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 had 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.
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 sole
proprietorship 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
it’s 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) 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.
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 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 8332 – Entity Classification
Election. 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 an LLC which is considered a
disregarded entity for tax purposes, and LLC that has filed form 8332 – Entity Classification
Election “is” considered and treated
like a separately taxable entity.
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. The C-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. A C-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.
Additional
Information For Rental Property Owners
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. 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 12.6% 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.
- 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 SCH E as a part of the 1120-S
Corporate Return, and you will also report the K-1 on SCH E as a part of your
personal tax return. But keep in mind that this 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 issured 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.
