The S-Corporation Tax Loophole by Austin Hendrickson
Tax season is drawing to a close, however it is never too late to learn some tax tips that may be helpful in 2018 and going forward. I work with a variety of investors, developers, landlords, flippers and other types of real estate professionals. If they are a new client and we are doing their return for the first time we usually find numerous mistakes because either they were trying to do it themselves or they had a previous CPA who did not specialize in or understand real estate. In this blog I will cover one topic all real estate investors should understand – the S-Corporation.
One big thing that investors who are flipping should think about is setting up an S-Corp to do flips in. Flipping is normally subject to a self-employment (SE) tax of 15.3% on all profits earned. SE tax is just a form of payroll taxes. Payroll taxes are charged on all W-2 wages at 15.3%, except employers pay half of it. So, the next time you see Social Security and Medicare coming out of your paycheck that is your half (7.65%) of payroll taxes. The reason for SE tax is that the government still wants its payroll taxes, regardless of whether you made it working a day job or flipping houses. If an investor reports flips in a single member LLC (SMLLC) or a partnership, then all the profit is subject to the SE tax in addition to federal and state income taxes. However, S-Corporation profit is exempt from SE tax, it is a loophole in the tax code that every single real estate investor should know about. The loophole may get closed at some point in the future as it should not make a difference if flips are done in an S-Corp or Partnership, however investors would be wise to take advantage of the benefit while it exists. S-Corporations do require a “reasonable salary” where SE tax would be paid on the wages, but this could be as low as 10% of the profits depending how much income is made. If flip profits start to climb then the tax impact of the entity structure can be enormous. On a side note the general rule is to always have buy and hold real estate in a partnership and to only have real estate that will be flipped in an S-Corp, for reasons that are outside the scope of this blog. It is highly recommended to sit down with a CPA before creating any legal entity to discuss your goals and see which entity structure fits your needs best.