So all I need is a single member LLC, right?
I get this question from both the new investors and experienced investors all the time. They go to a seminar or a boot camp, they hear the words “single member LLC” and think that’s the magic bullet that protects them and gives some massive tax advantages. Not necessarily true! In fact the choice of entity (the way your company exists: LLC, Inc, LP etc, what I call structuring) is the number one mistake that I see investors making.
Now, let me just tell you: If you are in business in GA, I usually recommend the use of an LLC as a legal entity. My attorney friends tell me that the LLC has better statutory protection than other Georgia entities. One of the biggest advantages is that “commingling of funds” will not necessarily void your protection. Commingling means you pay personal expenses out of your business account. It is the number one way that a corporate veil can be penetrated.
Notice above that I said LEGAL entity. The LLC is a legal entity, not a tax entity.
Contrary to popular belief, they are not the same thing! Your legal entity is the way you exist for protection purposes. It is established under state law, so the selection of your entity may vary depending on what state you’re working in. In Georgia, there are seven possible legal entities (actually there are more, but most of them you’ve probably never heard of.) In most cases, when possible, I prefer multi member LLCs. We will come back to that thought in another blog entry. Many states are the same or similar, but not all! The laws do vary and I have seen state filing fees as much as the $1000 for an LLC! Consult with an attorney licensed in your state.
Your tax entity is established under the Internal Revenue Code. There are only four of them: sole proprietor, partnership, S Corp and C Corp. Lucky for us, the legal entity LLC can be taxed as any of the four. It just depends on what paperwork you file with the IRS, or, as I all too often see, what paperwork you fail to file with the IRS. (If that’s you, there is still hope! The IRS has procedures in place to correct this common oversight.)
The correct entity depends on your specific situation and how the IRS views your business. As investors, we tend to think of ourselves as people whose money works for us. This could be renting property, flipping property, private lending, wholesaling or any of the multiple other strategies out there. But the IRS looks at us based on our investment activity. They essentially lump us into two major categories: investor or real estate business (and sometimes, just a business).
Under the IRS definition, an investor is someone who holds property for long-term appreciation. You have a capital asset that you will one day sell. Your income from the sale is taxed as a capital gain. While you are holding the property, you may collect rents. If you collect rents, you may also deduct expenses and depreciation (depending on circumstances.) If you are an investor under this definition then you have passive income. Passive income is the least taxed of all income. In fact, one of the things we are after is a positive cash flow, but on our taxes a phantom loss from depreciation, that we can deduct against our other income. As always there are specifics to whether or not something is deductible. We will cover this in-depth later.
If you have anything other than passive income from your business (portfolio income excluded ie: stocks and bonds), then you have a real estate business, or in some cases just a business. (This will become important later).
Here are some things to ask yourself:
1. Is your income ordinary or passive?
2. Do you have a large income already on your 1040?
3. Are you holding your interest individually or through another entity?
4. Do you have partners? If so how are they holding their interest?
Once you have the answers to these questions, then you’re ready to make a decision on what tax entity to use. In our next entry, we will cover proper structuring for those renting property.
