Discussion:As a CPA, can I recommend a business structure for a client?

Here's part 1 re: real estate holdings...Entity choice is probably the hottest on-going topic on a tax-pro board that I’m part of. Doing it well isn’t very exciting, but doing it wrong can be catastrophic. Figuring that some of you are normal people like those who write in for advice, recapping some of the issues here might be useful. Let me cover rental property quickly, and then move onto business. Rental has only recently gotten onto the entity radar screen for good reason. First, never ever ever under any circumstances of any kind do you want real estate inside a corp (unless it’s been there and we’re just waiting to get it back out). And since partnerships provided no legal protection, that topic was over—you owned rentals personally, no options. With the advent of the LLC in recent years, in most states, it makes sense to hold rental property in an LLC. Unless there are partners involved, it’s still just included in the personal tax filing as usual, so you get legal protection for low cost. With multiple LLC’s, in IL and a couple other states, there can be a parent LLC and sub LLC’s. The downside is that each must have its own checking account. After 2 or 3 rentals, no way anyone wants to keep that many checkbooks.

Now for business. This is a complex area and choosing wrong can haunt you and cost you big, for a really long time. Many websites now tout the LLC for everyone, but they’re creating ‘opportunities’ (read that as billings) for accountants and attorneys to straighten up the mess. There are three basic types of business: sole props, LLC’s, and corps. And there are two types of corps. When a one-person business is getting started, it’s almost always as a sole prop. I wave my pencil over the phone and *poof* you’re in business. Unless there are employees or sales taxes to collect, there’s nothing to register for, forms to fill out, filings to make or pay for. Many businesses remain in this mode forever, unless the earnings of the business make incorporating a good tax move. More and more often, just as with rental property going into an LLC for protection purposes, sole proprietors can and perhaps should be single-member LLC’s, which changes nothing for tax filings, but provides that extra layer of legal security. They’re still considered sole props for tax purposes. Simple.

As a business grows in profits, where the salary that the owner would take is less than the SS ceiling (currently 90k+) and there’s still profit after that salary, a lot of savings can be had by incorporating, specifically as an S corp. If you’re earning 70k per year, and a reasonable salary is 50k, then you’d save 20k * 15.3% in SS taxes each year, or over $3000. It probably costs $1000 per year to have the corp with added filing costs and fees, but you’re ahead of the game, and can take those savings and drop them into an IRA or SEP and get a deduction for that as well. That’s really using tax law in your favor. The higher the profit, or the lower the required salary, the better the results.

Additionally, S corps pay tax once, nearly all at the personal level. There are still some C corps around. While these are best used for large companies with many shareholders, they can be effective where a sole worker/shareholder has excessive medical costs, which can be deducted by the C corp. But there are pains and pitfalls in the C like nowhere else.

LLC’s are a new breed, still. Technically, IRS doesn’t recognize them, but defaults them as partnerships unless another choice is made. For reasons too complex to go into, an LLC should only be taxed as a partnership (or disregarded as a sole prop or Sch. E rental). LLC’s offer some flexibility that we can’t have in a corp structure with more than one owner. For example, if one owner brings the money, and the other will work the business, a corp structure can’t work without creating tax initially. So the LLC is the only choice. We can have different cash ownership, and split profits however we like. And some new techniques are giving the LLC the same opportunities to cut SS taxes as the S Corp, by creating two classes of partnership interest, an active interest and a limited interest. The limited interest is not subject to SE tax, while the active or general interest is. So we set the active interest at the level of a reasonable salary, and save the SS taxes on the limited interest. Some extra legal work is needed to make this bulletproof.

That’s the big pic. Where a partner comes to play, the conversation gets more complicated, and I touched on that a bit in the Sept 06 newsletter. But best to meet on that anyway.

I figure it's my job to explain options and give my opinion on what I think is the best choice for my client according to his or her goals. My opinion is why they pay me the big bucks.

Actually, unless we hold a gun to their heads (and I hardly ever do that), the client ultimately decides, and the client has to live with the decision. Like I said, we just report the news.

Perhaps realizing that you are not responsible for the decisions of your clients will alleviate some of your angst.

I don't think any of us were comfortable with this type of discussion from only the preparation for passing an exam for a license.

FLAcct - do a comparison of local rental rates and have the business pay toward the low end of that range. Be sure to document the rates. Don't forget that Common Area Maintenance is exempt from sales tax and have the tenant pay as many expenses as possibile (utilities, janitor, insurance, RE taxes) to keep the rent as low as possible.