What is the most advantageous business entity for real estate investors to form?

Establishing legal entities may offer many advantages for real estate investors, such as protecting personal assets, yielding tax benefits, and increasing capital. This article will weigh the advantages and disadvantages of different business entities when considering real estate investments.  For a variety of reasons discussed in this article, Limited Liability Companies (LLCs) are the most advantageous business entity.  

Sole Proprietorships

Sole proprietorships are business entities that are not legally separate from their individual owner.  They are simple to create and allow an easy avenue in purchasing property. They offer no protections however, and owners are personally liable.  Sole proprietorships are created by filing a Schedule C form (Profit or Loss from Business) with their owner’s federal and state taxes.  They do not require registration with the Secretary of State.  

Advantages:

• Sole proprietorships are easily managed.
• Sole proprietorships do not require registration with the Secretary of State.  

Disadvantages:

• Sole proprietorships offer no protections for an owners’ assets. Owners personally liable. 
• Sole proprietorships do not offer any tax benefits. Owners report their business income and losses on their personal tax returns. 

Due to the lack of personal liability protection, sole proprietorships are not recommended for real estate investors.

Partnerships

Partnerships are business entities which have two or more co-partners.  A partnership is a “pass-through” entity, in which an entity’s income is taxed as the owner’s income.  Partnerships do not suffer double taxation.  They are not taxed on their profits and then again taxed on their shareholders’ dividends.  There are two types of partnerships: general partnerships and limited partnerships.    All general partners share and control management duties in general partnerships.  General partners are personally liable for all business debt. Limited partnerships must have one general partner while limited partners fulfill passive roles acting as investors. Unlike general partnerships, limited partnerships offer personal liability protections.  Limited partners are not liable for any business debt and are only liable to the extent of their financial investments in the partnership.  In return, limited partners may not manage the business and may not rescind their original investments.  Partners must file Partnership Return of Income and Pass-Through Entity Ownership forms in order to create limited partnerships.  They must also report their partnership income, deductions, sales, and other financial information.  Limited Partnership Agreements define roles and management duties for all partners. 

Advantages:

• Partnerships are easy to create, manage, and control.
• Partnerships are pass-through entities, with no double taxation.
• Limited partnerships offer protections against personal liability, if limited partners remain passive investors. 

Disadvantages:

• General partnerships do not offer liability protections, and general partners are personally liable. 
• One partner may expose another to liability and risk. One partner’s actions may have adverse consequences for the other partners.
• Partnership interests can be hard to sell or transfer among partners.
• Limited partners must remain passive investors. Should a limited partner actively participate, that partner is deemed a general partner and assumes general partnership duties and liabilities. 

General partnerships are not recommended for real estate investments due to their lack of liability protections. 

C-Corporations (C Corps)

C-Corporations (C Corps) are structured like default corporations, which exist separately from their owners.  They are popular entities for real estate investors. C Corps do not limit the number of owners and can issue stock shares and dividends to their shareholders.  After liquidation, and after all creditors are paid, C Corp shareholders are entitled to all remaining assets. C Corps are, however, subject to double taxation.  They are separate entities from their owners. There are several methods to lessen the effects of double taxation.  Owners can reduce the impact of double taxation by paying shareholders reasonable wages, paying off interests on debts to shareholders, paying rents and royalties on properties leased from shareholders, or reinvesting income.  However, the IRS carefully analyzes these transactions to check if they should be categorized as dividends.  C Corps are created by filing Articles of Incorporation registration forms with the Secretary of State and filing Form 100 (California Franchise or Income Tax Return). 

Advantages:

• C Corps exist separately from their owners. 
• C Corps do not have a limit on the number of owners. 
• C Corps can be used to borrow funds in the corporation’s name and to shield owners from personal liability.
• C Corps provide better incentives for venture capital investors, due to the possibility of receiving dividends. 
• C Corps allow owners to easily manage shareholder profits and employee salaries, which can lessen the effects of double taxation and reduce other taxes. 

Disadvantages: 

• C Corps are subject to double taxation. After entity profits are taxed however, the second round of taxation upon dividends usually occurs at a lower rate. 
• C Corps may need documents to establish relationships among owners and shareholders.

Overall, C Corps are a good choice if you are seeking to finance real estate investments.  Their greatest disadvantage is double taxation. 

S-Corporations (S Corps)

S-Corporations (S Corps) are similar to partnerships.  They are popular entities for short-term investors who “buy and sell” their investments and wish to profit quickly by flipping real estate. S Corps have great taxation benefits as “pass-through” entities.  Unlike C Corps, S Corps allow for income to pass-through directly to their members, without double taxation.  S Corps must have directors and officers who receive what the IRS deems “reasonable salaries.”  The maximum allowed number of S Corps shareholders is 75, and only one class of stock can be issued. S Corps’ shareholders must be United States citizens or permanent residents.  S Corps are created by filing Articles of Incorporation registration forms with the Secretary of State and filing federal Form 2553 to elect S Corp status with the IRS.   

Advantages:

• S Corps are pass-through entities, without double taxation. 
• S Corps allow income to be categorized as self-employment, which may mean lower taxes. 
• S Corps’ dividends are exempt from some taxes, such as social security.  
• S Corps offer flexible ownership management. 
• S Corps’ stocks are freely transferrable. 
• S Corps offer liability protections, and creditors cannot touch members’ individual assets.

Disadvantages:

• The maximum allowed number of S Corps’ shareholders is 75. 
• S Corps’ requirements are updated frequently. Failure to remain cognizant of additional changes may result in fines or taxes. 
• S Corps may be taxed on built-in gains and passive income.

Overall, S Corps with their liability protections and tax benefits are more attractive than C Corps for real estate investors. 

LLCs (Limited Liability Companies)

Limited Liability Companies (LLCs) are popular business entities for real estate investors because they are a hybrid of the other entities’ best features.  LLCs combine the tax advantages and flexibility of partnerships with the liability protections of corporations.  Owners of LLCs can elect to operate LLCs as sole proprietorships, partnerships, or corporations.  They are the best entities for long-term investors who “buy and hold” their investments and wish to receive steady rental income and long-term capital appreciation.  There are no limits to the number of owners of LLCs. 

LLCs are created by filing Articles of Organization registration forms with the Secretary of State. Although LLCs may be more complicated to establish than other business entities, LLCs require little paperwork and have low-cost filing fees. 

Advantages: 

• LLCs can be taxed as either partnerships or corporations, and owners can choose pass-through tax advantages, without double taxation. 
• LLC members can sell property at favorable capital gains tax rates. Members can also make exchanges on tax-free bases.
• LLCs offer liability protections and creditors cannot touch members’ individual assets.
• LLCs are easily transferable when selling entire LLCs are a whole.
• LLCs provide easier marketability for their members’ interests. 
• LLCs require fewer yearly filings than corporations. 
• LLCs’ operating agreements establish the interests and relationships between members, and there is generally no need for other documents.
• LLCs provide deductions for depreciation.

Disadvantages:

• LLCs require payment of self-employment taxes, which may be significant for members. 
• The creation of an LLC may be more complicated than the creation of other business entities.  
• Members of LLCs must abstain from mixing personal and business expenses, which may result in the piercing of the corporate veil.   
• Although LLCs are easily transferable when sold as a whole, LLCs do not offer stock, because they offer LLC shares and percentages. 

Overall, LLCs are likely the most advantageous business entity for real estate investors.  They offer pass-through taxation benefits and protect owners’ personal assets from liability, while also providing the greatest structural flexibility.

If you are considering forming a business entity, it is highly advised that you retain a knowledgeable and experienced business law attorney.  Ms. Eileen Kendall of Kendall Law is a skilled attorney with over 15 years of experience counseling businesses.  For a consultation, contact Kendall Law at (310) 619-4941.