By Guest Contributor Mathew Owens, CPA
One of the main questions investors ask me when starting off investing is what entity should they setup when investing. Many investors have already setup an entity because some attorney said they needed it or they heard about it in a class as a good asset protection method. However, there are a ton of factors to consider whenever you are deciding on which legal and tax structure you should put in place. Here is my top 10 list of factors to consider when putting your structure together that not all attorneys or CPA’s will tell you.
1) WHAT ARE YOU TRYING TO PROTECT?
Many investors go setup an entity before they even have a property or investment in place. This can be a huge waste of time and money given that I have seen many investors setup entities they intend on using for investments but do not actual invest for years and have to do tax returns and pay LLC fees that could have been saved. My advice, wait until you have a property to even begin looking at your legal structure and even then a secondary legal entity may not be the answer.
2) WHAT ARE THE RISK DIFFERENCES IN YOUR SITUATION BETWEEN INSURANCE AS A FORM OF LIABILITY PROTECTION VERSUS SETTING UP A SEPARATE ENTITY FOR LIABILITY PROTECTION?
There is a constant trade-off when looking at using insurance to protect your assets versus an entity like an LLC or S-Corporation coupled with insurance. Typically just having insurance in place can save you an extra $1,000 – $1,500+ per year instead of having an entity, but then you also have some additional risks like if the insurance company doesn’t pay or you have exclusions in your policy that are not covered. If you do go the insurance route, understanding those exclusions and how good your insurance company is at paying out claims is really important. With the entity structure, as long as you are not breaking the corporate veil and doing everything by the book, it can give you liability protection above and beyond insurance that keeps the liability inside the entity and makes it much more difficult for lawsuits to get at your personal assets.
3) HOW MUCH IS YOUR NET WORTH?
When determining if you should setup an entity in the first place you should know and understand what assets are you trying to protect that a renter could go after. Do you own a home, have stocks, cash in bank accounts, cars, etc? If so you may want to consider putting your rental property in an entity for liability protection. The more you own, the bigger the risk that someone could come after you and make you a target. On the other hand if you do not have a lot of assets and your only asset is your rental property you may benefit from the savings by not forming an entity more than the liability protection. Also, if you’re net worth is greater than the liability insurance limits you may want to get an umbrella policy in place as well as a cover all. Again take a look at your exclusions in the insurance policy as well.
4) ARE YOU MAKING RENTAL INCOME OR CAPITAL GAINS INCOME?
The type of income you make is very important for tax purposes. Flipping and holding can have different tax consequences and should be looked at very differently when determining the right entity to invest in. When holding real estate many attorneys recommend using an LLC (or a Land Trust with an LLC) for liability protection, which is great for tax purposes as well because they are considered flow through entities which flow right onto your personal tax return without any federal or state tax consequences other than state LLC fees. When flipping, depending upon your volume, you may choose an LLC or S-Corporation structure. It really depends if you are classified as a dealer or not. Typically investors that flip a lot can get classified as a dealer, meaning the income then turns into active ordinary income instead of long term or short term capital gains income. Ordinary income comes with payroll taxes at 15% of your salary. Most of the time it makes sense to setup an S-Corporation to save on payroll taxes IF you are making enough money to warrant the entity setup and annual expenses due to the minimum salary requirements in S-Corporations. Bottom line, unless you are making over $40,000 a year net, after all of your expenses, your payroll tax savings is minor and may not make sense to setup an S-Corporation at all. This point should be discussed with your CPA and your attorney so that your team is on the same page.
5) WHAT STATE ARE YOU GOING TO FORM YOUR ENTITY IN?
Many investors start off forming an entity in the state they live in which may not always be the best choice. You want to understand the laws in the state your property is in along with the laws in the state you live in. Many investors choose to do business in completely different states like Delaware that has good privacy laws that hide owner’s information much better than other states. States like Tennessee have no state income taxes but have franchise and excise taxes which you can get around completely by forming an LLC in that state that qualifies for an exemption from those taxes when its 95% family owned. If you live in California, their stance is that you owe them their $800 Franchise Tax Fee because you are managing the entity from California, even if the property is in another state. Keep in mind if you have property in an LLC located in different states you should be registered in that state so you are valid entity in that state.
I hope this gives a little insight as to some of the key factors to consider when forming entities for real estate investments. Please consult your individual attorney for advice on this topic as every situation is different and the information above is a much higher level discussion.
Mathew Owens, CPA