So, you’re planning to start a property management business! One of the most important decisions you’ll make right away is choosing a type of business structure.
Will you be a sole proprietorship, an S-Corporation or a regular C-Corporation? What about a LLC?
All of these structures have very different tax implications and legal protection for you as the property management company owner. I’ve outlined the positives and negatives of each structure to make it easier for you to compare and choose.
Let’s discuss a sole proprietorship first. It is the easiest business structure to use. There are no special licenses or registrations to complete with the State or Federal Government. You would just need to establish a DBA (fictitious business name) with your local authority and you are pretty much good to go.
- you will be personally responsible for all business liability and debt
- you will be personally responsible if the business gets sued (not such a good position considering how litigious people are and the risks involved in managing properties and tenants);
- and you will be pay a very high tax rate on your net income
Your net earnings are $100k. You must report all business earnings and expense on schedule C of your personal tax return. If you’re single, your personal federal tax rate on these earnings would start at close to 18% (with no itemized deductions). So far that’s $18k in federal tax owed. However, since you are a sole proprietor, you would also be subject to self-employment tax which would be another 14% or $14k. The total federal tax owed on $100k would be around $32k. That is a large tax bite.
Personally speaking, I think a sole proprietorship is the worst structure you could choose for a property management business.
Limited Liability Company (LLC)
This structure is a legal structure only. It is not recognized for federal tax purposes and is called a disregarded entity by the IRS. What does this mean? Each state allows you to set up a limited liability company. The website for your Secretary of State website supplies the forms your state requires to open this type of business. A LLC has annual state filing and registration fees that are required to keep the LLC active.
Once the LLC is opened, you will establish and abide by the operating agreement of the limited liability company and set up a separate bank account for the property management company. As long as you operate the company financials separate from personal expenses, you are legally protected in the event someone sues the company. They can only go after the assets of the company and not your personal assets. However, if you comingle personal funds and expenses with company funds, you destroy the purpose of this entity and the court will decide that the company is not a true LLC. If sued, your personal assets are at stake. It’s very important to keep separate bank accounts and books for the company. You must be a good administrator or pay a bookkeeper to keep your finances straight.
As far as taxes are concerned, remember I said a LLC is not recognized by the IRS? That means the business does not file its own tax return. You report all income/expense just like the sole proprietorship, on your schedule C. You would still be subject to self-employment tax (see example of Sole Proprietor above). There is an option to treat the LLC as a corporation but you would need to file special paperwork with the IRS to do so (for tax treatment of this option, see Corporation below).
A corporation also protects you from personal liability in the event the company is sued. However, administration of a corporation is more demanding. You must file Articles of Incorporation in the state you intend to do business in and you must follow corporate formalities throughout the year, which include having annual board meetings, in order to maintain corporate status. The annual filing fees can be expensive as well. As a matter of fact, everything associated with being a corporation is expensive. It seems that when anyone sees the word “incorporated” they bump up your fees! Again, you will need to keep separate bank accounts and books and never comingle your personal funds with business funds.
As far as taxes, a C-corporation should only be operated by someone who has a very good grasp of tax law. C-corporations file separate annual Federal and State tax returns, due every March 15. The net income of the corporation is taxed at a minimum of 15% and moves up on a sliding scale depending on the amount of net income earned.
An owner of this structure must pay themselves a salary that is commensurate with the position. In other words, what do Presidents of property management companies make in your area? If the average salary of a property management president in your area is $50k, that is what you should be paying yourself (and paying payroll taxes on).
In a C-Corp, it makes sense to take as much of your net income as salary as possible because whatever amount is left and must be distributed to you (called a dividend) and taxed at another 15%. So in effect you have double taxation.
Example:The net earnings of C-corporation are $100k. Then tax would be $15k at 15%.
If you don’t pay yourself but later want to take money out of the corporation, the amount distributed is a dividend; now the $100k is taxed again at 15% on your personal return for another $15k.
Now you have paid a total of $30k in taxes. Ouch!
If you pay yourself a salary of $100k instead, the net income of the corporation goes to zero. There would be no corporate tax and no dividend tax since there is no money to distribute to you. You only pay the individual tax rate for the salary earned and documented on your personal tax return.
This is a simple illustration; actual taxes will vary depending on circumstances.
The final entity I will discuss is the S-corporation. It is exactly like a C-corporation except it has better tax advantages.
A S-Corp is just a regular C-Corp that makes a special election with the IRS that all the income and expense will be taxed on your personal tax return instead of on a corporate level. This is the structure most property management companies choose because it offers the best tax rates.
Your property management company would still file a corporate federal tax return (called an S-Corp return) every March 15th.
However, the corporation will not be taxed on its net income. You will receive a K-1 from the entity reporting the net income and you will pay taxes on the net income on your personal tax return.
Your property management business has an income of $100k. The S-corporation does not pay 15% tax on this income.
You will pay tax on the $100k at your individual tax rate on your return. But, unlike the other structures, you will not have to pay the 14% self-employment tax or pay a 15% dividends tax. That’s the beauty of the S-corp.
However, since you avoid the self-employment tax, the IRS expects you to pay yourself a reasonable salary so that you do pay payroll taxes. This is still the best option. Even though you pay yourself a reasonable salary and payroll taxes, you are allowed to take the remaining income as an owner draw and only pay Federal tax at your individual tax rate.
Your S-Corp earns $100k. You pay yourself a salary of $60k (along with the payroll taxes). The S-Corp net earnings are $40k. The $40k escapes 14% self-employment tax on your personal return saving you $5,600 in tax. On your personal return you pay Federal taxes on the $60k salary received + the$ 40k k-1 earnings of the S-Corp. So $100k ($60k salary + $40k net S-Corp earnings) x 18% tax is $18,000 Federal tax due.
When you take the $18k Federal tax due and add the payroll taxes you pay on the $60k salary which would be about $8,500, your total tax liability for the year is about 26.5k which is much lower than the $32k you would owe if you were a Sole Proprietor, a Disregarded LLC or a regular C-corporation.
It’s extremely important to set up your property management business structure for the best tax benefits. The money you save in taxes can be invested into improving and growing your business!
Richard Hart EA, CAA
Hart & Associates
Offices in Las Vegas NV, Manhattan NY and Beverly Hills CA
Disclaimer: LandlordSource does not represent the article content in this website as legal advice. It is shared information only and up to the reader to use this information responsibly, seeking legal advice as necessary to their business.