Recently, one of our real estate clients asked me what was the best business structure for her to use. Every business structure has advantages and disadvantages; however, for most real estate agents and brokers, using an S corporation or LLC is the best option.
What is an S Corporation?
“S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on corporate income.”¹
The major advantage for S corporations is the tax benefits. As an S Corp, you only pay regular income taxes and no self-employment taxes on your distribution. The current self-employment tax rate is 15.3%; therefore, since an S Corp’s income is not subject to the self-employment tax, there can be a reduction in your income taxes by more than half, in some instances.
With every business structure, there will be disadvantages. One of the biggest disadvantages is that S corporations require more discipline and organization. S corporations also require shareholder-employees to be on the payroll–meaning that a portion of shareholder income is still subject to Social Security and Medicare, which is the same as a self-employment tax. The amount a shareholder should pay themselves on payroll should follow the IRS reasonable salary rules. Many people find reasonable salary rules ambiguous; therefore, I recommend consulting an accountant. Failure to apply the IRS reasonable salary rules appropriately can negate your tax benefit by subjecting all income to Social Security and Medicare taxes. Additionally, payroll can be complicated to manage, so it is best to pay for a payroll provider. Lastly, being that an S Corp is a more complicated business structure, tax preparation is usually more costly and should only be done by an experienced accountant.
Even with all the downsides, the tax savings are too big to ignore!
S Corporation Tax Savings Scenario
In this scenario we have a real estate agent, Jessica, who set up a corporation called Jessi Realty Inc., then elected to be taxed as an S corporation. Jessica consulted her accountant and he recommended she pay a reasonable salary of $50,000 to herself for the year 2020. At the end of 2020, Jessica’s gross salary was $50,000 and $40,000 was distributed. Her salary of $50,000 was subjected to Social Security and Medicare, but the $40,000 distribution was not subjected. Since $40,000 is not subject to self-employment (15.3%), Jessica has a savings of $6,120 in taxes.
This amount of tax savings is worth having to pay for a payroll provider–which can run at about $540 a year with Gusto Payroll–and having to pay more for tax preparation.
What is an LLC?
If you are not ready for the complexities associated with managing an S Corporation, I recommend creating an LLC. LLC, which stands for limited liability company, is the chameleon of all business structures. An LLC is a “hybrid entity that combines the characteristics of a corporation with those of a partnership or sole proprietorship.”² An LLC can elect, for tax purposes, to be treated as a sole proprietorship, partnership, C Corporation, and S Corporation, with the power to switch again at a later time. When starting a business, most business owners need the convenience and ease of withdrawing and depositing money without fear of repercussions; that is why I recommend LLC structures.
One disadvantage of an LLC is that it can be expensive to form in comparison to other business structures. Depending on the state, starting an LLC can cost anywhere from $50-$500. My recommendation for anyone starting an LLC is to begin as a sole proprietor, which will allow you to be more flexible with your day-to-day operations, then gradually transition to an Scorp as your business becomes more profitable. This will allow you to prioritize reduced taxes over flexibility.
If you have any questions or thoughts on this topic, please leave your comments below. If you are interested in speaking to one of our accountants, please email us at [email protected] and one of our accountants will return your email as soon as possible.
¹Internal Revenue Service. “S Corporations.” IRS.gov. https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations. (accessed June 7, 2020).
²Kenton, Will. “Limited Liability Company (LLC).” Investopedia.com. https://www.investopedia.com/terms/l/llc.asp. (accessed June 7, 2020)