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Ed Johnson
Ed Johnson, Tax Preparer
Category: Tax
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Experience:  GPHR Cert; U.S. Treasury Tax Advocacy Panel appointee
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I am preparing to invest in real estate in Ohio. I am going

Customer Question

I am preparing to invest in real estate in Ohio. I am going to perform all of the duties but have fellow investors. I will have a controling interest as compensation. How should I incorporate for the best tax advantage?
Submitted: 7 years ago.
Category: Tax
Expert:  Ed Johnson replied 7 years ago.

Dear Shannonfreick,


Thank you for your question.



First of all, while many people believe they are incorporating for a tax advantage, this is not the most common reason for incorporating. The most common, practical, and main reason for incorporating is to separate and protect personal assets from business assets; so that during litigation and business failure, your personal assets are protected.


Tax advantages are secondary.


The tax advantages of incorporating may not be an advantage at all. for example, If you incorporate as a C-corp, there is exposure to double taxation. (Corporate tax rates on corporate earnings, and then payroll taxes for taxes reported on a W-2). So for most persons the C-Corp is out.


The real tax benefit of incorporation is that you can avoid higher corporate tax rates, by incorporating as a pass through organization, such as an LLC or S-Corp. LLC's and S-corps pay no corporate taxes, as the expenses and profit flow through to your individual return. Personal tax rates are often less than the corporate tax rates.


When you operate a business, whether as a single proprietorship, partnership, DBA, LLC, or S-corp, you are still able to expense all reasonable and customary business expenses derived from business and investment operations, depreciation, and net operating losses (if any).


LLC's are not considered corporations by the IRS. They are instead, a business entity unique to the states. The IRS treats the single Owner LLC as a disregarded entity, or rather, as a sole proprietorship, where the single owner then files a return using schedule C for net profits, and schedule SE to determine the MC and SS taxes paid in the form of Self Employment (SE) tax. (form 1040-SE)


The multi owner LLC is treated as a partnership, and it files a partnership return that flows to a K-1 to allocate the expenses, profits, and losses, that also then flow through to the individual returns. partners report their profits on Schedule E, which also flow to the 1040-SE for SE tax.


The LLC single owner or partners take their pay as a draw. As per IRS rules regarding this, the LLC partners are owners and are not paid on W-2. Technically, while some make this mistake, they really are not allowed to pay themselves on W-2. BUT this is a good thing, because you only pay SE tax, not on the draw, but on the net profits are reflected on the Schedule C (for single owner) or Schedule E (for partners).


If you in corporate as an S-corp (or take a check the box S, election), the partners (or single owner if that is the case) are required to pay themselves a reasonable wage as officers of the corporation according to the level of the work they do for the management and conduct of the business of the S-Corp. That means there is W-2 Withholding and the S-Corp must make the contributions to the employer's shares. The partners would also be taking distributions which are also taxable, and so they may also incur additional SE taxes later on.


The two best forms are LLC and S-Corp. In my opinion, the LLC is the best way to go for your situation, as there is a slight tax advantage. Some analysts would say the S-corp has a very small advantage over the LLC because the fact you pay SE Tax on all of your share of profits on the LLC. And with the S-Corp you only pay SS and MC tax on what you earned. BUT that margin of benefit is wiped out because:


1. All distributions to officers and owners are to be treated as wages to the extent of reasonable wages for officers. (what do presidents and VP's of companies get paid?) And so you may incur additional SE tax. AND


2. 50% of the SE tax paid on your share of Net profits in the LLC, are deducted from gross income on the form 1040.


The S-corp tax filing requirements are excessive in comparison to the LLC. This makes the LLC the more attractive option especially for a company less than 5 years old.


If you have a problem with division of labor and responsibility with your partners, regardless of whether you have an LLC or S, you would deal with that with the written partnership agreement between you, which might allocate shares based on level of work or performance. Those allocation rules can be used to allocate profits, and expenses on the K-1.






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