If you’re an investor in the real estate market, you’re likely aware of the numerous benefits, including the potential for recurring rental income and property value appreciation over time. However, it’s crucial to be aware of the legal liabilities and potential losses that could affect both your business and personal assets without the right protective measures in place. This is why many savvy investors choose to hold their rental properties under a business entity.
One of the most common business structures chosen by real estate investors is an S corporation for rental properties. In this blog post, we’ll delve into what an S corporation is, explore its advantages and disadvantages, discuss the registration process, and help you determine if it’s the right choice for your rental property investments.
What is an S Corporation?
The Internal Revenue Service (IRS) defines an S corporation as a corporate entity that elects to “pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” This means that income and losses are reported to each shareholder using Schedule K-1. Each shareholder then reports their share of income or losses on their personal tax return, with taxes assessed at their individual income tax rate. This is a significant advantage compared to C corporations, where profits are subject to double taxation at both the corporate and personal levels.
S Corporation Requirements
Unfortunately, not every company can qualify as an S corporation. To meet the eligibility criteria, a business must:
- Have owners who are U.S. citizens or residents.
- Have fewer than 100 principal shareholders.
- Be incorporated in the United States.
- Issue only one class of stock, ensuring that all shareholders have equal rights to proceeds from distribution and liquidation, even if their voting rights differ.
- Not be owned by other partnerships or corporations.
S Corporation for Rental Properties vs. an LLC
Both S corporations and limited liability companies (LLCs) offer similar advantages to real estate investors, such as liability protection, ease of capital raising, and avoidance of double taxation. However, they have some differences. For instance, an S corporation may have employees, which allows for more flexibility in income distribution. Additionally, there are variations in the tax implications of transferring rental property into an S corporation compared to an LLC.
How to Create an S Corporation
Creating an S corporation involves several key steps:
Business Registration: Begin by registering your business with a unique name, ensuring it’s not similar to others or trademarked.
File Articles of Incorporation: File the necessary documents with your state, including details about your business, directors, address, and registered agent.
Create Bylaws: Although not always required during registration, bylaws are essential for setting up your S corporation and guiding its operations.
Obtain Necessary Permits: Check with your state and local authorities to determine any additional permits your business might need.
Obtain an Employer Identification Number (EIN): This is crucial for various business dealings and can be obtained online through the IRS.
Hold Your First Board Meeting: Elect directors, approve bylaws, and ensure the business meets S corporation requirements.
S Corporation Election: Submit IRS Form 2553 to elect your corporation’s S corporation status.
Pros and Cons of Using an S Corp for Rental Properties
The advantages of choosing an S corporation for rental properties include personal liability protection and potential tax savings due to the pass-through taxation structure. However, it’s essential to consider the limitations, such as the restriction on the number and type of shareholders and the ongoing administrative requirements.
In conclusion, protecting your assets and minimizing tax burdens are crucial aspects of real estate investing. While an S corporation offers protection and tax advantages, it’s essential to weigh the potential downsides and consult with experts before making this business structure decision.
Before forming an S corporation for your rental properties, it’s highly recommended to seek guidance from a real estate attorney, financial planner, or certified public accountant (CPA) to ensure you make the right choice for your specific investment goals.
