One of the most important decisions any small business owner must make is how to structure their business for optimal asset protection. If you’re like most property owners, you’ve probably heard a lot of buzz about LLCs, C corps, S corps, and sole proprietorships.
Different types of entities offer their own benefits and drawbacks, which is why it’s important to understand each option available to you:
What is a Limited Liability Company (LLC)?
An LLC is a hybrid between a sole proprietorship or partnership and a corporation. Members enjoy corporate liability protection but with a partnership’s tax benefits – specifically pass-through taxation.
LLCs are common with real estate investors as they allow the members to buy and hold assets for long-term rental income and capital gains.
Forming an LLC
Each state has its unique process for creating an LLC, but the process typically requires you to:
- Choose a name for your LLC.
- Choose if your LLC will be a single-manager LLC or a multi-member LLC. A multi-member LLC will have a managing member elected to run the business’s day-to-day operations, sign documents, etc.
- Prepare your LLC’s Operating Agreement, which governs the business’s internal operations.
- Compile and file the Articles of Organization (a document that contains the company’s name and address along with the manager and registered agent of the LLC).
- File Form SS-4 to acquire an employer identification number (EIN).
- Open a business-only bank account. The bank will need a copy of your Articles of Incorporation, Operating Agreement, and EIN.
- Apply for the required legal permits and licenses.
- File a yearly Periodic Report with the Secretary of State’s Office.
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Pros of Forming an LLC
When deciding whether or not to create an LLC, it’s important to weigh out the unique benefits and drawbacks of this business entity. That said, an LLC:
- Offers liability protection against accrued debts
- Enables the owner to leverage pass-through tax benefits without risking double taxation
- Requires less paperwork since the operating agreements are enough to define the members’ relationships and interests
- Allows its members to share profits and losses however they wish, even though each must declare their profits and loss on their individual income tax filings
- Doesn’t restrict the number of members
- Doesn’t require the owner to file a separate tax return for the LLC
Limitations of Forming an LLC
- Members must pay self-employment and personal income taxes.
- Transferring ownership requires approval from the other members.
- The LLC might crumble if a member dies or declares bankruptcy. Adding a clause to the Operating Agreement that outlines what will happen in these scenarios will minimize this risk.
Just as the LLC formation process is different in each state, the filing charges also vary – but you can expect to pay $40 – $500 if you file alone and $1,000 – $1,500 if you use a lawyer or third-party service.
While you can form an LLC alone, it’s best to have a lawyer present just in case, especially for multi-member LLCs.
What is a C Corp?
A C corp is a corporation taxed under Subchapter C of the IRS code. A C corp exists separately from its owners. As such, the entity is subject to double taxation, where the C corp is taxed at the corporate level (Federal tax Form 1120) and the shareholders level (income tax on profits from dividends or stock sales). C corporations must hold annual meetings and have a board of directors as voted in by shareholders, which sets it apart from the other business entities on our list.
According to Investopedia, a C corp legally separates owners’ or shareholders’ assets and income from that of the corporation, and this type of business entity limits the liability of investors/firm owners since the most they can lose is the amount they’ve invested in the business.
That said, structuring your rental property as a C corp means you’ll incur more taxes on your returns. Additionally, you’ll incur taxes when transferring your property in and out of the C corp.
Forming a C Corp
To create a C corp, you’ll need to:
- Choose and register your business name with the Secretary of State’s Office
- Appoint a board of governors
- Create and file Articles of Incorporation with your Secretary of State
- Prepare your corporation’s by-laws
- Issue stock
- Apply for all permits and licenses
- File Form SS-4 to get an EIN
The filing charges will vary by jurisdiction but expect to pay $50 – $500 when you file yourself and $500 – $5,000 when filing with a lawyer or third-party service.
Pros of Forming a C Corp
- Enjoy liability protection since your corporation exists separately from you as an owner
- Avoid restrictions on the number of shareholders, their countries of origin, or their corporate status
- Remove stock class limitations
- Provide better gains and incentives from dividends and stocks, especially for capital investors
Cons of Forming a C Corp
Of course, it’s crucial to understand the potential drawbacks of utilizing a C corp, such as:
- Double taxation lowers your overall profits
- C corps don’t support personal sign-offs, meaning you can’t sign off a business loss on your income documents
- C corps are rigid, expensive, and time-consuming to create and maintain
Due to these complications, most DIY landlords elect to form LLCs or sole proprietorships. However, knowledge is power, so let’s explore what an S corp has to offer.
What is an S Corp?
An S corp is a business entity that has chosen to become a ‘pass-through’ entity taxed under Subchapter S of the IRS code. The business’s income passes through to the shareholders (or owners), avoiding double taxation.
These entities are managed by directors and officers who receive a reasonable salary that is subjected to income tax. As Investopedia notes, “S corporation shareholders must be individuals, specific trusts and estates, or certain tax-exempt organizations. LLCs aren’t subject to the same Internal Revenue Service (IRS) rules governing the number and type of members, who are typically sole proprietors or small groups of professionals.”
As such, S corps are favored by real estate investors who hope to benefit from buying and selling real estate, particularly those looking to flip property.
Forming an S Corp
While the process varies across different states, there are four general steps to follow when creating an S corp:
- Set up an LLC or Corporation through the Secretary of State’s Office
- Compile and submit the Article of Incorporation, any other documentation, and the required fees to your Secretary of State
- File IRS Form 2553, Election by a Small Business Corporation to acquire the S taxation designation
- File all other required permits and licenses
Before filing IRS Form 2553, let’s examine the pros and cons of creating an S corp.
Pros of Forming an S Corp
- After deducting the directors’ and officers’ salaries, the remaining S corp’s profits aren’t subject to federal taxes
- As an owner, you can receive a salary and dividend, resulting in lower overall taxes
- An S corp is a pass-through entity, allowing owners to avoid double taxation
- This business structure provides shareholders with limited liability protection
- S corps allow for flexible management and easy transfer of shares
- They exist perpetually and won’t dissolve after a shareholder’s death or bankruptcy
Cons of Forming an S Corp
- S corps are restricted to 100 shareholders or less
- Forming an S corp is more complicated due to its strict corporate protocols
- Profits and losses are divided based on the percentage of ownership or number of shares
- S corps can only issue one type of stock
The charges for filing an S corp vary by state. However, expect to incur $800 – $3,000 if you file alone and more if you use a lawyer or third-party service. Once you file Form 2553, the IRS might revert within 60 days with a determination.
What if the landlord only wants to be a sole proprietor?
You can also structure your rentals under sole proprietorship, meaning you’ll be the sole owner and manager. Unlike the other legal structures, being a sole proprietor means you aren’t separate from your rental property, so you won’t enjoy protection from debts and liabilities.
While you won’t get a salary as you would with an S corp or C corp, you’ll owe Federal Insurance Contributions Act (FICA) and income taxes on your earnings.
Forming a Sole Proprietorship
In order to create a sole proprietorship, you must:
- Pick and register your business name with the Secretary of State’s Office
- Obtain legal permits and licenses
- Obtain an EIN
- Get reliable insurance, as you aren’t protected from liability
- Open a business bank account and pay your taxes accordingly
Pros of Forming a Sole Proprietorship
The perks of creating a sole proprietorship include the following:
- Sole proprietorships are easy to create, manage, and prepare taxes for, which could explain why there are over 23 million sole proprietorships across the U.S.
- It doesn’t require payroll preparation or registering with the Secretary of State
- You are solely in charge of making all decisions
- You can easily diversify your rental property portfolio without requiring outside approval
Cons of Forming a Sole Proprietorship
Before you form your sole proprietorship, consider that:
- Your earnings are subject to FICA and income taxes as a sole proprietor
- This type of business entity doesn’t offer liability protection
- It can be challenging to raise capital or win investors
What business entity is best?
The answer depends on you and your business goals! However, the majority of DIY landlords find that LLCs and sole proprietorships adequately protect their assets, generate pass-through tax benefits, and organize their business without the additional stress brought on by S and C corps. In fact, 46.7% and 36.0% of landlords surveyed chose sole proprietorships and LLCs for their businesses, respectively.