Most agents are sole proprietors, but there can be some significant tax advantages to forming an LLC.
As a financial planner for real estate professionals in Salt Lake City and virtually across the country, I am often asked, “Should my real estate business be formed as a sole proprietor or as an LLC?”
The majority of self-employed real estate professionals just file under their social security number, or what’s called sole proprietorship.
Well, let’s face it, it’s easy! When you are a sole proprietor, the only thing you need to think about is separating out income and expenses for your business and your personal life. Which, hopefully you set up completely separate accounting for both.
A sole proprietor is a pass-through entity, which means that all income passes through to your schedule C on your tax return.
But, there is a major detour that your income takes. First, your business has to pay self-employment taxes. The total of self-employment taxes is 15.3%. Then the remainder leftover gets taxed at your ordinary income tax bracket.
Now there are some situational aspects that may change your specific situation, like deductions, credits, etc. It’s important to discuss with your tax accountant, but this is to help give a general idea.
Here is an example:
Real estate professional income: $100,000
Self-Employment tax: x15.3%
Pass-through income: =$84,700
Ordinary Income Tax (Fed) x 24%. ($20,328)
Take Home Income =$64,372
As you can see the self-employment tax pitstop can take a big hit on what you are bringing home as a real estate agent.
So, let’s contrast this with the formation of an LLC filing as an S-Corp.
The number one benefit of becoming an LLC is liability protection. That is first and foremost. What this means is that if an upset client were to take you to court over your business practice, they would only be able to go after your business assets. Your personal assets; like your home, cars, bank accounts, etc., would be protected from any lawsuit.
To learn more about the formation of an LLC and if it is right for you, please talk to your attorney. But for most real estate agents, this makes the most sense.
The second-best advantage of an LLC filing as an S-Corp is that it partially avoids self-employment tax. Although technically still a pass-through entity, not all of your income has to “pass-through”.
How does this work?
Well, as a type of corporation, you are going to pay yourself a “reasonable” salary. I have reasonable in quotations, because the IRS requires you to pay yourself a reasonable salary for your job type. Get with your accountant as to what a reasonable salary would be.
With your reasonable salary, you will pay self-employment taxes on that amount. There is no avoiding some self-employment tax at the 15.3%.
However, the rest of your annual income can be paid to you in the form of dividend bonuses.
Why is this good?
Dividends pay a lower tax rate. It’s dependent upon your annual income, but it is either 0%, 15%, or 20%.
Retained earnings do not get taxed! Meaning, you don’t have to pay out all of your income. Let’s say you wanted to build up an emergency reserve for your business savings. Or perhaps you want to buy out another brokerage. It doesn’t matter what it’s for, but if the money stays in the LLC, then the money does not have to get taxed.
There are many financial strategic opportunities with this. One of those opportunities is income flexibility. You have the choice of when to pay out that money in the form of a dividend bonus. So, in a year of lower income tax, you can pay yourself out of retained earnings at that time to take most advantage of your tax bracket. This is in opposition of paying out those retained earnings in a higher income year where any additional income would bump you into a higher tax bracket.
Real estate professionals who are sole proprietors will pay self-employment taxes on every dollar earned.
Real estate professionals who financially plan to pay themselves through an LLC filing as an S-Corp only pay partial self-employment tax. In addition, they have some flexibility in income and receive some significant financial planning opportunities.
For an analysis specific to your real estate business, feel free to reach out. I’ll be happy to put together a complimentary financial plan that can recommends your best financial action steps.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.