One of the most powerful tax strategies a small business owner has is the S corporation. Under most circumstances when a small business has grown beyond $30,000 to $50,000 of annual profits it is time to consider organizing as an S corporation or LLC electing to be treated as an S corporation for tax purposes.
The tax savings can be significant. A sole proprietorship is taxed at ordinary rates, plus self-employment tax. For 2019 the SE tax is 15.3% of the first $132,900 of partnership and/or sole proprietorship profits. (If you have wages from other sources this is included in the $132,900. Once you exceed that limit from all these sources combined the SE tax declines to 2.9%.) Partnerships pass profits to the owners where they pay the SE tax along with income tax. For partnerships, guaranteed payments to partners and profits are both subject to the SE tax.
An S corporation does not pay income tax. Instead, all the profits are passed-through to the owners of the entity and taxed as ordinary income only; SE tax does not apply to profits passed to owners of an S corporation. Owners of an S corporation are required to be paid reasonable compensation. The remaining profits avoid payroll taxes (FICA and FUTA) and SE tax.
Small business owners usually want some legal protections as well. The corporate or LLC structure is available to accomplish these goals. The LLC is more flexible with additional legal advantages than straight corporate entities.
Once organized, the LLC can then elect to take on the characteristics of other types of entities for tax purposes. The LLC does NOT have a tax form at the IRS. The LLC either defaults to a disregarded entity (sole proprietorship or partnership if more than one owner) or elects to be treated as a corporation. The LLC can elect S status if they inform the IRS they want to be treated as a corporation. These are two separate elections: electing to be treated as a corporation (Form 8832) and then electing to be treated as an S corporation (Form 2553).
Proper Allocation of Assets
If you had an attorney handle your LLC set-up and a qualified tax professional handle the structuring of assets inside and outside of the business you already know the S corporation rarely, if ever, has real estate inside it.
The proper structure of a business where the owners also control the real estate is to organize the business LLC, treated as an S corporation, to hold the business only and a separate LLC, defaulting to a disregarded entity, for the real estate. The business LLC then pays rent to the LLC holding the real estate.
Recently a reader on this blog asked why this is important:
Comment from Hobo Millionaire:
Keith, would you mind explaining the benefit of you renting to your business vs your business buying the building and paying a note over time. Is there a tax issue with the depreciation? You can depreciate/offset your taxes and the business can’t? A specific post on this setup, showing actual numbers, would be great.
We will discuss why you never want to own real estate inside an S corporation or an LLC treated as such.
Most of the time it is a mild inconvenience only. Then there are instances where the legal and tax problems are significant and serious.
Every issue surrounding separating the business entity from the real estate holding entity are easily remedied.
There is no law requiring you to separate the business from the real estate. However, the LLC is a legal structure designed to protect the LLC owners. If the real estate and business are held within one LLC, the real estate is at risk if the business gets sued. Depending on the industry, this can be a serious issue or a low-risk probability.
Separating business from real estate also makes it easier to sell fractional ownership of each easier. If the real estate is held inside the business LLC it is impossible to sell the real estate (or business) without selling the same fraction of the other at the same time.
Example: If you sell 10% of the business LLC and the real estate is held within that LLC, you have sold 10% of the business and real estate.
Held separately you can sell all or a fraction of either the business or real estate in any fraction you want. You can also add another member (or have fewer members) to the real estate investment without also including the individual in the business side of the equation.
Once real estate is inside an S corporation there is no easy solution to removing it. Tax issues of holding real estate with a business inside the same LLC can be significant.
Removing real estate from an LLC is deemed a sale of the real estate for tax purposes. This means all the gains and recapture of depreciation are currently reported and taxed accordingly. Even if you are a 100% owner of the LLC and remove the real estate from the LLC to your name only (ownership really hasn’t changed, now has it?) you will be taxed on the gains!
Therefore, if you have real estate inside an S corporation it might be better to keep it there even though it isn’t an ideal situation. You should consult a qualified attorney and/or tax professional with experience in this area of practice to avoid making a bad situation worse.
Serious Tax Issues
S corporations are not taxed except in a few situations. In each situation where an S corporation does pay tax the S corporation was a C corporation first for a period of time. (Electing S status at the time the corporation is organized means there was no time when the company functioned as a regular (C) corporation.)
Holding real estate inside an S corporation with accumulated earning and profits (AE&P) from when it was a C corporation has tax consequences.
S corporations are subject to tax on Excess Net Passive Income (ENPI) when :
- The S corporation’s passive investment income is more than 25% of gross receipts, and
- At the end of the year the S corporation has AE&P from when it was a regular corporation.
The ENPI tax rate is 35%! Lets look at an example of where an S corporation might pay the ENPI tax.
XYZ Corp elects to be an S corporation with AE&P. XYZ has $100,000 of gross receipts this year. Of the $100,000 of gross receipts, $40,000 is passive investment income (dividends, interest, rents, royalties and annuities). Directly connected expenses to the production of the passive investment income is $10,000.
The net passive income is: $40,000 – $10,000 = $30,000
25% of gross receipts are: $100,000 x 25% = $25,000
The amount by which passive investment income exceeds 25% of gross receipts is $15,000 ($40,000 net passive income – $25,000 25% of gross receipts).
ENPI calculation: $15,000 / $40,000 x $30,000 = $11,250.
XYZ as an S corporation with AE&P pays a passive investment income tax of $3,938 ($11,250 x 35%)
Easy Tax Problems to Fix
The good news is that all deductions related to real estate ownership remain intact even when you separate the business entity from the real estate entity. You can still borrow against the building and deduct the interest on the real estate holding LLC tax return, as well as, depreciation and other expenses paid and related to the property.
You can still have a triple-net lease between the real estate LLC and the business LLC. This means the business LLC can still pay and deduct insurance costs, repairs and maintenance, property taxes, utilities and so forth. Only the interest and depreciation goes with the real estate LLC. Rent is paid by the business LLC and deducted; the rent is claimed as income by the real estate LLC.
There are times where the real estate LLC might show a large loss due to a cost segregation study or some other tax strategy. This means your business might be earning a large profit while the real estate LLC gets a special tax benefit that allows a massive deduction which causes that LLC to show a loss.
Passive activity rules tell us we are limited in some instances, especially when our income climbs above $100,000. This is easily solved with a simple election on the individual’s tax return. (The LLCs don’t make the election. It is taken on the personal tax return level.) Having a large loss on the real estate LLC if you are a high earner would be a problem if there were no outs.
The good news, again, is you can group the activities. By grouping the real estate LLC and business LLC activities you are allowed all the deductions as if they were one entity on the personal tax return. This resolved the passive activity rule issues.
There are no drawbacks to separating the real estate and business into separate LLCs that I’m aware of. Every attorney I’ve ever spoken with agrees with me on this. Real estate should never be held inside an S corporation or LLC treated as such. Any tax negatives are easily resolved with elections.
The issues involved with combining real estate and a business under a single S corporation are many. Legally you limit your options and put assets unnecessarily at risk. The tax problems are hard or impossible to resolve without inflicting additional tax pain.
Structured properly your business and assets can enjoy legal protections while basking in the light of lower taxes.
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