It’s the end of the year and the tax man cometh soon. I have asked several different places here about why people chose an LLC over an S-Corp. The consensus has been that for rental properties LLC is the way to go and for Flipping / Rehabbing S-Corps are the way to go. Well, strictly speaking about taxation, here is some information that may help people decide.
The following is an exerpt from Robert A. Cooke’s book entitled “How to start your own S-Corporation”. Robert Cooke is a CPA who has written quite a few books and here is his website www.robertcooke.com .
Regarding LLC’s and how they are taxed I’ll be referring to pages 117-118 of this book under the section ‘Earnings may be subject to Social Security Taxes’
“In a limited partnership, those partners with limited liability (the limited partners) do not pay social security taxes on their share of the profits. General partners, who are active in the business, do pay social security taxes on their share. Some tax professionalsargue that, inasmuch as members of an LLC have limited liability, their share of the earnings should not be subject to social security taxes. It follows that, because there is no general partner in an LLC, no partner pays social security taxes, no matter how active he or she is in the busines.”
…(I’m deliberately skipping through where he recites the tax code as it’s written in IRS language and is boring, but here is the important aspect)…
“The courts have sided with the IRS: members of an LLC may have limited liability, but they are not limited partners. Notice that this strict interpretation means that those members who are only investors are subject to social security taxes.
Also, all the earnings of an LLC are subject to social security taxes, whether or not those earnings are distributed to members. Conversely the earnings of an S-Corp are not subject to social security taxes, provided that, if there are distributions to stockholders who are also employees, there are reasonable salaries paid to them. Only the salaries are subject to social security taxes.”
It is quite an important consideration that the LLC is subject to an extra 15.3% tax liability on all earnings versus just the salaried portion paid to you in an S-Corporation as to whether this designation is the best. REGARDLESS of whether it’s rental income or flipped income that your company is generating profits from.
According to Section 469(c)(2) of the Internal Revenue Code, rental property activities are treated as per se passive under the passive activity rules unless the taxpayer is a real estate professional.
For all of us landlords who are not real estate professionals, this means, that regardless of the taxpayer’s level of material participation, a rental activity is a passive activity. Thus, by extension, the income earned by the LLC whose income is derived from rental property operations is, by default, passed through to the taxpayer as passive income.
Therefore, if the taxpayer is not a real estate professional, self-employment income taxes do not apply even if the rental income is earned by an LLC.
Ok, I understand what you are saying but conversely, using the same IRS section pass through income from the LLC to the individual does not mee the Sub-Issue requirement for exclusion of the $25,000 rule.
"As long as a taxpayer participates in management decisions in a bona fide sense, he actively participated in the real estate rental activity. There is no specific hour requirement. However, the taxpayer must be exercising independent judgment and not simply ratifying decisions made by a manager.
Several categories of taxpayers do not meet the standard of active participation and therefore do not qualify for the $25,000 special allowance:
A limited partner in an activity (IRC § 469(i)(6)(c)).
A taxpayer who has less than 10 percent ownership (IRC § 469(I)(6)(A)). A trust or corporation. The $25,000 is available only to natural persons."
The last statement that is in bold reitterates my understanding of the tax code. Only individuals can qualify. A limited partner would not be able to nor would a corporation. Everything I’ve researched has indicated than an LLC’s total income (since it’s a pass through entity it’s understood that all of the income is passed through to members) is Taxed as self-employed.
I could me misinterpreting this information. I’m also not arguing to prove I’m right, I’m just looking for definitive evidence to validate the LLC taxation on rental income. I guess what I really am looking for is some one to say something like :
According to court case XXX v. YYYY the courts have upheld that rental income from an LLC when passed through to an individual is passive only in nature. I have read on these boards that CPA’s indicated that an LLC was the way to go, but as of yet, I haven’t found any written evidence from a CPA to suggest this.
You are correct for an active income business. In addition to reporting income on Schedule C, the taxpayer will also use Schedule SE to calculate his payroll taxes.
In the case of a rental property activity – a passive income activity – the income is passed through to the taxpayer’s Schedule E. No payroll taxes are calculated on passive income.
A disregarded entity is, for federal income tax purposes, simply a sole proprietorship – for tax purposes, a business without a formal business entity. A sole proprietorship can have active income as would be the case with a real estate professional, a dealer to real estate, even the hot dog vender on the corner. This income is taxed as ordinary income subject to self-employment income taxes. The taxpayer would file Schedule C and Schedule SE with his annual 1040. The passive loss allowance does not apply to the active losses suffered by this taxpayer.
A sole proprietorship can also have passive income. The landlord who operates without benefit of a formal business entity, is an example of a passive income sole proprietorship. The landlord who conducts his rental operations from within an LLC treated as a disregarded entity also has a passive income activity. This taxpayer would report his rental income on Schedule E, and would be eligible to use the passive loss allowance in the event of a net passive loss from rental operations.