Choosing the Best Entity Structure for Tax Efficiency

For most people, selecting an entity type is primarily revolved around various issues like tax flexibility, asset protection, limited liability protection and ownership flexibility. However, what business owners may not realize is that the type of business structure they are forming can have an extremely harmful effect on their taxes if they do not plan ahead and discuss with a tax professional beforehand.

Below are a few types of real estate business types, and we will discuss the best entity structure based on the facts and circumstances of each.

Developers for Resale

As a Developer for resale, the main focus will be on building and managing the construction of real estate property with the intention of selling the property after construction is completed. As a result, this would fall under the category of an Ordinary Trade or Business, filing on page 1 of the tax return. Generally speaking, an S Corporation is the best entity choice for a developer for resale due to the following:

• Developer owners often face significant self-employment tax challenges as all their activity is reported as Ordinary income. General Partners in a Partnership are typically subject to SE taxes on generated Ordinary income. In contrast, S Corp Ordinary income is exempt from self-employment taxes. However, S Corps lack the flexibility of special allocations as profits must be allocated and distributed according to Shareholder ownership. S Corps are also required to pay their shareholders that actively participate in the business a reasonable salary, whereas partnerships are not allowed to pay wages to their shareholders.

Owners/Operators

Operators aim to operate a profitable rental business, making entity choice crucial for exit strategies, whether operating multiple properties or a single one. In most cases, a Partnership is the most beneficial entity type due to various factors:

• A common issue arises when S Corp debt does not provide Shareholders with debt basis, unlike in a Partnership. This can lead to suspended losses for Shareholders unless sufficient capital is contributed or the Corporation has enough cumulative income to establish tax basis. In certain cases, these losses may remain suspended until the related property is sold or disposed of.
• For property distributions to a S Corp Shareholder, the distribution becomes a taxable event based on the FMV at the time of distribution (as if it were sold to the Shareholder), leaving the Corporation (and its Shareholders) with a potentially large tax bill and no cash to pay it with.
• For inheritance purposes, a decedent of a S Corp Shareholder would not receive a step up to in the basis of the property at time of death; only a step up to the S Corp stock. Resulting in a potentially large tax bill should their loved ones sell the property at FMV upon inheritance.
• As mentioned above, an S Corp is very limited in allocation flexibility as well as ownership class and other recapitalization options. Therefore, if the expectation is to have multiple classes of ownership and/or promote interests, a Partnership is the only option.
• Finally, rental income is not subject to self-employment taxes, meaning an S Corp provides no advantages against a partnership.

Investment Funds

Forming a real estate entity is often driven by investment goals. Income/loss as an investment fund is reported on Schedule K, with investment expenses currently nondeductible for individuals due to the TCJA. Property sales are taxed at the capital gains rate, typically lower than the ordinary tax rate. Hence, investment entities are commonly structured as Partnerships for optimal tax treatment. Some key considerations include:

• Investment Funds commonly feature complex capital structures, including options for carried interest/promote members. S Corps cannot easily accommodate these structures due to restrictions on non-prorated income allocations and distributions. In contrast, Partnerships are well-suited for implementing such arrangements.
• The exit strategy is likely a top priority, especially if potential distributions of property are desired later in the future. Similar to property managers, any distributions to Partners through a Partnership are a non-taxable event for the Partnership.
• Since investment income is not taxed as Ordinary income, it is not subject to self-employment taxes.

If you are setting up a new business, contact a Weaver tax professional to ensure you have the most efficient tax structure possible. We’re here to help.

Authored by Chris Andrews, David Nolan, Aaron Grisz and Brad Weltens

©2024