S-Corps for Real Estate
The rise of the sharing economy has given birth to a new business model: the S-Corp. If you’re unfamiliar with this term, it’s a type of corporation that offers many benefits and advantages over traditional businesses. In this article, we’ll explore the basics of S-Corp form and what they can offer real estate professionals. By understanding the pros and cons of this structure, you can create a business that is tailored specifically to your needs.
Technically, the S-corps is a designation by the IRS for the corporations that pass their losses, income, credits and deductions via the shareholders to avoid the case of double taxation on corporate income. But before we get into the aspect of S-Corps for Real Estate, let us find out what the S-Corps is all about.
The S-Corps: All About it
Essentially, S-corp is a business ‘structure’. However, the S-corp is permitted under the tax code to pass the taxable income, deductions, credits, and losses directly to the shareholders. The best part is that this offers a benefit over the more common C corp. Nevertheless, one needs to bear in mind that the S-corp is advisable for small businesses that have 100 or fewer shareholders which is an alternative to the LLC or the Limited Liability Company.
Also, for the record, both the S-corps and LLC are categorized under ‘Pass-through entities’, as they do not have to pay any corporate taxes. Instead, they pay their shareholders, who are responsible for the due taxes.
What makes S-Corps Important
Wondering where the name ‘S-Corps’ derives from? Well, interestingly, the name comes from the ‘Subchapter’ ‘S’ of the Internal Revenue Code. under which they have been categorized to be taxed. The main features of the corporation filed under Subchapter S: It can pass through business income, deduction, and losses, and offers direct credit to the shareholders, without having to pay any federal corporate tax, hence making it more of a ‘pass-through-entity’. Hence a special tax benefit under 2017’s Tax Cuts and Jobs Acts. Nevertheless, it is considered liable at the corporate level for taxes for certain special built-in gains and passive incomes.
Apart from the tax status, the S corporation is much similar to a C-corporation as it is officially known. This is generally a for-profit company that has been incorporated and governed under the same state corporation laws. Also, under it are offered similar liability protection, management advantages, and ownerships as that of the C-corporations. The other aspects of consideration comprise internal practises and formalities. This comprises having a board of directors, conducting shareholders’ meetings, writing corporate bylaws and also to maintain the precision of significant company meetings.
It is the manner of taxation that marks the main difference between the S corp and the C corp. The various profits emerging from C corp are taxed over to the corporation when earned. It is then taxed over to the shareholders when distributed as dividends. Thus a double tax is created in the process. One must bear in mind that the income may be passed directly to the shareholders without having to pay federal corporate taxes.
IRS and the S-Corp: The requirements
It is vital to get yourself ‘to qualify’ for the S-corporation status. For this, one must meet the required Internal Revenue Services requirements as stated by the latter. Some of these include:
- Must comprise only one set of stocks.
- Must not comprise more than 100 shareholders
- Needs to be incorporated within the United States of America
- The shareholders need to be either individuals, estates and trusts
- Must also be of certain tax-exempt organizations, partnerships and corporations.
- Likewise, the non-residential Aliens do not qualify as eligible shareholders.
Note: It is important to keep in mind that the S corp shareholders need to report losses, gains, and income, from the corporation in their tax returns. Also, they need to pay the taxes within their regular income tax rates. As the money coming is free of corporate tax, hence double taxation can be avoided for any earnings or income from the corporation
S-Corps for Real Estate
It has been stated by the experts that a partnership and LLC taxed are much-recommended entities in case of holding Real Estate. This is also because the S corporations within the real estate industry have their own set of benefits; which is highly advantageous when you are flipping through properties, real estate development, brokerages and the other areas of self-employment where the taxes are vital. But, first, let us understand a bit about Self-Employment taxes:
The Self-Employment Taxes
The Social Security and Medicare tax is also known as the Self-employment tax which is paid by the individuals in this category. It is much like the Payroll taxes that are withheld from the wages of an employee. But, in the case of self-employment, like those of house flippers and real estate brokers, they need to cover both the employee’s and the employer’s portion of the tax.
In the case of self-employment the tax ranges from 12.4% to 15.3%, as reported in 2019. In the case of the members and the partners of an LLC taxed are taxed as a partnership and can be subjected to the self-employment tax. This is in case they materially participate in the business and trade of the partnership. There are cases, such as that of rental income, the income from real estate investment is categorized as Passive income. Here, this is not subjected to the self-employment tax, this is the reason why the partnerships are considered a common vehicle for the holdings of real estate investment.
The Reasons for the Creation of S Corporation instead of a Partnership
There are cases when real estate is considered an active trade or business. In such a case the self-employment tax might become a problem. However, this can be easily resolved with the application of an S corporation. So, when and where does real estate become a case of self-employment tax? Here are two prime cases:
The Case 1
- Tom and Jerry purchase a property worth $ 350000 and wish to rent or keep it vacant for a couple of years till the market value of the same increases.
- Now, after two years, they decide to sell the property for an amount of $400000.
- At this point, the two realize that the $50000 gain observed falls under the ‘passive income’. Hence, it is not a subject of Self-Employment tax.
- Likewise, since the property has been held for longer than 1 year, Tom and Jerry can also benefit from the capital gain tax rates that are much lower than the rates under ordinary income.
The Case 2
- Tom and Jerry purchase a property to spruce up and flip within a couple of months from the time of purchase.
- Consider this case when it is the third time in a year that the pair have purchased a rundown property, revamped it and sold it for a profit.
- Now, Tom and Jerry are no longer passive investors in real estate. They are operating a business of flipping houses and in this case, the profits are subjected to self-employment tax and ordinary income tax rates.
- On selling the property, the $50000 profits will result in a $6200 Self Employment tax considering their business has been structured as a ‘partnership’. This is in addition to the income tax that they are subjected to.
- Nevertheless, in the case of S Corporation, the structure can help decrease the self-employment tax issue.
In the case of the S Corporation, a certain percentage of the profits are designated as wages and are subject to self-employment tax. The remaining profits are distributed as the ‘Dividends’ or Return Capital sans the Tax. As in the scenarios above, Tom and Jerry need to pay a reasonable salary to ‘themselves’ for their input into their business. However, the best part is that they are also entitled to distribute the remaining profits without having to be subjected to self-employment tax.
One must bear in mind that Real Estate flipping, as it is called, is not exclusive to benefits from the entity being taxed as an S corporation. Likewise, the real estate agents, developers, brokers, and management organizations are all qualified for this exclusive business structure and can benefit greatly from it.
Likewise, certain real estate investments use the Partnership and an S corporation simultaneously as a required structure that allows the partnership to hold the property but the S corporation holds the operating business. For such structures, proper tax planning is also advised.
How Does OneSet Up an S Corp
To set up an S corp one needs to:
- Have a business that is incorporated
- Then you need to file Form 2553 with the IRS.
- According to this form, the IRS will accept the S Corp position only under the condition that the business comprises all the qualifications for the status.
- All the shareholders need to sign the consent form, with the officer having signed it below and the exact correct address of the corporation and the other details are provided.
So, there you have it people, these are some of the vital facts, features, and benefits of the S-Corps for Real Estate. However, there is no denying the fact that taxes are a tricky aspect that one needs to tread carefully around. For this, one can easily get in touch 1800 964 3096 with our team of experts and we will be more than happy to help you accordingly.
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💠Frequently Asked Questions💠
What are the Advantages of Registering as an S corp?
Some of the prime benefits are:
🔹 One does not have to pay any federal taxes at the entity level. Hence, saving money on corporate taxes is beneficial, especially during the early years of the business.
🔹 With the help of the S corp, the personal income tax is lowered for the business owners, likewise. As and when the money is characterized after it is received from the business as a salary or dividends, S corps owners often lower their liability for the self-employment tax. The deductions are generated for the business expenses and salaries that are paid to the employees. This also comprises the pass-through entities that are applied for the S corp owners.
🔹 The Shareholders of S Corp can also be company employees, earn salaries, and also receive corporate dividends that can be categorized as ‘tax-free’. This is in case of the distribution not exceeding their stock basis. In case of the excess, it is taxed as capital gains. However, these are taxed at a lower rate than ordinary income.
🔹 The other major benefit is that one can easily transfer the interest or adjust the property basis without having to face adverse tax-related consequences. Likewise, one also does not have to comply with complex accounting rules.
🔹 The S corporation status can also help establish credibility with potential customers, suppliers, employees and investors by displaying the owner’s formal commitment to the organization.
What are the Disadvantages of the S Corp?
Some of the major disadvantages are:
🔹 As the salaries can be disguised as corporate distributions to avoid paying the payroll taxes, hence the IRS scrutinizes how the S corp pay their employees. Hence, it is required that the S corporation needs to pay reasonable salaries to the shareholder-employees for the services rendered before any distributions are made.
🔹 In the case of making the distributions to the stakeholders, it is required by the S corp to allocate the profits and losses or to make any other non-compliance prepositions, like certain mistakes in elections, consent notification, stock ownership or filings as required. Likewise, a swift rectification of non-compliance mistakes can advert severe consequences.
🔹 Another major setback is the time and money that setting up the S corp usually requires. It is required that the owner should submit the articles of incorporation to the secretary of State in the state where the company is based. Also, a registered agent should be obtained by the corporation, for the business and the other fees should be paid concerning the incorporating itself.
🔹 There are cases in certain states where the owners must pay annual report fees, a franchise tax and other such fees. Likewise, the charges applied are generally inexpensive and might be deducted from the cost of doing business. Finally, all the investors receive dividend and distribution rights as well, irrespective of whether they hold voting rights.
What Entity is considered the best in the case of the Rental Property?
Both LLC and S corp are considered equally beneficial for rental property, as both offer liability protection for the owners.
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