S Corp To Flip, LLC To Hold

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As a CPA, I speak to a lot of clients and prospects that own real estate. I am always amazed at how many of them hold property in their personal names. In many cases, significant assets that they have worked all of their adult lives to amass. It would only take one simple misfortune turned to litigation to destroy the fruit of a lifetime of hard work. In other cases, individuals are operating businesses using entity structures that simply are not tax advantageous. They pay the government thousands, even tens of thousands of extra dollars annually simply because they don't know any better and never were advised properly by their tax accountant.

While the topic of entity selection does require that you ascertain and examine the facts and circumstances of the individual and the business, there are certain general rules that will work for most circumstances. For real estate investors, the general rule is as follows: S Corporation to flip properties, LLC (or Limited Partnerships (LP)) for holding properties. Here's why:

Flipping Properties

If the primary objective of your real estate business, or one of your real estate businesses, is to buy, potentially fix up an existing property and resell it within one year, the Internal Revenue Service can consider that to be an active trade or business. Unlike passive rental income, the income from an active trade or business is subject to self employment tax (a nasty 15% tax commonly referred to a "social security and medicare" by working folks). If your goal is to reduce that self-employment tax to a minimum, an S Corporation is the best entity to use. Why?

It is the only entity structure whose rules allow the business owner to take a "reasonable salary" (subject to social security and medicare) and then take the remaining profit (often as much as 50% of the remaining income) out as distributions not subject to self-employment taxes. Correspondingly, all business income taken from an LLC under similar circumstances is subject to self-employment taxes. For a business owner with $100,000 taxable annual income, the net tax savings for using an S Corporation instead of an LLC in taxes paid every year can be as high as $7,500.

Holding Properties

When holding properties as a cash flow investor, the LLC (or LP) is generally the better choice because an LLC has more liberal distribution rules. The key here is flexibility. If you purchase a large piece of property and later decide to sub-divide it, you could distribute out a piece from an LLC without incurring a taxable event. LLC distributions come out of the LLC at cost basis. If the same circumstances applied to an S Corporation, the distribution of a piece of the sub-divided property comes out of the S Corporation at fair market value and it is likely to be a taxable event.

While there is never only one answer that is correct for all circumstances, there is a general rule that is almost always the correct choice. So remember, for legal and tax planning, we recommend that clients hold their properties in an LLC or Limited Partnership and run their businesses as S Corporations to avoid self-employment taxes.

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Information about the Author:

Ted Lanzaro, CPA owns and operates Lanzaro CPA, LLC, a boutique tax strategy, accounting and IRS debt resolution firm with offices in Shelton, CT. He can be reached by phone at 203-922-1742 or via email at Ted@lanzarocpa.com. You can visit his website at www.lanzarocpa.com.