If you are a real estate investor starting out, or maybe even a seasoned one, you may have asked yourself (or your colleagues) if you should incorporate your real estate business. While having an S-Corp or a LLC may be beneficial to your situation, you should understand why you are doing it and make sure it is for a reason other than to say “I have a LLC.” There are a couple of ways that you can go about incorporating and each has their own set of pros and cons. Hopefully today’s post will give you a little introduction into incorporating and help you decide if it is something you want to pursue. I am not a CPA, attorney, or business start-up specialist, so you should always consult with one (or all) of these before making any major decisions.
A corporation is a company or a group of people created under state law that is authorized to act as a single entity. One of the reasons for having a corporation is to reduce the amount of risk that your group is exposing itself to. If you invest a certain amount of money in the corporation and that corporation fails, in theory, the most money that you can lose is the amount that you invested. In addition, this would also shield your personal assets in the case that your corporation was deemed liable for damages in a court of law.
S Corporation (S-Corp)
An S-Corp is one in which the income and/or losses of the corporation are passed down to the shareholders. In order to qualify to be a S-corp, you can have no more than 100 shareholders. For a regular corporation, profits could be taxed at the corporate level as well as the individual level when shareholders are paid dividends. When using an S-Corp, the corporation would not be taxed as the responsibility would only flow down to the shareholder level.
Limited Liability Corporation (LLC)
Like an S-Corp, a LLC is an entity that is distinct and separate from the owners. One of the main differences between an S-Corp and a LLC is that a LLC can elect to either be taxed as a regular corporation or have the taxes passed down to the owners, like with an S-Corp. There are other differences between S-Corps and LLCs, some of them state specific, but those differences are beyond the scope of this post.
Advantages to Incorporating
When most people think about incorporating, they usually have one main reason in mind, liability. In this situation, the owners of the corporation would not be personally liable for any debts that the corporation is unable to pay. Additionally, the liability from any lawsuit would be contained only to the assets that you hold in that corporation. So in theory, if someone were to sue your LLC, they would not be able to come after any of your personal assets, such as your salary, home, car, etc. Incorporating does not mean that you will never be sued or that it is impossible to lose your personal assets. When the courts hold the owners personally liable for any business debts, this is known as “piercing the corporate veil.” Some instances where the corporate veil may be pierced is when there is no real separation between the company and owners (for instance, paying personal bills with business accounts) or the company is involved in fraudulent behavior. The ease at which a court can pierce the corporate veil varies by state, but you should be aware that it is never impossible for owners to be held personally liable.
Disadvantages to Incorporating
Incorporating is not free. If you are incorporated in the state of California, you will be paying an annual fee of $800. Even if you are operating out of Ventura County but incorporated in another state, there is still a fee that you have to pay to California, in addition to whatever fee the state you’re incorporated in charges. Depending on if you hire someone to set up your corporation or you do it yourself on the internet, you could be looking at a couple thousand dollars out of pocket. I am not saying that the expense is not worth it, but newer investors on a limited budget may feel that their money is better used on marketing or elsewhere until they start bringing in profit.
I don’t know if this is always the case or not, but some lenders will not give you a loan on a property you are trying to close under your corporation. In fact, we know of someone in this exact situation right now. They applied and were pre-approved for a loan on a home that they wanted to put under their corporation. When the bank received their paperwork with the company’s name all over it, the bank told them that they would not loan to a LLC and that they had to put it under their personal name if they wanted to continue. They did continue with the loan and put it in their personal names, but this defeats the purpose of the corporation, especially if a lawsuit were to happen and the court saw that the mortgage is tied to you and not your company.
Should you incorporate?
Although I have listed two disadvantages and only one advantage, I’m not saying that the cons of incorporating outweigh the pros. That one advantage is huge and can more than outweigh any disadvantages in many cases. Especially for those people who have assets and/or wealth that they would like to protect, incorporating might be a no-brainer. However, if you are an investor who is just starting out, incorporating might not be at the top of your priority list. Like a lot of things in life, this decision will depend on your situation. And remember, even if you don’t incorporate right away, that doesn’t mean that you can’t incorporate at some time in the future when you are ready.