Should You Create an LLC for a Rental Property?

A limited liability company (LLC) is a popular business structure for all types of entrepreneurs, including rental property owners. One reason is that an LLC offers personal liability protection for owners, who are called members in the case of an LLC. 

But LLCs also offer several other advantages for the business owner, as detailed in this handy guide, to help you make an informed decision.   

What Is an LLC?

An LLC is a popular business structure for startup companies due to its many benefits. First, an LLC provides you with personal liability protection, as mentioned above, so that your assets are not at risk if your business is sued or cannot pay its debts. 

Also, an LLC is a “pass-through entity” in taxes, meaning that the LLC itself is not taxed. Instead, income passes through the company to the members, who report it on their tax returns. LLCs also offer flexibility in management, as there are few requirements regarding organizational structure. 

Know the Risks of Owning a Rental Property

Owning rental property comes with risks, so you should consider forming an LLC to protect your assets. These risks include:

• Injuries to tenants, their visitors, or others 
• Disputes regarding rent or security deposits
• Disputes regarding the condition of the property
• Issues with the purchase of a property

Any of those situations could lead to legal action and incur damages. If you run your rental property business as a sole proprietorship, you and the business are legally the same, which puts your assets, including your home, at risk.

An LLC offers personal liability protection, so the only assets at risk are those of the LLC.

Other Benefits of an LLC

An LLC offers many other benefits that make it a good choice for your rental property business.

1. Simplicity of Administration

LLCs are easier and less expensive to form than a corporation. Unlike corporations, LLCs are not required to have a board of directors or hold annual meetings. LLCs do, in most states, have to file annual reports. Corporations are more complex.

2. Control

In an LLC, the members do not have to answer to anyone. They ultimately control the company and can structure the management in any way they choose. In a corporation, on the other hand, managers answer to the board of directors, which has overriding decision-making power. 

3. Taxes

As mentioned above, LLCs are pass-through entities, which means income passes through to the member or members. If the LLC has only one member, it’s taxed as a sole proprietorship. If the LLC has more than one member, it’s taxed as a partnership. 

However, LLCs are unique because they can elect to be taxed as a corporation if the members decide it makes financial sense. This is done by filing an election form with the IRS. In addition, you can choose to be taxed as a C-Corp or an S-Corp.

For corporations, the business income is taxed at the current rate for corporations (21% as of late 2022), which is lower than the usual individual taxpayer rate. But remember that corporation shareholders must also pay taxes on their distributions. 

However, members are subject to self-employment tax in an LLC taxed by default as a sole proprietorship or partnership. Once such LLC switches to being taxed as a corporation, self-employment taxes no longer apply. 

Similarly, self-employment taxes do not apply to members with S-Corp status, which is the main advantage of electing S-Corp status. 

With S-Corp status, members are generally paid as company employees, which means more accounting and payroll expenses. Therefore, S-Corp status is only beneficial when the self-employment tax savings exceed those additional expenses. 

4. Profit Sharing Flexibility

Most businesses split profits based on owners’ capital contributions, no matter which entity type. Corporations, for instance, pay dividends based on the shareholders’ ownership percentage. 

But with an LLC, owners can specify in the operating agreement any profit-sharing plan they choose. As a result, one member can take a share of profits greater than their ownership interest, while other owners take less. This may be based on the fact that one member is more involved in day-to-day operations.

5. Credibility

If you have a sole proprietorship, your name is the legal business name. However, an LLC allows you to choose your business name, lending greater legitimacy. 

In Closing

Entrepreneurs often choose to form an LLC for many reasons. It’s easier to form and manage than a corporation and offers liability protection and flexibility about management, taxation, and profit sharing. 

If you’re unsure whether an LLC is right for you, consult an attorney and tax advisor. It’s best to take your time and choose the option that will give your rental property business the best chance of success.