As a real estate investor, you may be thinking about forming a business to purchase your properties. After all, buying real estate as a business gives you greater tax benefits and legal protections.
But maybe you’re not sure which kind of business entity to form. Should you create an LLC taxed as a partnership or an LLC taxed as an S-Corporation?
Let’s look at the differences between the two and how they shape your real estate business.
A limited liability company (LLC) is a legal entity that investors often use to buy real estate. Forming an LLC gives you more legal protection, privacy, and tax benefits.
Your business can either be a single-member LLC (just one owner) or a multi-member LLC, such as a partnership.
Filing taxes is relatively straightforward for a single-member LLC. You simply record your business’ net profits in your personal tax return with a Schedule C. If you have partners, you can decide beforehand how much of the profits each person will receive—and it doesn’t have to match the ownership percentage. For multi-member LLCs, your taxes are reported on Form 1065.
Income taxes for LLCs are due April 15. But multi-member LLCs must file their 1065 partnership tax return no later than March 15.
As the LLC owner, you pay a 15.3% self-employment tax and a regular income tax on all your profits, whether you distribute money to yourself and your partners or not. In other words, you don’t get a tax deduction for distributions. You can pay these taxes quarterly or at the end of the tax year. To ensure owner distributions are calculated correctly, you must make sure you keep your financials accurate with proper real estate bookkeeping completed each month.
An S-Corporation (or S-Corp) is a tax entity/designation. But in order to set up that tax structure, your business must already have a legal entity in place, such as an LLC. Once your business is incorporated, you can elect S-Corp status with Form 2553.
So how does an S-Corp work? And how is it different from a regular LLC?
First of all, an S-Corp has to file a separate tax return on Form 1120S, which is due March 15.
The business’ net profit passes through to the owners with a K-1, which the owners then report on their individual tax returns. Unlike an LLC taxed as a partnership (the default), an S-Corp requires you to allocate the profit according to each person’s exact percentage of ownership.
If you choose S-Corp status, you also have to pay yourself a reasonable salary (and the accompanying payroll taxes), according to the IRS. You still pay income taxes on your business’ profit (which is net of your salary), but you only pay employment taxes—also called payroll taxes—on your salary. In other words, unlike a partnership, an S-Corp DOES get to deduct payroll paid to owners. These are due each month instead of simply at the end of the tax year.
These unique rules on employment taxes could save you money as an S-Corp. For example, let’s say your business made $100,000 in profit and you paid yourself a salary of $50,000. You only have to pay employment taxes on that $50,000, which comes to $7,650.
If your business were simply an LLC, you would have to pay employment taxes on your entire net profit, which would come to $15,300.
Keep in mind, though, that an S-Corp isn’t necessarily the best option for every real estate investor, as there are added administrative costs (such as managing payroll in general, form 1120S, etc), and taxation rules differ based on the character of the income (e.g., active vs. passive). In our next article, we’ll explain when it makes the most sense to file as an S-Corp and when it’s better to stay an LLC.