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Starting a real estate investing business can be an exciting and challenging adventure. One of the first things you’ll need to do is to register your business as an entity. The type of entity you register your business as will impact your tax classification, personal liability, how the company is run, and other rules and regulations. In this article, we will address the pros and cons of 10 common types of business entities so that you can decide which one is the most applicable for your real estate business.
What is a business entity?
A business entity is the way the state government recognizes and structures different businesses for tax purposes, and choosing the right one will help maximize the financial and operational success of your business.
What are the different types of business entities?
In this guide, we’ll cover the most common business entities. These are:
- Limited Liability Company
- Limited Partnership
- General Partnership
- Joint Ventures
- Statutory Trust
- Common-Law Trust
- Sole Proprietor/Natural Person
Once you understand the basic principles of each business entity and how they impact different aspects of your business, you’ll be able to determine which one works best for your real estate investing business.
Corporations: The four different types
Before you dive into the differences between limited liability companies and sole proprietors and all of the other business entities, you should have a basic understanding of the four types of corporations under which these entities fall.
By definition, a corporation is “a legal entity that is separate and distinct from its owners.” Corporations have most of the same rights and responsibilities as individuals. They loan and borrow money, pay taxes, generate income, pay employees, and own assets.
Limited Liability Company (LLC)
An LLC is a Limited Liability Company. An LLC, is considered a corporation if the LLC owners elect to be treated as a C or S corporation for taxation purposes. Owners of an LLC are not personally liable for their company’s debts and liabilities. It combines the elements of a sole proprietorship and a corporation in a way that reduces risk for the owners.
If something happens to an LLC, like a lawsuit, the owners of the business do not risk losing their homes or their personal assets. If the LLC files for bankruptcy, the owners are not responsible for paying the company’s debts. An LLC is a popular option for companies that face a reasonable risk of lawsuits or where accumulating significant business debt is a genuine possibility.
An LLC does not pay income tax. Instead, the owners list all of the profits and losses of the business on their personal tax returns.
Pros of LLCs
- Individuals aren’t personally responsible for the actions of the company
- Profits go right to members without being taxed by the government
- Simple to start up
Cons of LLCs
- Subject to self-employment tax
- LLC must be dissolved if a member leaves, dies, or goes bankrupt
An S corporation is known as a pass-through business entity, similar to the LLC. However, an S Corp has some advantages that an LLC does not. For example, stock in an S Corp is easily transferable.
Similar to an LLC, an S Corp keeps your personal and business assets separate, does not require you to pay federal taxes, and gives you multiple options for how you characterize your income. In an S Corporation, owners receive a salary and receive dividends from any profits the company makes instead of reporting all income and expenses on their personal tax return.
Pros of S Corps
- Allows owners to write off most start-up losses
- Offers liability protection
Cons of S Corps
- Requires hosting regular meetings and maintaining company minutes
- The pass-through tax set up and the limit on shareholders could deter some investors
C Corporations are typically better for larger businesses that publicly trade their shares. Many large companies in the United States are structured this way; however, a C Corp could be owned by just one person. This type of corporation allows individuals to bring their resources together for a common purpose, and the risk is limited only to the stock that they own in the company. Generally, if you own a C Corp, you are protected from being liable for any of the business’s debts or liabilities. A C Corp is a popular option for corporations that want to attract investors because it allows a wide range of ownership. The fluidity of ownership is another benefit to a C Corp.
Pros of C Corps
- Does not dissolve if the owner leaves/dies
- No limit to number of shareholders
Cons of C Corps
- Subject to double taxation
- Must have a board of directors, hold regular meetings, keep minutes, register with the Securities and Exchange Commission, and create a set of bylaws and articles of incorporation
The purpose of a nonprofit is to make money that benefits another organization or cause. It donates revenue to a specific goal for the benefit of the public instead of distributing it to its owners or investors as a salary.
Any of the money a nonprofit makes has to go back into the company, whether that’s by paying employees or paying overhead costs. Nonprofits aren’t owned by a single individual or group, and any assets sold from a nonprofit must benefit the whole organization rather than an individual. Common nonprofits include schools, museums, churches, and homeless shelters. Within the umbrella of nonprofits, there are specific categories including public charities, foundations, and trade organizations.
Pros of Nonprofits
- Extensive tax deductions/exemptions
- Eligible for public grants
- Members are not responsible for the company’s debts
Cons of Nonprofits
- Can be costly to start
- Required to keep detailed records to maintain its exemption status
- Limited personal control
When two or more people go into business together, it is a partnership. But not all partnerships are created equal. There are three different types of partnership: general partnerships, limited partnerships, and joint ventures. In all types of partnership, every individual is responsible for contributing to the cause, whether it’s through time, money, or resources. The difference between the different partnerships comes down to who is responsible for investing what, and who is responsible for the company’s liabilities.
Limited Partnerships are common for investment businesses such as real estate. This type of partnership is different from the others because some individuals in the partnership are only responsible for liabilities up to the amount that they invested. In an LLC, the general partners are responsible for all financial aspects of the business, including managing debts and handling any liabilities and litigations. The other contributors, known as the limited partners, can invest money but don’t have the same managerial decision-making power that the general partners do. There is a definitive hierarchy in this type of partnership, giving more decision-making power and responsibility to certain partners while limiting others.
Many entrepreneurs who are getting started in real estate investing choose to work through a limited partnership. This allows them to invest their own money, work with a general partner who typically has more experience and capital than they do, and learn the ropes of investing while reducing their risk.
A real estate limited partnership, or RELP, is a type of limited partnership entity that focuses on buying, selling, and investing in real estate. This usually looks like a general partner who has extensive experience in real estate development or property management, along with limited partners. These limited partners are only liable up to the amount of money they invest in the property while the general partners assume all liability for the business. The general partner may use the money contributed by the limited investors to buy and sell property, along with a hard money loan.
Pros of Limited Partnerships
- Easy to form and operate
- Investors can profit from the business without actually being involved in the day to day decision making of the business. This gives business owners more control.
- Reduced turnover. Limited partners can leave or be replaced without terminating the partnership.
Cons of Limited Partnerships
- Limited partners have limited say in day to day decision making within the business
- Required to hold annual meetings and create a specific partnership agreement.
A general partnership is when all partners are created equal. Everyone who invests in the business shares in the profits and the decision-making responsibilities and everyone is responsible for the business debts equally.
Pros of General Partnerships
- Simplified taxes. Owners deduct most of the businesses losses on their personal tax returns.
- Less paperwork to start. No annual meetings or formal paperwork required.
- Since all partners have equal say in the business, they also divided the risk and the losses so it’s not all on one person.
Cons of General Partnerships
- When all partners have equal power, it can be difficult to compromise, come to a consensus, or agree on every business decision.
- There isn’t a separate business entity between the partners.
- Every partner is responsible for the actions of the other, even if they don’t agree or participate in the decision.
A joint venture is when two different businesses come together and combine their different skill sets and resources to reach a similar goal. In a joint venture, both partners agree to split the profit in a specific ratio for the duration of their partnership. It also allows for a diversification of a business line and establishes new relationships between businesses.
Pros of Joint Venture
- Doesn’t require a long-term commitment.
- Risk and reward are shared between the companies.
- Pooled resources, insights, experience and expertise.
Cons of Joint Venture
- Contracts can be hard to break, making it challenging to leave the partnership if things aren’t going well.
- Management styles and work cultures can clash, making it difficult to work together.
- Reduced flexibility.
A trust is an arrangement that allows a trustee to acquire assets on behalf of someone else, usually the beneficiary. Trusts often avoid probate, which means beneficiaries can gain access to the specific assets easier than they could if they were transferring the assets using a will. In businesses, there are two main types of trusts:
In a statutory trust, the trustee holds real property and has the intention to sell it. All the profits that come from the rent or sale of the property go into the trust. Then, these profits are paid to the benefactors of the trust. This is a popular option for businesses because all the internal affairs of the trust are carefully regulated, and they are inexpensive and straightforward to form. Statutory trusts are separate from the individual who opens them, which means even if the trust holder dies or becomes incapacitated, the trust will continue to exist.
Pros of Statutory Trusts
- Capital gains from the sale of your property can be deferred.
- Can be a very efficient and practical form of fractional ownership when it comes to real estate.
Cons of Statutory Trusts
- This is a long-term commitment. Often, individuals can expect to wait 7 to 10 years before gaining access to cash.
- Structure requires a significant release of control from investors.
The rules and regulations regarding a common-law trust are different depending on the state. Everyone involved in the trust can legally sue or be sued for violation of the common law trust agreement, but they have to do so using their own name. In this type of trust, the owners of a property or business all hold legal title to the property and manage the affairs. The specifics of this type of trust are derived from a common-law agreement instead of statutory law.
Pros of Common-Law Trusts
- You can keep the common law trust and your personal social security number separate.
- Common law trusts are created without the help and resources of public officials.
- Not as closely federally-regulated as a statutory trust.
Cons of Common-Law Trusts
- Can require multiple steps to set up.
Sole proprietor/Natural person
This is arguably the simplest and most common structure for those deciding to start a business. A sole proprietorship is owned and run by one person, and there is no distinction between the business and the owner. As the owner, you are entitled to all the profits and are responsible for all of the debts, losses, and risks associated with the business. There aren’t very many steps to form a sole proprietorship, because as long as you’re the only one who owns the business, this category is automatically applied to your business. However, you do have to have the necessary licenses, permits, and documentation to run a business as a sole proprietorship.
While the benefits of this type of business entity are that they are easy and inexpensive to start and give you complete control of your business, there are also risks involved. Because you are the sole owner and manager of the company, you are ultimately responsible for the success of your business. It can also be hard to raise money for this type of business entity, and because there’s no separation between you and the company, if the business is sued, it means you are sued.
Traditional lenders tend to be hesitant to loan money to sole proprietors because of their perceived lack of credibility. Traditional banks may see a sole proprietor’s unlimited liability as a risk, and can make it harder for this type of business entity to secure a traditional loan. Real estate investors may have to get creative when it comes to financing their property investments when they categorize their business as a sole proprietorship.
Pros of Sole Proprietorship
- Most business losses can be deducted on your personal tax return.
- If you’re the only owner of your business, you’re automatically registered as a sole proprietorship. No separate registration required.
- Not required to hold annual meetings or complete formal paperwork.
Cons of Sole Proprietorship
- Can be difficult to finance and qualify for a business loan.
- Building business credit can be challenging.
- As the single owner, you benefit from all of the gains but also put yourself at risk for all of the losses. If you are sued, your car, your house, and other personal assets could be at risk.
Choosing the right entity for you
Start by asking some of the following questions to get a clearer picture of your short-term and long-term goals.
- Will you be a solo leader and decision-maker with a few employees? Or will you be taking on partners and investors?
- How will you raise capital for your business?
- How large do you want your business to grow?
- Will you be bringing in shareholders and issuing stock to them? If not, are you open to that in the future?
Generally, a sole proprietorship and a general partnership are great for companies that are just starting out. When a business begins to generate more income and grow, registering as an LLC or a corporation may make more sense. Some other things to consider when characterizing your business include:
In the event that your company faces a lawsuit, you want to be sure your personal assets are protected. If you do business as a LLC, C Corporation, or S Corporation, your assets (car, house, etc.) will not be at risk. However, since there is no distinction between you and your business when you do business as a general partnership or sole proprietor, your assets aren’t protected.
If you’re running a C-Corporation, the money your company makes will be taxed from the state and the federal government. However, an issue many C-Corps run into is that their personal income is also taxed. This is referred to as double taxation. LLCs and S-Corps avoid this by being classified as a pass-through entity. Instead of both the owner and the corporation being taxed, it is just the income generated by the owners and investors that is subject to taxation.
Another thing to consider is self-employment tax. LLC owners will have their salaries taxed, and S-corp owners will be subject to self-employment taxes on all of the profits they bring home.
Some business entries require very little to form and get started, while others must follow a strict set of rules to remain compliant with the federal government. With a sole proprietorship, as long as you’re the only owner, you are automatically classified as such. There aren’t any formal meetings to hold or special papers to fill out. However, you still have to register.
All other business entities must follow specific guidelines to be recognized. LLCs, S-Corps, and C-Corps have to abide by a particular set of rules to protect their limited liability status. Some businesses are required to hold annual meetings and develop and submit formal contracts and agreements.
Ability to raise capital
The goal of any small business owner or entrepreneur is to raise enough capital to finance and fund their business. It can be challenging to raise capital for a partnership because there are so many rules and regulations regarding raising capital for this type of entity. While S-Corps have much more freedom and flexibility when it comes to raising money, the law limiting shareholders to 100 for a C-corp can make this process more challenging.
Separation between ownership and management
Liability is a big deal when it comes to running a business. The business entity you choose will determine who is responsible for what when it comes to risks and losses that the company may face.
There is a clear distinction in ownership and management in entities like corporations, LLCs, and limited partnerships. But owners doing business as a sole proprietorship or general partnerships assume all the risk. This means if the company is sued, they are being sued. Their homes, cars, and assets could all be at risk.
How to register your business with government entities
In order for your business to be formally recognized by the government, you will have to register as a business entity with your state. The only business entity that does not have to register with the state is a sole proprietorship, however they must still obtain the appropriate licenses and permits to do business.
If your business provides goods or services across state lines, you’ll have to register in both states. You will register as a “domestic entity” in the first state and a “foreign entity” in any additional states. In most cases, you’ll only need to register at the state level, not necessarily at the federal or local level.
For your convenience, below are your state’s Secretary of State websites and phone numbers so you can take the first step toward registering your business entity:
1. Alabama Secretary of State, 334-242-7200
2. Alaska Secretary of State, 907-465-2530
3. Arizona Secretary of State, 602-542-3230
4. Arkansas Secretary of State, 501-682-1010
5. California Secretary of State, 916-653-3795
6. Colorado Secretary of State, 303-894-2251
7. Connecticut Secretary of State, 203-566-3216
8. Delaware Secretary of State, 302-739-4111
9. District of Columbia Secretary of State, 202-727-7278
10. Florida Secretary of State, 904-488-9000
11. Georgia Secretary of State, 404-656-2817
12. Guam Government Site, 671-472-7679
13. Hawaii Secretary of State, 808-586-2727
14. Idaho Secretary of State, 208-334-2300
15. Illinois Secretary of State, 217-782-7880
16. Indiana Secretary of State, 317-232-6576
17. Iowa Secretary of State, 515-281-5204
18. Kansas Secretary of State, 913-296-2236
19. Kentucky Secretary of State, 502-564-2848
20. Louisiana Secretary of State, 504-925-4704
21. Maine Secretary of State, 207-287-3676
22. Maryland Secretary of State, 410-225-1330
23. Massachusetts Secretary of State, 617-727-9640
24. Michigan Secretary of State, 517-334-6206
25. Minnesota Secretary of State, 612-296-2803
26. Mississippi Secretary of State, 601-359-1333
27. Missouri Secretary of State, 314-751-1310
28. Montana Secretary of State, 406-444-3665
29. Nebraska Secretary of State, 402-471-4079
30. Nevada Secretary of State, 702-687-5203
31. New Hampshire Secretary of State, 603-271-3242
32. New Jersey Secretary of State, 609-530-6400
33. New Mexico Secretary of State, 505-827-4508
34. New York Secretary of State, 518-474-4752
35. North Carolina Secretary of State, 919-733-4201
36. North Dakota Secretary of State, 701-328-4284
37. Ohio Secretary of State, 614-466-3910
38. Oklahoma Secretary of State, 405-521-3911
39. Oregon Secretary of State, 503-986-2200
40. Pennsylvania Secretary of State, 717-787-1057
41. Puerto Rico Secretary of State, 787-722-2121
42. Rhode Island Secretary of State, 401-277-2357
43. South Carolina Secretary of State, 803-734-2158
44. South Dakota Secretary of State, 605-773-4845
45. Tennessee Secretary of State, 615-741-2286
46. Texas Secretary of State, 512-463-5555
47. Utah Secretary of State, 801-530-4849
48. Vermont Secretary of State, 802-828-2386
49. Virgin Islands Secretary of State, 340-776-8515
50. Virginia Secretary of State, 804-371-9141
51. Washington Secretary of State, 360-725-0377
52. West Virginia Secretary of State, 304-558-8000
53. Wisconsin Secretary of State, 608-266-3590
54. Wyoming Secretary of State, 307-777-7311
Once you’ve decided which business entity makes the most sense for your new adventure, you can move onto financing it. For easy financing, choose LendingHome. LendingHome offers fix-and-flip bridge loans and rental loans with low rates, top tier technology, a supportive team, and an unbeatable, easy process.
LendingHome can help you grow your business today! Get a rate.
Disclaimer: The above is provided for informational purposes only and should not be considered tax, savings, financial, or legal advice. All information shown here is for illustrative purpose only. All views and opinions expressed in this post belong to the author. NMLS ID: 1125207 Terms, Privacy, and Disclosures. Copyright LendingHome Corporation 2020.