Disclaimer: This article was initially written for Texas investors. Since business entities are regulated by state law, there are some differences between the states. This is especially true for LLCs – Limited Liability Companies and LPs – Limited Partnerships. Before making your final decision, please consult professionals with the knowledge of your state law.
Which entity is the best? This is second most frequently debated question when at least two investors get together. (The number one question, of course, is – where can I borrow more money?)
Ask a traditional CPA, and she will probably say – corporation. Ask a seasoned investor, and he will likely mention an LLC (Limited Liability Company), maybe an LP (Limited Partnership). Out-of-town crooked promoters will try to sell you Nevada entities. Who is right? My answer: none of the above. The only correct response should be the infamous “it depends” – which, by the way, includes an option to do nothing, no entity at all.
For those of you who are lazy to read the entire article, let me give you the rules of thumb right away, so you can make some fast (and possibly wrong) decisions.
- DBAs (Doing Business As) are totally harmless and almost useless. In fact, they are not business entities at all – just nicknames you can use for marketing.
- If you’re starting a big (say, at least half-million) project – you really should consult two specialists: a real estate lawyer and an investor-focused tax guy. This is especially true if you are bringing in partners.
- This is my favorite. If you’re a new investor looking for your first deal – forget about business entities. Do couple deals and make some money first.
- If you started making substantial money in flipping or wholesaling – form an LLC and ask a good tax guy whether your LLC should “elect” S-Corporation status.
- If you own some rentals – ask a good attorney about LLCs and Land Trusts: do you need them, and if yes – how many. Stay away from corporations.
- If you have a business partner other than your spouse, even if you are just starting – go see an attorney together, while you are still friends. Otherwise, you may not stay friends for long. Run your attorney’s recommendation by your tax guy, just in case.
Now, with these dangerous rules out of the way, let’s discuss whys and whats.
Who should you ask for advice on entities?
I already mentioned two people you will need: a lawyer and an accountant. (Well, that plus Dr. Phil or Oprah – pick one.) I suggest two professionals because creating business entities chases two main goals:
- Reducing legal liability (also known as asset protection)
- Reducing taxes
Attorneys specialize in one, and accountants specialize in the other. Unfortunately, these two goals sometimes conflict with each other, and you may have to bridge them.
How do I create a business entity in Texas?
You will need to fill out some forms with the State of Texas and pay some modest fees – typically between $300 and $800. Depending on your self-confidence and on how complex your setup is – you can try to do it on your own, use some online outfits, or (if you care about things being done right) – hire an attorney.
Either way, creating a company is no big deal. The problem is running the company as a business. Let me use an analogy. As some of us learned the hard way, saying “I do” was the easy part. What followed AFTER the vows required effort and was not always fun. Another example? Signing up at the Health Club. I wish somebody had warned me that actually losing weight requires way more work than paying monthly fees.
Who should you ask for advice on entities?
This is how a proper business entity operates:
- It has its own bank accounts, loans, and credit cards
- All business income and loans (rents, sale proceeds, commissions, draws) come into the company’s accounts
- All business expenses are paid from business accounts or charged on business-only credit
- Business cannot pay for any personal expenses of the owners
- Owners cannot personally pay for any business expenses or charge them on personal credit
- All money contributed and withdrawn by owners is strictly recorded
- Mixed use of automobiles, equipment, and home office requires diligent accounting
- All legal formalities, IRS reports, and Texas reports must be regularly done
Are you ready for all this hassle? Most investors are not. If you’re going to treat your company’s bank account as “just another account” of yours – then do not waste time and money setting up your business. You will have no legal protection and no tax benefits, only a mess.
What is the best entity for asset protection?
It’s a great question, but it is a legal question. Only an attorney can answer it, and I am not one. But before you make a lawyer appointment, let’s not forget that asset and liability protection involves much more than creating a business entity. In layman’s terms, here is some food for thought.
- You need protection in case you’re attacked. Minimize your chances of being attacked by running a clean business.
- Most problems are caused by people. Choose who you deal with. (This is a lesson that I myself learned the hard way.)
- Having partners always increases your risk and exposure to problems.
- Ask a good insurance agent about various kinds of insurance that can protect you.
- Many legal issues are regulated by state law. Use a local attorney.
- Expect to hear conflicting advice if you ask more than one lawyer. If you ask good lawyers, that is. If you ask bad ones, they will even contradict themselves. What can we do when our legal system is such a mess?
- Law changes often. What worked yesterday may not work today.
What is the best entity to save on taxes?
Ignore people who tell you that “business entities reduce taxes.” Not true. Yes, entities sometimes CAN reduce your taxes, but they can also increase them – if you pick a wrong one. And in many cases, entities make no difference for taxes – none at all.
DBAs
They are not entities and have nothing to do with taxes.
Land Trusts
They make no impact on taxes either, and they do not appear anywhere on your tax returns.
LLCs
LLC is the weird kid on the block. If a Texas LLC is owned by just you or by you and your spouse (called “single-member LLC”) – it will not change anything on your tax returns. The IRS calls such LLCs“disregarded entities” – meaning exactly what the name says: for the IRS, they do not exist. They still exist, however, for the Texas Franchise tax, so creating an LLC may expose you to this pesky tax.
If you co-own an LLC with somebody other than your spouse (called “multi-member LLC”) – your LLC becomes a partnership.
Partnerships
This group includes GPs – General Partnerships (avoid them!), LPs and FLPs – Limited and Family Limited Partnerships, and multi-member LLCs. Tax rules for partnerships are insanely complex, and you probably need professional help. In most cases, partnerships will not save you taxes.
Corporations
There are two variations, known as C-Corporation and S-Corporation. Warning: if your business is losing money, corporations can do more harm than good – stay away. Also, for a number of reasons, rental properties usually should not be owned by corporations, especially not by C-Corporations.
However, if your business is making a substantial profit, both types of corporations can provide you some tax savings. What is substantial? I would say, at least $20,000 net income, after all legitimate business deductions.
The price for these potential tax savings is increased complexity of running a corporation and extra bookkeeping, particularly with a C-Corporation. Don’t try it at home.
As you can see, getting tax benefits out of a business entity is no piece of cake. To summarize, this is our field of contestants:
- Neutral: DBAs, Land Trusts, single-member LLCs, simple partnerships
- Can help: corporations when your business is profitable, some complex partnerships
- Can hurt: corporations with rentals or unprofitable businesses, some complex partnerships
So – to be or not to be?
Nobody can tell you for certain – at least, not until they carefully review your specific situation. Short of that, I humbly propose this simplistic approach.
- Discuss legal protection with an attorney. If your attorney suggests tax-neutral entities, go with it. If she suggests an entity that can have tax consequences, run it by your accountant.
- Don’t set up anything for tax purposes until your business is running and you can make some realistic predictions of the near future.
- Bringing non-spouse partners requires some entity from get-go – which should be primarily an attorney’s call.
- Real large deals, such as new development or apartments, require an entity from the beginning – only here you should ask an accountant before a lawyer.
- There is nothing wrong with running a small operation without entities.
Good luck building your business!