There are several benefits to investing in real estate, including the potential for recurring rental income and appreciation of property value over the long term. However, legal liabilities and losses could affect your business and personal assets without the proper protective measures in place. That's why many investors hold their rental property under a business entity.
One of the most common entities for real estate investors is an S corporation for rental properties. We’ll explore what an S corp is, its pros and cons, how you can register, and whether it is a good option for your rental properties.
What is an S corporation?
The Internal Revenue Service (IRS) defines an S corporation as a corporation that elects to "pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes."
Income and losses are reported to each shareholder using Schedule K-1. In turn, each shareholder reports income or losses from the K-1 on their personal tax return, and taxes are assessed at each taxpayer's individual income tax rate.
By comparison, profits from a C corporation are subject to double taxation at the corporate and personal levels when shareholders receive distributions or dividend payments.
S corporation requirements
Unfortunately, not every company can be an S corporation. To qualify as an S corp, the following requirements must be met:
- Owners must be U.S. citizens or residents.
- The company must have fewer than 100 principal shareholders.
- The company must be incorporated in the U.S.
- The company must have only one class of stocks, meaning that all the stocks should provide the shareholders with equal rights to proceeds from distribution and liquidation, even if the voting rights are not identical.
- Other partnerships or corporations may not own the company.
S corp for rental properties vs. an LLC
S corporations and limited liability companies (LLCs) both offer similar benefits to real estate investors:
- Liability protection for each owner or shareholder to keep personal and other business assets separate
- Ease of raising capital by selling shares in the company to new investors
- Avoidance of double taxation because profits and losses are passed through to each owner, with taxes assessed at each taxpayer's individual income tax rate
Both an LLC and an S corporation for rental properties are "pass-through" entities for taxation purposes but in slightly different ways. While profits or losses from a rental property held in an S corp pass through to each shareholder, similar to an LLC, the S corporation may also have employees.
For example, an investor could receive part of an S corporation's income as a salary while passing through any remaining gain. Of course, quarterly payroll reports would need to be filed and paid. But, an investor could also create a simplified employee pension (SEP) to shelter part of the income from taxes until retirement withdrawals begin.
Another difference between an S corporation and an LLC is potential tax consequences of transferring rental property. Generally speaking, a rental property with a mortgage transferred into an LLC will not trigger a tax liability. On the other hand, moving a rental property into an S corporation may require the company to pay corporate taxes on the difference between the basis and fair market value.
How to create an S corp
These are the steps to create an S corp.
The first step to creating an S corporation is registering your business. The business name must be unique. To ensure that you are not unintentionally using another company's name, you can run your business name idea through your Secretary of State's website and the federal trademark database to ensure it is not similar to others or trademarked.
If the name is available, consider reserving it if you will not be immediately registering the business. The registration and name reservation process usually requires paying a small fee, which varies between states.
File articles of incorporation
The second step in the business registration process for an S corporation is to file articles of incorporation in the state where you are registering the business. You can get the form from your Secretary of State's office and provide the following information:
- The proposed name of your business
- Names of directors (there must be at least one director)
- Principal physical address of the company, rather than a post office box number
- Name and contact information of the local registered agent for the business who will be responsible for receiving legal notices and other documents
Once you have provided all the necessary details of the articles of incorporation, you will submit the documents through the mail or online. Research your state's process to see which methods are available.
Although bylaws are not always required when submitting the articles of incorporation, they are necessary to set up your S corporation. In addition, bylaws act as an operating manual for the business, removing any guesswork and helping to minimize any unnecessary tension in decision-making among the company's directors.
S corporation bylaws typically contain:
- The business's identification details, such as registered name and contact details
- How meetings between directors or shareholders will be held
- The required number of directors and other management
- How business documents will be stored and who has access to them
- The process of changing the bylaws
Obtain necessary permits
States often require businesses to obtain additional permits, such as city and state business licenses and tax licenses for collecting and remitting rental tax collected from a tenant. An investor may wish to work with a local real estate attorney to ensure that all of the necessary permits and licenses are obtained.
Another option is to check with your state's government to learn if your business requires additional permits, the process for obtaining them, and the fees involved. The Small Business Development Center (SBDC) is an excellent option for conducting research to learn about additional permits your business might need.
Obtain the Employer Identification Number (EIN)
The EIN is a corporation's tax identification number, similar to an individual's Social Security number. Having an EIN is essential for almost all business dealings, like opening a bank account, remitting payroll taxes if you have W-2 employees, and filing income taxes. A business can obtain an EIN online with the IRS.
Hold your first board meeting
You must hold a board meeting where board members elect the bylaws and approve the company to become an S corporation. Every board member should review the requirements for becoming an S corp, ensure that the business meets them all, and elect the corporation's officers or directors.
S corporation election
The final step is to elect your corporation for an S corporation status. The election will require filling out IRS Form 2553 Election by a Small Business Corporation. The form must be submitted on time, usually within 2 months and 15 days of the beginning of your tax year.
Missing the deadline doesn't necessarily mean you will not get the S corporation status if you qualify. However, the status will only take effect during the following tax year. After submitting Form 2553, it should take about 60 days to learn if the IRS accepted your application for an S corporation.
If approved, your S corporation status will remain effective indefinitely unless you choose to revoke it or the IRS cancels it.
Pros and cons of using an S Corp for rental properties
The allure of an S corporation for rental properties is easy to understand. In addition to potentially limiting your personal liability, you may also reduce your tax burden. For example, an S corporation could save you from double taxation since income and losses are passed through and assessed at your individual income tax rate.
Nevertheless, the potential disadvantages of electing an S corp for real estate cannot be overlooked. An S corporation cannot have more than 100 shareholders or different class stock types. The shareholders must also be U.S. citizens or residents and not other corporations, partnerships, or institutions.
A certain amount of time and effort is required to keep an S corporation active, including holding annual shareholders' meetings and filing a tax return (Form 1120S) each year, even though an S corporation generally does not pay tax. K-1s must also be prepared and delivered to each shareholder after each tax year ends, and 1099s must be filed if the S corporation pays independent contractors.
Protecting yourself and your assets when investing in real estate is paramount. Like other
corporations, an S corp offers protection against losses and liabilities. But, most importantly, it saves you from double taxation.
But you must consider its cons, including any tax effects that might come in the future when you need to sell or transfer the property. Therefore, before forming an S corporation for rental properties, an investor may wish to consult with a real estate attorney, financial planner, or certified public accountant (CPA).