Is an LLC or S Corp best for Real Estate Agents?
Perhaps the biggest tax mistake I see Realtors make over the years is that they choose the wrong business entity.
Most agents and brokers start as sole proprietors; it’s probably the way you started. 85% of Realtors do. Heck, 85% of all small business owners do.
In fact, sole proprietorship is the default legal structure for any business owner who hasn’t taken the formal step of incorporating or choosing some other business entity structure (ex, S Corp, C Corp, Partnership, LLC)
But then somewhere down the road, a lawyer spoke at one of your office meetings, or maybe a mentor shared from his / her knowledge and experience, and that’s when you first heard about the benefits of setting up a limited liability company (LLC).
As it’s name suggests, an LLC structure protects your personal assets (home, savings, etc.) by limiting the liability that might arise from selling real estate.
An LLC makes total legal sense!
But …choosing the right business entity structure involves all sorts of tax considerations as well.
Today we find many Realtors operating under entity structures that may have been appropriate when they first started in real estate… but no longer work effectively.
Now keep in mind, I’m not a lawyer. I can’t make you an expert in business entities. Rely on an attorney for legal advice.
But I do have over 20 years experience as a tax pro and I’ve worked with thousands of self-employed taxpayers. My specialty is helping Realtors avoid overpaying on their income taxes.
So I know what I’m talking about when I say that operating as an S Corp can make a lot of sense, tax-wise.
By choosing to operate your real estate business as an S Corp, you can save yourself thousands of dollars in taxes that you don’t have to be paying.
That’s the general rule. Whether an S Corp is specifically the best choice for you depends on your particular situation.
How an LLC is taxed
To help you assess your situation, first consider how a sole proprietorship is taxed. For that matter, consider how an LLC is taxed.
Because if you’re set up as a single owner LLC, then your business is a “disregarded entity” in the eyes of the IRS. This means that your LLC is taxed exactly the same way a sole proprietorship is taxed!
Here’s what happens: You report your business income on Schedule C of Form 1o40. You take your Gross Commission Income (GCI), and deduct all your real estate expenses from it, which leaves you with your net income.
Then your net business income is taxed two ways:
- Your net income from real estate sales is then subject to regular income tax, plus
- Your business net income is subject to self-employment tax (at a 15.3% tax rate).
What this means to you
So let’s plug in numbers to illustrate what this means to you. Keep in mind, it’s difficult to come up with an “average” income for Realtors, since numbers vary greatly depending on location in the country, type of agent, type of homes, number of hours you spent working, etc.
That said, let’s go with some easy round numbers. Suppose an agent’s GCI is $100,000, and Expenses are $20,000 (including Advertising, Auto Expense, MLS Dues, Association Memberships, and so on). This yields a net income of $80,000.
Under the new tax law (TCJA ’17) if you are netting $80,000, and you’re operating as a sole prop or single owner LLC, you’re paying over $11,000 in self-employment tax before you can even look at your regular income tax.
If you are a single filer, you’ll pay an additional 22% in regular income tax, for an additional $17,000 to the IRS.
While we’re at it, it’s worth mentioning that the self-employment tax rules work essentially the same if you’re a partner in a business. That is to say, you pay regular income tax on your Form 1065 Partnership income, plus self-employment tax.
“Self Employment” Tax … ???
And by the way, if you’re asking what “self-employment” tax is, the answer is that it’s the money that goes for social security and medicare.
Remember back when you were a W2 employee, and you paid 7.65% toward social security and medicare? You probably saw it deducted on your paystub. You just shook your head because you couldn’t do anything about it anyway. But you probably didn’t realize your employer matched your 7.65% tax with money coming out of his / her pocket.
Well, now that you’re self employed, you pay both the employee and employer portions, for a total of 15.3% tax on your net business income for social security and medicare.
But, and here’s where the good news comes, by establishing your real estate business as an S Corp, you can substantially reduce your self employment tax.
The S Corp Strategy Explained
Here’s how it works. Say your name is Sandy. You set up a corporation named Sandy the Agent Inc., which becomes a separate legal person from Sandy. You then become an employee of the business entity, which will pay you a salary for the services you perform selling and managing real estate properties.
You’ll get a W2 for that salary at the end of the year, just like any other employee. The rest of the business entity’s net income, after your salary is paid, will then pass through to your personal tax return as what’s called a “shareholder distribution”.
This effectively divides your $80,000 net income into two parts. The first part ($40,000 salary to you from your S Corp) is subject to Social Security and Medicare. But the second part ($40,000 distribution to you) is NOT subject to employment taxes.
Which means you’ll save $5,184 in self-employment tax.
What makes this tax saving technique especially powerful is that we’re simply eliminating a tax.
We’re not asking you to put $5,184 into a retirement plan, and then deduct it from taxable income. We’re not telling you to take $5,184 and buy new equipment, and then deduct it from taxable income. We’re simply avoiding $5,184 in tax.
Plus, this is an every year savings. If your real estate career spans another 10 years, then your overall savings could be $51,000 over that time period.
Which could go a long way toward college costs for your child, or toward your own tax deferred retirement account.
General Rule vs. Specific Situation
As a general tax saving strategy, establishing an S Corp will help you avoid overpaying the IRS. (Big-time!)
How much you save in your specific situation will vary depending on your GCI, your expenses, your filing status (married?), and more. To get a better understanding of how you can benefit, contact me, I can help.
If you have questions or thoughts on this topic, please leave your comments below
In the meantime, I have some follow up questions for you:
- What if you’re already an LLC? How can you take advantage of S Corp tax advantages?
- And what if it’s mid-year? Does it make sense to establish an S Corp in July, or August, when move of the “season” for real estate has passed?
- And how much does it cost? Do the tax savings outweigh the costs of operating as an S Corp?
Stay tuned, because we’ll tackle these questions and more in our next blog post.
Jim Flauaus, EA