Limited Liability Companies, better known as LLCs, are the most common business entity, especially in Real Estate. Many LLC are owned by a single person or by a married couple – which, in the community property states like Texas, are considered a single owner. Typically, such single-member LLCs are treated by the IRS as “disregarded entities.” Strangely, it means exactly what it sounds like: the IRS completely ignores such LLCs and does not want any tax returns from these disregarded entities. Instead, all income and expenses from single-member LLCs are reported on the owners’ personal tax returns, as if there was no LLC at all.
Yet, some LLCs do file a separate tax return. We will discuss the 7 reasons why you may decide to do so.
1. Professional appearance
Just that: appearance. Ironically, this is the most common reason to file a separate tax return for an LLC. Somehow, to some people it just feels more serious and proper to isolate all LLC numbers on a different tax return. However, there is no substance here, just a prettier packaging. You can sense that I’m not a big fan of this superficial thinking.
2. Multiple owners
Now, this one is a completely valid reason. The only type of LLCs that can be disregarded by the IRS are single-member LLCs, including husband-and-wife LLCs. If you own LLC together with somebody other than your spouse, then it is a multi-member LLC, and it must file a separate tax return. Usually, it should file a partnership tax return, unless you specifically elected to be treated as a corporation.
3. Financing considerations
Your lender may request that you file a separate tax return for your business, on order to qualify for a loan. This is fine, just keep in mind that you’re doing this strictly to please your lender and for no other reason. There are no rules here, and whatever rules exist – they change all the time. A different lender (or even the same lender at a later time) may have different requirements. This is how lending works.
4. Financial aid eligibility
When you or your kids apply for financial aid, reporting your business separately can sometimes make a difference in your eligibility. Especially when we’re talking about rental properties. Financial aid is not my area of expertise, so make sure to consult a specialist. Just remember that it may matter.
5. Asset protection
Liability protection is the most common reason to create an LLC, in the first place. Some attorneys believe that filing a separate tax return is essential to ensure you do have proper legal protection. Maddeningly, there is never a consensus when it comes to attorneys. They never agree of anything, and I’m in no position to decide which one of them is correct. If your attorney tells you that your LLC needs a separate tax return, so be it.
6. IRS audit risk
I hear this argument very often: partnerships and corporations have lower risk of an IRS audit, compared to personal tax return, percentage-wise. Yes, it is true. The question is: is it an important enough concern to justify the extra hassle and cost of filing a separate tax return? I am not sure that it is. No matter what you do, you always have some chance of getting audited by the IRS. Unless your numbers are out of the ordinary in some way, the odds of being audited are pretty low. Reducing an already low risk to an even lower risk would be a good idea – if it did not involve more work and more cost. You decide.
7. Tax savings
Finally! Who does not want to pay less taxes! For some reason, it is widely assumed that LLCs provide more tax deductions and more loopholes than a personal tax return. Wrong! There’re no new deductions just because you organized your business as an LLC. Whatever you can deduct with an LLC you could also deduct without LLC.
Am I saying that real estate investors cannot save on taxes with LLCs? I am not saying that. LLCs can provide tax savings under some specific situations, and these situations should be evaluated case-by-case by a competent tax professional. As a rule, LLCs cannot save money to landlords. Savings are possible for highly profitable builders, rehabbers, flippers and wholesalers. What do I call highly profitable? Let’s say those who make at least $50k net profit, after deducting all business expenses. If you reached this level of profitability, we need to talk, because the tax savings do not happen automatically. We will need to do some paperwork and establish new processes.
Thanks Michael. This is very helpful information. I’ve some of these questions in my head. My husband and I have our rentals owned by an LLC.
I meant to type “I’ve had some of these questions in my head.”