Investing in real estate can be beneficial for several reasons, like recurring rental income, property appreciation, and tax benefits. However, you’ll want to protect your business from losses or legal liabilities. That’s why many real estate investors hold their properties under a business entity. A common business entity for real estate investors is an S corporation. Today, we’ll review what it is, how to create an S corporation, and the pros and cons. Read along to learn more.
Contents of This Article:
- What Is an S Corporation?
- How to Create an S Corporation
- S Corporation for Rental Properties vs. LLC
- Pros and Cons of S Corporations
- Considerations for Rental Property Owners
What Is an S Corporation?
When it comes to owning rentals and property management in Baltimore, it’s important to know how to protect your business. An S corporation, also known as an S-corp, combines the limited liability protection of a traditional corporation with the tax advantages of a partnership or sole proprietorship.
According to the Internal Revenue Service (IRS), S corporations elect to “pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.”
Rental income and losses are reported to each S corp shareholder using a Schedule K-1. Then, each shareholder reports the income or losses from the K-1 on their personal tax return. As a return, taxes are assessed at each taxpayer’s individual income tax rate instead of the rate of a rental property business.
Some investors prefer to create an S corporation for rental properties to limit their personal liability in a rental situation and reduce costs at tax time. However, before exploring this option, it’s important to know the requirements, the steps to creating an S corporation, and the pros and cons.
S Corp Requirements
Not every company can be an S corporation. To qualify, you must meet the following requirements.
- The company must be a domestic corporation
- You must have eligible shareholders
- Owners must be U.S. citizens or residents
- The company cannot have more than 100 shareholders
- The company must have only one class of stock
- Other partnerships or corporations may not own the company
How to Create an S Corporation
Creating an S corporation for your rental properties involves several steps. That said, it’s important to note that the process can be complicated, so you might want to consult a qualified attorney or tax specialist who can guide you based on your circumstances. Nevertheless, if you want to create an S corporation, here’s a general outline of the steps involved.
- Register Your Business
- File Articles of Incorporation
- Create Bylaws
- Obtain Necessary Permits and an EIN
- Elect for an S Corporation Status
Register Your Business
The first step in creating an S corporation is registering your business with a unique business name. It’s important to ensure you’re not using another company’s name, so consider running your business name idea through your Secretary of State’s website and the federal trademark database to ensure another business entity does not already take it.
File Articles of Incorporation
To create an S corporation, you must incorporate your business by filing the necessary documents with the state in which you’ll operate. You can pick up the required form from your Secretary of State’s office and provide the necessary information, like your business name, name of directors, company address, and contact information.
Create Bylaws
Next, you’ll want to create corporate bylaws that outline your S corporation’s internal rules and procedures. For instance, bylaws typically address matters like the powers and responsibilities of shareholders and directors, meeting procedures, business identification details, and more.
Obtain Necessary Permits and an EIN
Some states require businesses to obtain additional permits, like city and state business licenses and tax licenses for collecting and remitting rental tax collected from a tenant. So, you’ll want to ensure that all of the necessary permits and licenses are obtained while creating an S corporation.
Next, you’ll need to apply for an EIN, an Employer Identification Number, from the IRS. An EIN is a unique identification number for your corporation, similar to a social security number for an individual.
Elect for an S Corporation Status
Once you have all the necessary permits and documents, you must file Form 2553 Election by a Small Business Corporation, with the IRS to elect S corporation status for your entity. This form must be filed within a specific timeframe, generally within two months and 15 days of the beginning of the tax year. If you miss the deadline, you can still get S corporation status. However, it will only occur during the following tax year.
S Corporation for Rental Properties vs. LLC
S corporations and limited liability companies (LLCs) offer similar benefits to real estate investors. For instance, they both offer liability protection for each owner or shareholder to keep personal and business assets separate. Additionally, they allow investors to avoid double taxation since profits and losses are passed through to each shareholder and assessed at each taxpayer’s income tax rate.
However, there are some differences between S corps and LLCs. For instance, LLCs are generally more flexible than S corps since they aren’t subject to IRS regulations concerning the number and type of shareholders. As such, they can allocate profits and losses however they choose.
Additionally, LLCs have fewer formal requirements and ongoing compliance obligations. While LLCS must maintain proper records, the operational requirements are generally more flexible than those for S corporations.
Ultimately, choosing between an S corporation and an LLC depends on various factors, like your business goals, desired tax benefits, and operational preferences. So, if you’re wondering which route you should take, consult a qualified attorney or tax professional to determine which business entity suits your needs and goals.
Pros and Cons of S Corporations
Creating an S corporation offers several advantages and disadvantages. So, here are some of the pros and cons to consider if you’re looking to create an S corporation.
Benefits of S Corporations
- Pass-Through Taxation- One of the significant benefits of an S corporation is pass-through taxation. The corporation itself doesn’t pay federal income taxes at the corporate level. Instead, the profits, losses, deductions, and credits “pass-through” to the shareholders’ personal tax returns.
- Limited Liability Protection- Like a C corporation, an S corporation provides limited liability protection to its shareholders. As such, the shareholder’s personal assets are generally protected from the debts and liabilities of the corporation.
- Easy to Transfer Ownership- S corporations offer greater flexibility in transferring ownership interests. For instance, shares of stock can be transferred to other individuals or entities, making it easier to bring in new investors or pass on ownership.
- Potential Tax Savings- By utilizing pass-through taxation, S corporations can potentially reduce their overall tax liability. Since the corporation’s income is taxed at the individual shareholder’s tax rates, eligible shareholders can have tax savings.
- Ability to Retain and Reinvest Profits- Unline C corporations, S corporations aren’t required to distribute all profits as dividends. As such, the company can retain and reinvest its profits for business growth or other purposes without incurring corporate-level taxes.
Disadvantages of S Corporations
- Eligibility Restrictions- S corporations have several eligibility restrictions. For instance, an S corporation cannot have more than 100 shareholders, and all shareholders must be eligible individuals.
- Limited Stock Classes- S corporations are restricted to having only one class of stock. Although it simplifies the structure, it can limit the ability to offer different rights and privileges to shareholders or issue different classes of shares.
- Formalities and Ongoing Requirements- S corporations are subject to certain formalities and ongoing requirements. For instance, you’ll need to hold regular shareholder and director meetings, maintain corporate records, adhere to bylaws, file annual reports, and comply with state and federal regulations.
- Restrictions on Ownership- The eligibility restrictions on shareholders can limit the flexibility of attracting certain investors or partnering with other entities.
- Self-Employment Taxes- S corporation shareholders can potentially save on taxes by receiving distributions instead of salaries. However, they still need to pay themselves reasonable compensation for their services, which is subject to employment taxes.
Considerations for Rental Property Owners
Owning rental properties is a great way to build wealth, earn tax benefits, and create a name for yourself. However, it’s crucial to take certain measures to protect your business and your income. As such, knowing how to create an S corporation or other business entity for your rental properties can be a great first step.
How can BMG help your rental business?
Another great way to protect your rentals is with comprehensive property management. Bay Property Management Group offers various rental management services, including marketing, tenant screening, rent collection, maintenance, and more. So, if you own properties in or around Baltimore, Philadelphia, Northern Virginia, and Washington, DC, contact BMG today.
