When you’re starting a rental property business, one of the key decisions you’ll make is how to structure your business. The legal structure you choose matters because it will affect your tax liability and management responsibilities—not to mention your asset protection. Today, we’ll discuss the pros and cons of LLCs, S corps, and C corps and how they may affect your rental property business.
Why Have a Formal Business Structure?
Although skipping the organizational setup may be tempting, without a formally structured business, you could be personally liable for legal costs and damages related to your company.
You may have liability insurance for your rental properties, but your policy probably has limits. Depending on those limits, you may be responsible for covering costs that exceed your caps. An umbrella policy can help defer those additional costs. Even that may not be enough to protect your personal assets, though.
Your formal business structure, such as an LLC, S corp, or C corp, is what ensures a separation between your personal and business assets. That’s a key driver behind forming an LLC or corporation: you want to optimize protection for your assets.
Limited Liability Companies
- A limited liability company, or LLC, separates the owner’s and business’s assets and debts. An LLC also combines the management flexibility of a sole proprietorship or partnership with the tax benefits of a corporation. Owners of an LLC are called members, and an LLC may have a single member or multiple members.
- A TurboTenant survey found that 36 percent of DIY rental property owners use LLCs for their businesses. Consider these pros and cons of limited liability companies to see if this entity type is a good fit for your investment properties.
Advantages of LLCs
Liability Protection
Members receive liability protection similar to corporations.
Pass-Through Taxation
Members receive tax benefits and avoid double taxation, which is when you pay tax at the entity and personal levels.
Limited Paperwork
Members are responsible for an operating agreement, articles of organization, permits, licenses, and yearly state-required reporting.
Flexible Profit Sharing
Members can decide how to share profits and losses instead of relying on ownership percentages.
No Member Limits
LLCs don’t have limits on the number of members they can have, nor are there limits on how many LLCs a member may be a part of. Members may be US citizens, non-US citizens, or non-US residents.
Less Tax Paperwork
Members don’t need to file a separate tax return for the LLC unless the LLC is taxed as a partnership. Even then, they’d file an information return, with no additional payments due.
Flexible Management Structure
Compared to corporations, there are fewer regulations on how to manage an LLC, giving members greater control over how to run the business.
Lower Cost Requirements
Forming an LLC costs between $40 and $500 if you handling the filing yourself. If you use a lawyer, it may cost between $1,000 and $1,500.
Disadvantages of LLCs
Tax Requirements
Members are required to pay self-employment tax and personal income taxes.
Potential Issues for Ownership Transfers
Transferring ownership of the LLC requires approval from all members.
Potential Organizational Risks
If a member of the LLC dies or declares bankruptcy, the entire LLC may be jeopardized. However, a thorough operating agreement helps mitigate that risk.
Annual Administrative Costs
Yearly filing costs run up to $500.
Lending Difficulties
Purchasing property through an LLC may make it harder to qualify for a mortgage or trigger a higher interest rate.
Commingling Risks
If a member commingles personal and business funds, they jeopardize the liability protection an LLC can provide.
S Corporation
An S corp is a business entity that chooses to operate as a pass-through entity. So, the business’s income passes through to the shareholders. An S corp is a tax classification, not a legal business structure like an LLC. These entities have a management team of salaried directors and officers, but the business is owned by shareholders.
S corps are also popular with real estate investors, rental property owners, and property flippers.
Advantages of S Corps
Pass-Through Taxation
Shareholders—not the business—pay taxes on profits.
Limited Federal Taxes
The salaries for the officers and directors are subject to federal taxes, but the remaining profits are not.
Potential for Lower Taxes
Owners may receive both salary and dividends, lowering their overall tax liability.
Liability Protection
Shareholders’ personal assets receive protection.
Flexible Management
Compared to a C corp, there are fewer regulations for the management of an S corp.
Perpetual Existence
If a shareholder dies or declares bankruptcy, the business is not put at risk.
Outside Funding
Many banks and investors favor corporations, so having an S corp may make it easier to get outside investments.
Easy Conversion
If needed, an S corp may be converted to a C corp.
Disadvantages of S Corps
Shareholder Limits
S corps may have 100 members or fewer, and all members must be US citizens or permanent resident aliens with valid US Social Security numbers.
More Paperwork
Directors and officers must file articles of incorporation, state-required documentation, IRS Form 2553, permits, and licenses.
Less Flexibility with Profits
Shareholders must divide profits and losses based on the number of shares or ownership percentages.
More Regulations
Corporations must hold an annual shareholders’ meeting, and directors’ meetings are required, including giving proper notice and taking minutes.
Taxable Property Transfers
Transferring property out of a corporation is a taxable event and may be subject to double taxation.
More Expensive Fees
Forming an S corp may cost between $800 and $3,000, depending on your state.
C Corporation
A C corp is the most common type of corporation in the US. They are entirely separate entities from their owners, so the IRS also taxes them separately from their shareholders. Although the IRS taxes S and C corps differently, under state corporation laws, they are the same type of entity.
This structure is best for businesses earning over $150,000 annually whose owners want certain tax benefits and deductions.
Advantages of C Corps
Limited Liability
A C corp legally separates the shareholders’ and business’s assets and liabilities.
No Shareholder Restrictions
C corps don’t have limits on the number of shareholders a company may have, nor are there restrictions on shareholders’ citizenship or countries of origin.
Better Gains
Capital investors may receive better gains and incentives from stocks or dividends.
More Financing Opportunities
C corps attract venture capital and equity financing.
Separated Management
The ownership of a C corp is separate from its management.
Perpetual Existence
A C corp may exist indefinitely since it isn’t tied to its owners.
No Self-Employment Taxes
Shareholders pay taxes on dividends received, and salaries for the business’s directors are subject to payroll taxes.
Reduced Risk of Audits
Compared to LLCs and S corporations, C corps are less likely to be audited by the IRS.
Disadvantages of C Corps
More Admin Requirements
C corps are required to have annual meetings, and shareholders must vote on the board of directors.
Double Taxation
The business pays income tax at the corporate level, then shareholders also pay tax on income received from the entity.
Rigid Management Structure
Shareholder and director meetings are required for C corps. This includes giving proper notice and keeping minutes, and there are strict record-keeping requirements—all of which require additional time and expenses.
More Admin Expenses
If you form the C corp yourself, the fees range from $50 to $500. If you use a lawyer, costs are between $500 and $5,000.
Taxable Property Transfers
Transferring property out of a corporation is a taxable event and may be subject to double taxation.
Higher Capital Gains
C corporations will pay more capital gains compared to an LLC when selling property.
Takeaways
- The easiest and most affordable way to protect and separate your business and personal assets is to structure your rental property business as an LLC. If you need a more rigid management structure or your business is larger, than an S corp may be more appropriate for you. C corps are popular among small businesses, but they’re usually not the best fit for rental property.
- Just remember, the goal is to optimize your asset protection. No two businesses are the same, so talk with your tax preparer and attorney. They’ll advise you on the best entity type for your situation as well as any additional steps you can take to protect your assets.
- Are you ready to tackle the accounting for your rental properties? Sign up for REI Hub’s 30-day free trial! We’ll help you with reporting, document storage, lease tracking, and bookkeeping—all customized for real estate investors like you.
