Most builders and investors today understand the importance of protecting personal assets from creditors, especially in this uncertain economic climate. One very effective method for protecting personal assets is to incorporate or form an LLC. Both the corporation and the LLC structures offer asset protection features; for a moment, however, we’ll focus on the LLC. Here’s a basic primer.
Asset Protection 101
The LLC is considered to be a “Separate Legal Entity.” In fact, a properly formed and maintained LLC will have both a state-certified filing date and an IRS-archived Tax ID Number. This is comparable to an individual’s birth date and social security number.
Experienced builders and developers who work with investors most often form one LLC for each property being developed. In fact, it’s commonplace to name each LLC after the address of the property: e.g. “123 Main Street Project, LLC.”
By following this practice, the liability exposure for the individuals that own the project is limited to the amount invested in that specific project or LLC. Thus, creditors of a specific project (or LLC in this example) are limited in their recovery to the assets of that one project; the personal assets of the builders, developers, and investors remain protected.*
The S Corporation: An Introduction
A plain-vanilla, run-of-the-mill corporation is also referred to as a C Corporation. To create a C Corporation, one must file a document usually referred to as “Articles of Incorporation” with the state office (usually the Secretary of State for a given jurisdiction.)
In the eyes of the IRS, this C Corporation is a separate entity and is taxed as such. Any money paid out to owners in the form of a dividend is taxed again. This is commonly referred to as “Double Taxation”
The IRS recognized that this “double taxation” made owning a corporation very expensive to the small business owner. Thus, the S Corporation was born. Briefly stated: after a corporation is formed, the IRS will allow all qualified shareholders to elect “S Corporation” status. If granted, the IRS will allow “pass-through” taxation. i.e. each individual shareholder is taxed for the taxable income of the corporation in proportion to his/her ownership.
Today, the LLC and the S Corporation are very popular business structures. Which business structure, however, is most beneficial to builders and real estate investors — the S Corporation or the LLC?
LLC vs. the S Corporation
In general, both the LLC and the S Corporation offer their owners / members asset protection and pass-through tax treatment for purposes of Federal Income Tax. The key differences in these business structures, however, are as follows:
- The S Corporation restricts WHO can be a shareholder.
- The S Corporation is restricted in its allocation of income to shareholders.
- The S Corporation has a lack of ability to increase pass-through losses.
Restrictions on Ownership of the S Corporation
The S Corporation is limited in the type of person or entity that may share in ownership. While a few exceptions exist, in general, another C Corporation and certain trusts cannot be a shareholder in an S Corporation. In addition, individual shareholders must be either U.S. Citizens or permanent resident aliens. Furthermore, the S Corporation is limited to only 100 shareholders.
Allocation of Income – LLC is more flexible
The S Corporation is very strict in terms of allocating income amongst shareholders. Each shareholder shares in the corporation’s income in the same proportion as his/her ownership. An LLC, on the other hand, is very FLEXIBLE in how it owners / members may allocate income amongst each other. In an LLC, the operating agreement usually states what share of profits each owner is to receive.
Increasing Pass-through Losses – LLC is More Flexible
In certain circumstances, the IRS allows the loss in a corporation or LLC to “Pass-through” to the individual shareholders / members. This loss can then offset other sources of income in effect reducing an individual’s overall tax liability. For Real Estate owners and investors, these “pass-through” losses can provide an enormous reduction in tax liability.
In an S Corporation, there is a lack of ability to increase pass-through losses in real estate when compared to an LLC.
Real Estate Investments in an LLC
In general, the tax basis for a share in a corporation or LLC is equal to the investment in the corporation or LLC. In an LLC used for real estate investments, however, the members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss.
An Example of Ronald Gump
Ronald Gump invests $10 in Gump Towers. The tax basis is $10. Gump Towers mortgages the real estate and borrows $20. Rental income and values decline leaving Gump Towers with a $20 loss at the end of year one.
Simply stated, Gump has lost $20 through investment activities in real estate.
- S Corporation: Because the tax basis for Gump Towers is $10, the IRS will only allow Gump a $10 loss on his personal income taxes. The remaining $10 loss will be deferred.
- LLC: LLC members are allowed to add the amount of the mortgage to their basis for purposes of calculating loss. In an LLC, Gump may deduct the entire $20 loss in year one.
Thus, generally speaking, most builders and real estate investors choose the LLC as their preferred business structure / holding entity. This may or may not apply to you!