When it comes to your real estate investments, selecting the right business structure is critical. After all, the legal and financial ramifications can be significant. In previous posts, we discussed the LLC (Limited Liability Company) and its pass-through tax advantages. Another business structure, the S Corporation, also allows owners to report profits and loss on their personal tax statement. However, there are some differences between the LLC and S Corporation that have big implications for the real estate investor.
An S Corporation begins as a plain vanilla C Corporation. Soon after incorporation, shareholders must submit Form 2553 to the IRS to be treated as a pass-through entity. While both the LLC and S Corp offer pass-through tax treatment and personal asset protection, there are some key differences:
1. The S Corporation restricts who can be a shareholder
An S Corp cannot have more than 100 shareholders (of course, this limitation is probably not of much consequence to most real estate investors). All individual shareholders must be either U.S. Citizens or permanent residents. The LLC does not have such restrictions on owners.
2. The S Corporation has strict income allocation
In an LLC, income and loss can be allocated disproportionately among the owners; in the S Corp, income and loss are assigned to each shareholder strictly based on their pro-rata share of ownership.
So, if I own 80% of an LLC, my share of the tax burden doesn't necessarily have to be 80% of the taxable income. But if I own 80% of an S-Corp and that company makes $100,000 in taxable income, I will be taxed on $80,000 of income.
3. The S Corporation cannot increase pass-through losses
In certain circumstances, the IRS allows the loss in a corporation or LLC to pass through to the individual shareholders. For real estate owners, these losses can provide an enormous reduction in an individual's overall tax liability. However, the LLC allows you to pass through more loss than in the S Corp – most notably when it comes to mortgage payments. In an LLC, members are allowed to add the amount of the mortgage to their basis for the purpose of computing a loss. Clearly, that can add up to a significant difference in your tax statement.
Of course, details may vary based on your specific circumstances. However, in most cases the LLC is the ideal business structure to both protect your personal assets and offer the maximum in tax benefits.