In the hopes this will assist you in making a well informed decision, here's some basic (and I do mean *BASIC*) definitions of the most common business types. The information is *not* all inclusive. But gives you some extremely basic knowledge as a starting point.
Sole Proprietorship – This is a business with one owner, and only own owner. There are no other investors or share holders. This type of business is considered a “disregarded entity” by the IRS. All income and expenses for the business are reported on SCH C as a physical part of the owner’s personal tax return. Again, a sole proprietorship has only own owner. Depending on what state the business is in, registration is not required at the state level. But it may be required at the county, town, or other level of government below the state. For example, your county may require you to register and obtain a county issued Occupational License, which authorizes you to conduct business only within the jurisdiction of the authority that issued the Occupational License. This is most often required when the county, city or other authority below the state taxes personal income or imposes a tangible property tax on business assets utilized to produce business income.
Single Member LLC - This is a business with one owner, and only own owner. There are no other investors or share holders. This type of business is considered a “disregarded entity” by the IRS. All income and expenses for the business are reported on SCH C as a physical part of the owner’s personal tax return. Again, a single member LLC has only own owner. This type of business is required to be registered at the state level, weather that state taxes personal income or not. Additionally, this type of business may also be required to obtain an Occupational License for the county(s), city(s) or other more localized jurisdictions within that state, in which the business will be operating in.
Multi-Member LLC – This is a business with more than one owner. It’s also the exact same as a Partnership (for tax purposes) This type of business also has to register at the state level, and may also be required to obtain an Occupational License from more localized jurisdictions within the state, in which that business will operate. This type of business will file its own physically separate tax return with the IRS (and state if applicable) referred to as a Partnership Return, on IRS Form 1065. When completing the 1065 (using TurboTax Business) the business will issue each individual owner a K-1 reporting the income (or loss) of each owner. Each owner will use this K-1 to complete their personal return. So an owner can’t even start their personal return, until after the 1065 Partnership Return has been complete, filed, and all K-1’s issued to all owners.
In the community property states of Louisiana, Arizona, California, Texas, Washington, Idaho, Nevada, New Mexico, and Wisconsin if you have a multi-member LLC where there are only two owners, those two owners are legally married to each other, and those two owners will be filing a joint 1040 tax return, they have the option of splitting all business income and expenses down the middle and each partner reporting their share of the business income/expenses on a separate SCH C for each tax filer on the joint return. That means your joint 1040 return will have two SCH C’s included with it – one for each owner. But this can present its own problems in the event of divorce, separation. The issues can become even more compounded upon the death of one of the owners. If that deceased owner’s will does not pass all assets to the surviving partner, then that surviving partner can find themselves in a tax hell, not to mention the problems that can arise with the “new” owner or owners.
LLC “Like an S-Corp” – For tax purposes only (and I reiterate: FOR TAX PURPOSES ONLY!!!!!) one can elect to have the IRS treat their single member LLC or multi-member LLC “like an S-Corp” ****FOR TAX PURPOSES ONLY!!!!!**** This means your business is treated like and considered to be a physically separate taxable entity. This is accomplished by filing IRS Form 2553 – Election by Small Business Corporation. This allows you to act as if your single member LLC or multi-member LLC is an S-Corp. But understand that if you want the IRS to treat your LLC like an S-Corp, then the business “must” act like an S-Corp, and follow all the laws, rules and regulations required of an S-Corp by whichever state your LLC is registered in. All business income and expenses is reported on IRS Form 1120-S – Income Tax Return For An S-Corporation. The S-Corp will then issue each owner, investor and/or shareholder a K-1 which they will need before they can even start their personal tax return. Unlike a single member LLC which is considered a disregarded entity for tax purposes, an LLC that has filed form 2553 “is” considered and treated like a separately taxable entity.
LLC “Like a C-Corp” – For tax purposes only (and I reiterate: FOR TAX PURPOSES ONLY!!!!!) one can elect to the the IRS treat their single member LLC or multi-member LLC “like a C-Corp” ****FOR TAX PURPOSES ONLY!!!!!**** This means your business is treated like and considered to be a physically separate taxable entity. This is accomplished by filing IRS Form 8832 – Entity Classification Election. This allows you to act as if your single member LLC or multi-member LLC is a C-Corp. But understand that if you want the IRS to treat your LLC like a C-Corp, then the business “must” act like a C-Corp and follow all the laws, rules and regulations required of a C-Corp by whichever state your LLC is registered in. All business income and expenses is reported on IRS Form 1120 – IU.S. Corporation Income Tax Return.
S-Corp – This type of business is registered at the state level and must conform to the laws, rules, regulations and ordinances of that state which apply to an S-Corp. All business income and expenses is reported on IRS Form 1120-S – Income Tax Return For An S-Corp. The S-Corp will then issue each owner, investor and/or shareholder a K-1 which they will need before they can even start their personal tax return. Unlike an LLC which is considered a disregarded entity for tax purposes, an S-Corp “is” a separately taxable entity, and therefore files its own physically separate tax return and issues K-1’s to all owners, officers, investors and shareholders.
C-Corp - This type of business is registered at the state level and must conform to the laws, rules, regulations and ordinances of that state which apply to a C-Corp. All business income and expenses is reported on IRS Form 1120 – Income Tax Return For A C-Corp. A C-Corp “is” a separately taxable entity, and therefore files its own physically separate tax return.
Additional Information For Rental Property Owners
The below is not to deter you from making a business the legal owner of your rental property. It's more to educate you so that you can make an informed and educated decision. Any decision you make should not be based only on the information provided here. You should seek legal advice not just from a tax professional, but from a "legal" professional knowledgeable in all the legal aspects outside of the tax ramifications of your decision.
Occasionally a rental property owner will be “convinced” they need to put their rental property into an LLC (be it single owner or multi-owner LLC) as a means of protecting themselves and their personal assets from legal litigation should they ever be sued by a tenant. The property owner is told the LLC gives them and their personal assets a “veil of protection” from any legal litigation that may arise as the result of legal actions perpetrated by a rental tenant. Nothing could be farther from the truth. If you check court records (even in your local area) you’ll probably find numerous cases where a tenant sued their landlord and the LLC provided practically no protection of the property owner’s assets. That “veil of protection” supposedly offered by an LLC is so thin, even a new first time lawyer has no problem piercing that veil and attacking the personal assets of the property owner on behalf of the tenant. In fact, many legal firms will give such cases to their “new hires” right out of law school because it’s a great confidence builder for them since it’s practically a guaranteed win for the tenant. There are other problems and issues with this too.
In order to legally transfer ownership of rental property to an LLC, the owner must have the permission of the mortgage holder. No lender in their right mind will give this permission either. Even if you think you can refinance the property or “sell” it to your LLC, unless your LLC has the cash on hand to pay for it in full, your LLC will never qualify for the mortgage loan. The lender doesn’t want to risk your LLC going under (by filing bankruptcy for example), and they lose money because of it. So I’m confident in telling you, that’s not going to happen.
When you create an LLC for your rental property, it’s generally understood that business income gets reported on SCH C as a part of your personal tax return. However, a SCH C business produces “earned” income, and a rental property produces “passive” income. What’s the difference?
Earned income is income which you have to do out and “do something” in order to earn it. This income is subject to regular income tax, and also an additional 15.3% self-employment tax. The SE tax is basically the employer side of your social security and Medicare. But rental income is not “earned” income, and therefore is not reported on SCH C. So if you create an LLC for your rental property, then absolutely nothing concerning that rental property will be reported on SCH C. Not one penny of rental income and not one penny of rental expenses.
Rental income is “passive”. That’s because all you do with rental property on a recurring basis is just “sit there” and collect the rent every month. You are not “doing anything” to “earn” it on a recurring basis. That’s why rental income is reported on SCH E. Rental income is subject to regular tax, but is NOT subject to the additional self-employment tax. This means that rental income DOES NOT COUNT for your social security account or Medicare contributions.
SO if you create an LLC for your rental property, there are two things that will NOT happen.
- You will not be able to “legally” transfer ownership of the property from you, to the LLC unless you have a really dumb lender.
- You will not report one penny of rental income or one penny of rental expense on SCH C.
So in the end, you will be filing a zero income/expense SCH C with your personal tax return.
Now let’s say you decide to file the 8832 to treat your LLC like an S-Corp, and then you transfer ownership of the property to your LLC. You can and will report your rental income on form 8825 as a part of the 1120-S Corporate Return. Then the corporation issues each owner/member a K-1. Each owner/member enters the K-1 on their personal 1040 tax return, and the rental information ends up on page 2 of the SCH E as a part of your personal tax return. But keep in mind the S-Corp election for an LLC is for ***TAX PURPOSES ONLY!!!****. So if a tenant sues you, I seriously doubt the courts will recognize your S-Corp, and I seriously doubt the court will recognize the S-Corp as a physically separate owner of the property. Remember, that 8832 Entity Classification Election is for “TAX PURPOSES ONY”. It has no weight at all for any and all other legal purposes – such as you being sued by a tenant.
SO if you want to do this (and it still makes no financial sense) then form an actual S-Corp and transfer ownership of the property to the S-Corp. More than likely the lender won’t allow the transfer. But you can sell the property to the S-Corp if the S-Corp can qualify for a mortgage loan. Overall though, it’s still financially dumb to do this. Here’s why I say that.
When you move out of your primary residence and convert it to residential rental real estate, you have to convert your homeowner’s insurance policy to a rental dwelling policy. Or if you buy the real estate as rental property outright, then you have to obtain a rental dwelling policy at that time. A rental dwelling policy will, at a minimum, include $300,000 of liability coverage. For most that will suffice. But if the property is in certain areas of the country you may want more liability coverage. I have three rentals myself and have a total of $1,000,000 of liability on each. It cost me less than an additional $100 a year on the insurance for each property. So for me, it’s worth it. It’s also significantly cheaper not only in money, but in time spent dealing with corporate taxes and all that other additional paperwork crap.
One mistake I see quite often is that when an owner converts their primary residence or 2nd home to rental property, and they fail to update their insurance policy. This can bite when you have a claim. If the property is insured as your primary residence, but you are using it as rental property (which is other than it’s insured use) don’t be surprised when the insurance company denies your claim, and you can’t find any lawyers that will take your case. If it’s a case of you being sued by a tenant, then to be honest and put it bluntly, you’re screwed.
