Determining the proper entity structure can be complex. Any discussions surrounding entity structure should involve your accountant as well as an attorney. We will provide an overall discussion on some of the pros and cons of the various structures provided to investors.
A foreign investor may acquire real estate individually. This requires minimal set up and allows for reduced tax and compliance issues. However, even though owning real estate individually is easy to maintain, it does not offer the legal protection that other structures offer, such as a limited liability company. We will discuss this structure in greater detail shortly.
S corporations are corporations that elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders of S corporations report the flow-through of income and losses on their personal tax returns and are assessed tax at their individual income tax rates. This allows S corporations to avoid double taxation on the corporate income.
However, nonresident aliens are not allowed to be shareholders in S Corporations. In addition, S Corporations typically do not offer any special tax advantages to real estate investors.
For federal income tax purposes, a C corporation is recognized as a separate taxpaying entity. The profit of a C corporation is taxed to the corporation when earned, and then is taxed to the shareholders when distributed as dividends. This creates a double tax. The corporation does not get a tax deduction when it distributes dividends to shareholders. In addition, shareholders cannot deduct any loss of the corporation.
For US citizens a C Corporation is rarely a good option for rental real estate unless the taxpayer is a dealer. But for nonresidents, a C Corporation can be good if there are concerns over estate and gift taxes. This is a discussion you will have to have with your tax advisor.
A partnership is the relationship existing between two or more persons who join to carry on a trade or business. A partnership must file an annual information return to report the income, deductions, gains, losses, etc., from its operations, but it does not pay income tax. Instead, it “passes through” any profits or losses to its partners. Each partner includes his or her share of the partnership’s income or loss on his or her tax return.
Partnerships are very flexible entities and are often used for real estate activities. If you are pooling your funds together with other partners then this would be the filing option for you.
Like other entities, foreign corporations can be taxed on a gross or net basis. However, if they make an election to be taxed on a net basis they will generally be subject to the branch profits tax (BPT). This tax is calculated as 30% of the “dividend equivalent amount” unless calculated differently or excluded based on a tax treaty. In addition to BPT, the entity will have to pay normal income tax. The result is an incredibly high effective tax rate that will often exceed 50%. Accordingly, this tax structure is often not recommended.
The main advantage to owning real estate through a foreign corporation is that it will allow you to bypass US estate tax. The US estate tax is based on individual non-resident ownership of US assets, but in this case the assets are directly owned by a foreign corporation. The ownership of the foreign corporation shares by the individual does not constitute US property. Upon a nonresident’s death, the foreign shares are merely passed to the heirs outside of US estate tax.
Limited Liability Companies (LLCs)
A limited liability company (“LLC”) is a business entity organized in the United States under state law. It is a hybrid type of legal structure that provides the limited liability features of a corporation and the tax efficiencies and operational flexibility of a partnership. LLCs are almost universally preferred for holding investment real estate, having replaced the limited partnership as the entity of choice.
Owners of an LLC are called members. Since most states do not restrict ownership, members may include individuals, corporations, other LLCs and foreign entities. There is no maximum number of members. Most states also permit “single member” LLCs, those having only one owner.
In general, members are protected from personal liability for business decisions or actions of the LLC. This means that if the LLC incurs debt or is sued, members’ personal assets are usually exempt. This is similar to the liability protections afforded to shareholders of a corporation. Keep in mind that limited liability means “limited” liability – members are not necessarily shielded from wrongful acts.
The federal government does not recognize an LLC as a classification for federal tax purposes. An LLC business entity must file a corporation, partnership or sole proprietorship tax return. A business with at least 2 members can choose to be classified as a corporation or a partnership, and a business entity with a single member can choose to be classified as either an association taxable as a corporation or disregarded as an entity separate from its owner, a “disregarded entity.”