Background:
I own a rental property through a single member LLC (say LLC-A). Currently, I am self managing all the operations. I am planning to setup an S-corp (say LLC-B) to manage this rental property and a new property I will be acquiring this year. LLC-A is a disregarded entity for tax purposes and I report the rental income/expense on Sch-E. The income from LLC-B will be reported on Sch-C where all of it will go to my solo 401K leaving zero tax liability.
Problem:
I dont understand why the strategy above is a bad one. I have read many articles from various CPAs advising against it, including my CPA. Whereas I consider it as an excellent strategy. Below is an example which makes me believe why this is a great strategy:
Example:
1) Say I charge $47000 for full 1 yr of management, repair, and clean fees. This is a writeoff on sch-E.
2) $47000 I report as income on Sch-C. Here I am exposed to SE taxes. However, I already maximize social security taxes from my W2 income. Hence, I only pay medicare taxes which will be ~$1100.
3) After paying this medicare taxes I move the remaining amount to my solo 401K making sch-C income zero and tax free.
4) If I did not pay myself, I would have likely ordinary tax on $47K income on Sch-E (even after depreciation, interest, insurance, etc), whereas by moving $47K to sch-C it goes to my retirement account with only medicare taxes due right now. On sch-E this $47K is a writeoff making income zero or creates loss which is carried forward till absorbed by capital gains at sale.
What am I missing? Why everyone is advising me against it including my CPA? Please help me understand. Where am I going wrong?
Regards,
Nick
Side notes:
1) Choosing $47K above as I contribute $23K from my W2 and $70K is max 401K contribution limit for 2025.
2) $47K as management fee for 1 property is high, but for 2 properties it will be <15% of the total rental income which is quite standard.
3) I know only self-employment income can contribute to solo 401K, and management fees ARE a valid self-employment income.
4) Business purpose for LLC-B is literally to manage two rental properties. I don't get it how IRS can classify this as serving no business purpose. After all somebody has to manage the properties, pay utilities, find tenants, pay city fees, etc. LLC-A files sch-E and cant be expected of doing anything as its a passive income and treated as such.
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why there is no economic substance: Property management is a valid active business, and by making the setup above I am correctly segregating passive activity reported on Sch-E and active activity of property management through LLC-B.
What you stated above is exactly why there is no economic substance. You are segregating passive activity from business activity of property management solely for tax purposes. Can you state any reasonably valid, non-tax, reason for doing so? You can easily manage the properties without creating a separate S corporation, which you alone own and control, for management purposes. I mean, you're actually doing that now.
You brought up a number of hot issues but the one in bold below may be problematic.
"Say I charge $47000 for full 1 yr of management, repair, and clean fees."
$47k worth of management fees would only be justified if you had $250k in gross rental income at the very least. The standard management fees are typically around 10% and sometimes less than that depending upon the property. Some firms charge fees as high as 20% but that figure is usually limited to short-term rental properties (even at 20% - about maxed out - you'd need close to $500k in gross rental income).
I think you need to tackle the threshold question of whether $47k in management fees is reasonable. You might also want to note that the IRS can blow up your entire schema by concluding that the legal structures and fee payments lack economic substance (i.e., they have no purpose other than tax avoidance).
Your post is confusing with schE & C & S corp. If you set up a SMLLC S corp you do not report it on schedule C. You file a separate business return 1120-S for it. Then you would get a W2 or K-1 to enter into your personal return. I'll page @dmertz for info on the 401k.
I am planning to setup an S-corp (say LLC-B) to manage this rental property and a new property I will be acquiring this year. LLC-A is a disregarded entity for tax purposes and I report the rental income/expense on Sch-E. The income from LLC-B will be reported on Sch-C where all of it will go to my solo 401K leaving zero tax liability.
An S-corp must file an 1120S tax return. The income is not reported on Schedule C but on page 2 of Schedule E. For a moment disregarding that the IRS may blow the whole thing up saying there is no economic substance, the S-corp is now conducting a business - managing property - you would have to take a reasonable salary that would flow to your 1040. You would be paying FICA and Medicare taxes and your retirement plan contributions would be limited. Should the IRS blow it up any money in that retirement account would be immediately taxable.
Thank you for your kind response. I will keep this mind.
However, $47K is justifiable management fees. I am going to get a service quote from some of the large rental properties in my area to back this up.
The total rental income expected is just over $360K and management fees depending on the level of involvement range from 8-15%. I believe you agree with me here.
As Mike9241 said, nothing about the S corp goes on your Schedule C. You are an employee of the S corp. As a disregarded entity, the sole proprietorship can't be a shareholder in the S corp. You as an individual would be the shareholder.
If you are proposing switching from a sole proprietorship to an S corp, the sole proprietorship would have no income or expenses, nothing to report on Schedule C. Under the circumstances, your sole proprietorship and the S corp having the same ownership would mean that they would be a controlled group for the purpose of a retirement plan, so with your only compensation coming from the S corp, your retirement contributions would be limited to the amount of your compensation paid to you by the S corp and reported on your W-2 from the S corp.
Many thanks for your response.
You are right I did create some confusion.
Lets see if I can clarify:
S-corp receives management fees --> issues W2 to me --> From this 100% goes to solo 401K + 25% contributed by S-corp
Total taxes in this transaction --> Medicare taxes which might total (employer + employee) to around 3.8% max. This is significantly less than $47K of original income going into Sch-E.
I am aware of the filing requirement for the S-corp itself. That is just bunch of forms. Main issue is the actual income that flows through it.
Social security taxes are caped and already maxed out through my W2 income. Hence, the LLC-B and resulting W2 from it DOES NOT have to pay social security.
Hence, the FICA taxes will only be 3.8% versus the ordinary income tax rate applicable on Sch-E income.
(In my original post I mention 2.45% which is only the employee portion. I didnt add the S-corp portion of 1.45%.)
Reasonable salary = Max. contribution limit to solo 401K
Management fees collected by S-corp = reasonable salary + 0.25*reasonable salary
Distribution = 0 (as provides no benefit)
Also why there is no economic substance: Property management is a valid active business, and by making the setup above I am correctly segregating passive activity reported on Sch-E and active activity of property management through LLC-B.
@dmertz: LLC-A is a disregarded entity that owns the property and it pays management fees to LLC-B which is an S-corp.
why there is no economic substance: Property management is a valid active business, and by making the setup above I am correctly segregating passive activity reported on Sch-E and active activity of property management through LLC-B.
What you stated above is exactly why there is no economic substance. You are segregating passive activity from business activity of property management solely for tax purposes. Can you state any reasonably valid, non-tax, reason for doing so? You can easily manage the properties without creating a separate S corporation, which you alone own and control, for management purposes. I mean, you're actually doing that now.
The S-corp won't get back its share of Social Security and Medicare taxes. There would be other payroll taxes in addition to Social Security and Medicare. The IRS could use other code provisions to upset your plans. Truthfully, we don't know what the IRS would do. In part that may depend on the auditor, if there ever is one. I would strongly suggest you discuss your plans with a paid professional.
I would strongly suggest you discuss your plans with a paid professional.
If you read the original post, @nickam already did discuss these plans with a paid professional. The result was this:
"Why is everyone advising me against it including my CPA"
I guess the result is looking for validation under every rock. My point is if you're going to be rolling the dice, at least be aware that's what you're doing.
Also be aware that you have to factor in state/federal unemployment tax as you will be an employee of your S corporation (LLC-B with an S corporation election).
@nickam wrote:Social security taxes are caped and already maxed out through my W2 income. Hence, the LLC-B and resulting W2 from it DOES NOT have to pay social security.
Hence, the FICA taxes will only be 3.8%
That is incorrect. You will also pay 6.2% for the employer portion of Social Security.
In addition to the Medicare tax that you mentioned, the S-corporation will withhold 6.2% Social Security from the paychecks, plus it will pay 6.2% for the employer portion of Social Security.
When filing your tax return, you effectively will get the 6.2% back that was withheld (because you hit your Social Security maximum), but the corporation is still paying 6.2% for the employer part of Social Security.
Plus Federal Unemployment (and maybe State unemployment, worker's compensation or other state requirements, but those rules vary from state to state).
Everyone, thank you so much for helping clarify my confusion. I had quite a few misconceptions and poorly understood ideas which your feedback and suggestion help me clarify.
@M-MTax: Yes, I am trying to look for validation from all the worthy avenues. The feedback above is very useful. This lets me ask focused questions to my CPA and keep our discussions bounded and to the point. Btw, I am happy non of the feedback above is asking to check ChatGPT 🙂
I agree with your concern of "economic substance". This might be the Achilles' heel for the strategy I proposed. Also, good point about unemployment taxes. I missed that and will include it in my list of questions.
@Mike9241: I totally agree with you !! It is hard to estimate what position IRS would take. One option here is to look at IRS workbook or any prior tax court cases involving such strategies. Unlike me, there might have been a pioneer brave enough to directly implement this strategy and face the crosshairs of the IRS. If you know of any issues or cases please point them to me.
My next steps will be to list the concerns raised by you and other community members above, and take it back to my CPA. If I still cant convince them, then I will have to drop the ball.
@AmeliesUncle : You might be right. I need to further read about the SS cap. My understanding is that once the annual wage base limit from any source is met (W2, 1099, etc), no additional SS taxes are due for the year, either as an employee or an employer.
But thanks for your feedback. May be this would be another reason why my strategy wouldnt work.
An employer is required to pay the employer portion of SS tax whether or not the employee has met the SS wage base with earnings from a different employer. An employer (other than an individual who is considered to be the individual's own employer as a sole proprietor) operates in isolation from any information about whether the employee has earnings from another source that are subject to SS tax.
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