Types of Legal and Tax Structures for Property or Business Owners
One of the first and critical decisions of real estate investors is choosing the right business type. In this article we will compare the most common legal and tax structures as well as their advantages, disadvantages and limitations.
Direct Ownership by Individual
This option means that the owner of the real estate is directly the investor. Under this option, all the income and expenses from the asset are reported annually on Schedule E of the investor's personal tax return (1040NR for foreign investors and 1040 for U.S. citizens and residents).
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Advantages of this option:
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Less Bureaucracy - forming a separate legal entity creates bureaucracy, which is required by law and depends on the type of the legal entity, such as, forming agreements, conducting meetings, voting, etc. Direct ownership allows you to save your time and energy on paperwork and focus on your business.
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Progressive Tax Rates - A progressive tax is a tax rate that increases as the taxable income goes up. This is an advantage in comparison to other entities that pay a flat tax rate (such as corporations that have a tax rate of 21%). In the U.S., as of the tax year 2020, the first tax bracket is 10% of taxable income up to $9,875, 12% of the taxable income between $9,876 to $40,125, 22% of the taxable income between $40,126 to $85,525, 24% of the taxable income between $85,526 to $163,300 and thereafter increases gradually to a maximum tax rate of 37%.
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Reduced Costs and Expenses - Bureaucracy often also means increased set up and ongoing costs such as set up registration fees, payments to lawyers and legal councils to be legally compliant, annual state fees, tax compliance might be more complicated which makes the tax preparation fees higher, etc.
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Disadvantages of this option:
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Personal Liability Risk - There is no legal separation between the owner and the real estate property you own. This means that in the event of a lawsuit (which is not a rare sight in the U.S.), your personal assets are at risk since the other party can sue you personally. In such a lawsuit, your potential risk is not limited by the amount you invested, but also your non-U.S. property.
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Estate Tax: Any individual, even those who are not U.S. citizens, who hold assets in the U.S. at the time of his/her death is subject to estate tax. U.S. assets include owning real estate property in the United States. A foreign (Israeli) investor with property in the U.S. can claim an exemption of up to $60,000 towards the estate tax, while U.S. citizens can do so up to $11,580,000 (as of the tax year 2020) using the unified credit. Above the aforementioned amounts, the property owner can be taxed at 40%.
Limited Liability Corporation (LLC) With a Single Owner (Member)
This option means that the investor is buying real estate property through an LLC in which he is the single owner. An LLC is a legal form that can have multiple tax treatments, depending on the circumstances and elections made. In most cases, a single-member LLC is not treated as a separate entity for federal income tax purposes.
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Advantages of this option:
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Liability Risk Protection - An LLC allows you to shield yourself from personal liability if your business goes bankrupt or otherwise runs into legal trouble. Your personal assets wouldn't be exposed in the event of a lawsuit; only assets belonging to the LLC.
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A disregarded entity - for tax purposes, the LLC is transparent, which means that all the income and expenses are reported as part of your individual tax return where you can still receive the progressive tax rates. It also means that you don't have to file a separate tax return for the LLC, which saves your tax preparation fees.
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Disadvantages of this option:
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Some Bureaucracy and costs apply - Forming an LLC and maintaining it implies costs such as set-up costs and registration fees, annual state fees, payments to registered agents, etc. The amounts depend on the specific state, but usually, it is a matter of several hundred dollars a year. For some investors, it might significantly change their return rate on investment (ROI).
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Depends on State - An LLC is not a federal entity, but an entity formed under state law. This means that you have to account for legal and taxation differences between the states.
To avoid any chance of personal liability, it is important to keep LLC records and finances completely separate from the owners’ personal finances. The LLC should have its own bank account and credit cards. Contracts, invoices, purchase orders and other important documents should always have the LLC name on them and should be signed on behalf of the LLC.
Limited Liability Corporation (LLC) With Several Owners (Members)
This option means that the investors are buying real estate property through an LLC in which there are several owners/members. An LLC is a legal form that can have multiple tax treatments, depending on the circumstances and elections made. Unless otherwise elected, the IRS treats a multi-member LLC as a partnership for income tax purposes.
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Advantages of this option:
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Same Liability Risk Protection as described above.
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Different Ownership Classes - LLC ownership percentage is usually determined by how much equity each owner has contributed. Nevertheless, It is also possible for ownership interests in an LLC to have different classes. The reason for different ownership classes would be the ability to allocate special voting power and profits. For instance, you could create voting units that could grant extra power.
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Pass-through taxation - There is no double taxation unless the LLC elects to be taxed as a C corporation. The partnership will file annually Form 1065, but this is only an informational return. Each investor's relative part income and expenses are reported as part of their individual tax return where they can still receive the progressive tax rates.
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Reduced costs and paperwork - Much less administrative paperwork and record-keeping than a corporation (but higher than direct ownership or single-member LLC).
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Members can be also Non-U.S. citizens (or formally - Nonresident Alien).
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Disadvantages of this option (in addition to single-owner LLC):
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Abide the Operating Agreements - Partnership allows you some level of flexibility, but at the end of the day partners have to abide by the operating agreement, such as voting. Also, changing the ownership percentage or adding members can be complicated.
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Higher Tax Preparation Fees - As we have to file Form 1065 for the partnership itself and then each one of the individual members of the LLC.
There are time limitations when LLC can elect to be treated as S-corp or C-corp. There are also limitations to change its classification once elected.
C Corporation
This option means that the investors are buying real estate property through a C corp which is incorporated by a charter from the Secretary of State. The profit is taxed to the corporation when earned (a flat tax rate) and then is taxed to the shareholders when distributed as dividends - double taxation. They also might be subject to additional taxes such as branch profit tax.
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Advantages of this option:
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Corporations may be able to raise additional funds by selling shares in the corporation.
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Same Liability Risk Protection as described above.
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Might be beneficial to investors with a higher marginal tax rate than the corporate tax rate (21%), who wants to defer the second step of the tax payment by deferring the distribution of dividends.
Disadvantages of this option:
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Forming a corporation requires more time and money than forming other business structures, as well as many formalities that can be both complicated and expensive.
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The double taxation might lead to an overall higher rate of tax paid.
S Corporation
This option means that the investors are buying real estate property through an S corp. S corp cannot have foreign investors as shareholders. Therefore this option is not applicable to foreign (Israeli) investors. Generally, an S corporation is exempt from federal income tax other than tax on certain capital gains and passive income. On their tax returns, the S corporation's shareholders include their shares of the income, deduction, losses and credit.
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