors like you before.

      Thanks and I hope that helps you out a bit.
      -Scott

  1. Jesse Daconta

    Hey Scott,

    This seems like a really neat system. If each of the series LLCs is just holding the asset (I’m assuming just the property) and the traditional LLC is not holding any cash (just all of the series LLCs) does that mean that the individual is holding all cash flow? Or… do each of the series LLCs hold cashflow from rent? If that’s the case, would you buy more properties from series LLCs (I’m certain this thought is wrong but I’m new :P)?

    Thanks again,
    Jesse

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here