Which Legal Entity Is Best for Real Estate Investors?

Michael Bjorn Huseby

Forming a legal entity to hold your real estate investments can protect you from liability, make your business more credible, and pave the way for growth. But what’s the best business type for real estate investments? 

What Types of Legal Entities Are There? 

Let’s take a quick tour through some of the most common legal entities. 

  • Sole proprietorships
  • General partnerships
  • C-corporations
  • S-corporations
  • Limited liability companies (LLCs)

How to Choose the Best Legal Entity for Real Estate

When deciding on a legal entity, you’ll want to consider the following factors:

  • Liability: Will you be held personally liable for business debts and obligations?
  • Taxation: How much money will you have to pay the government? 
  • Administration: Is the entity easy to set up? Is there a lot of paperwork? 
  • Fundraising: Can you take on investors and business partners?  

Now, let’s dive in.

Sole Proprietorships and General Partnerships — The Worst Legal Entities for Investors 

First up, we have sole proprietorships and general partnerships. These aren’t ideal for real estate investors because they don’t offer limited liability protection. 

Sole Proprietorships 

If you’re operating by yourself and don’t form a legal entity, you’re automatically a sole proprietor. In fact, a sole proprietorship isn’t really a legal entity at all — it’s just you doing business as yourself. 

While sole proprietorships don’t require filing fees or legal documents, sole proprietors face unlimited liability for the debts and obligations of the business. So, if someone gets injured on your rental property, the plaintiff (the person suing you) can reach all of your personal assets — your personal home, brokerage accounts, cash under the mattress, etc. 

General Partnerships 

This is like a sole proprietorship but with multiple people. No filing fees. No legal documents necessary. 

However, each partner in a general partnership is personally liable for the obligations of the partnership — even liabilities that the other partner incurs. So, if Partner A takes out a loan in the partnership’s name, Partner B is personally on the hook to pay back the loan. 

Advantages of Sole Proprietorships and General Partnerships 

  • Taxation: You’re only taxed once on your earnings.
  • Administration: No formation documents, filing fees, or government reports.

Disadvantages of Sole Proprietorships and General Partnerships 

  • Liability: You’re personally responsible for all business liabilities, debts, and obligations.

For serious real estate investors, there’s really no argument for a sole proprietorship or general partnership. Let’s move on. 

C-Corporations — Limited Liability With Double Taxation 

C-corporations are at the other end of the spectrum. Unlike a partnership or sole proprietorship, you need to file legal documents with the state to get a C-corporation up and running. You must also maintain corporate minutes and submit periodic filings to the state. We’ll dive into corporation formation in another article. 

The big benefit for corporations is limited liability protection — your liability is limited to your investment in the corporation. If someone injures themself on your property, they can seize the value of your property within the corporation — but that’s it. Your personal assets are safe and sound. 

Another benefit of C-corporations is the ease of raising capital. You can have unlimited stockholders, generally without restrictions on who can own your stock. Plus, you can issue multiple classes and types of stock, each with different rights and preferences. 

The downside of C-corporations is double taxation. The corporation itself is taxed as a legal entity. Then, shareholders (like you) are taxed again when the corporation distributes the profits to your personal account. 

Currently, the corporate tax rate in the United States is 21%. So, if your real estate business generates $100,000 in profit, the government takes $21,000, leaving you with $79,000. Assuming a 35% personal income tax bracket, you end up with $51,350 ($79,000 * 0.65) — much less than the $65,000 you’d have if you only had to pay personal income tax on the $100,000. 

Advantages of C-Corporations 

  • Liability: Shareholders aren’t personally liable for corporate debts and obligations (subject to limited exceptions). 
  • Fundraising: Unlimited stockholders and classes of stock. 

Disadvantages of C-Corporations 

  • Taxation: Shareholders in C-corporations are subject to double taxation. 
  • Administration: Corporations require formation documents, corporate minutes, and periodic government filings. 

While C-corporations offer limited liability and easy fundraising, double taxation makes them unattractive for most real estate investors. 

S-Corporations — A Great Option for Flippers 

Alright, now we’re getting to the good stuff. S-corporations are similar to C-corporations. To convert a C-corporation to an S-corporation, you must file an IRS Form 2553, which eliminates the double-taxation problem. With an S-corporation, you’re taxed only once on your business profits — this is called pass-through taxation. 

The tax benefits don’t end there. 

Individuals running active businesses (like house flipping) typically need to pay self-employment tax on their income. On the other hand, passive income (like rental income) is not subject to self-employment tax. Currently, the self-employment tax rate is 15.3%. 

With an S-corporation, so long as you pay yourself a “reasonable salary,” you can take the rest of the profits as dividends, which aren’t subject to self-employment tax. So, you’ll have to pay self-employment tax on your salary but not on the dividends, which can end up saving you a serious amount of money. 

While the tax advantages are great, S-corporations aren’t perfect. With limited exceptions, S-corporations can have a maximum of just 100 shareholders, each of whom is a US resident. Plus, S-corporations can have only one type of stock and can’t go public through an initial public offering. Plus, as with C-corporations, S-corporations require significant documentation and reporting. 

Advantages of S-Corporations 

  • Liability: Shareholders aren’t personally liable for corporate debts and obligations (subject to limited exceptions). 
  • Taxation: No double taxation. Plus, after paying a “reasonable salary,” owners can take the rest of their income as dividends (which aren’t subject to self-employment tax). 

Disadvantages of S-Corporations 

  • Fundraising: Limited types and number of stockholders and classes of stock. 
  • Administration: Corporations require formation documents, corporate minutes, and periodic government filings. 

S-corporations are perfect for flippers because of limited liability protection and tax advantages. However, for passive income from rental properties, limited liability companies are your best bet. 

Limited Liability Companies (LLCs) — Ideal for Rental Properties 

Limited liability companies — “LLCs” to the cool kids — offer a mix of pass-through taxation and limited liability protection. So, your risk is limited to your investment within the LLC. Plus, the IRS doesn’t typically tax the LLC itself, so you don’t have to deal with double taxation. If you want, you can elect to have your LLC taxed as a C-corporation, but pass-through taxation is better for holding rental properties. 

The LLC’s claim to fame is its customizability. Unlike corporations, which have structured rules about profits splitting, shareholding, and corporate governance, LLC owners (called “members”) enjoy greater flexibility. In the LLC’s operating agreement — the main internal governance document — members can craft their own rules regarding management, profits splitting, admitting new members, and more. For more info, check out my article on LLC operating agreements.

LLCs are also easier to set up than corporations and require fewer government filings. While it’s always better to respect the rules in your operating agreement and document the LLC’s decision making, LLCs aren’t quite as strict as corporations. 

While LLCs offer pass-through taxation (the opposite of double-taxation), income from active businesses is typically subject to self-employment tax. You can’t use the fancy strategy of paying yourself a reasonable salary and taking the rest as dividends like you can with an S-corporation. 

Therefore, an S-corporation might be better for flipping businesses. However, rental property income is treated as passive income not subject to self-employment tax, so an LLC works just fine. 

Finally, LLCs offer charging order protection, which we discussed in this article. While some states (like Nevada) have favorable charging order rules for S-corporations, they’re the exception. In most states, charging order protection is only available for LLCs. 

Advantages of LLCs

  • Liability: Members aren’t personally liable for corporate debts and obligations (subject to limited exceptions). Charging order protections safeguard your investment. 
  • Taxation: No double taxation. 
  • Fundraising: Flexible options for fundraising and profits distributions.
  • Administration: Relatively simple set-up process and limited ongoing documentation obligations. 

Disadvantages of LLCs

  • Taxation: Active income is subject to self-employment tax. 

Protect Your Real Estate Investment With a Legal Entity

Forming a legal entity for your real estate business is the first step in protecting your assets. While a variety of other options exist — such as trusts and limited partnerships — an S-corporation or LLC will work perfectly for most real estate investors. 

If you have any questions about choosing or forming a legal entity for your real estate business, please feel free to get in touch.