Folks who flip houses almost never do so as sole proprietors, because this form of entity confers unlimited liability, meaning you can be sued for debts in excess of your investment in the property. Creditors can come after your entire bank account and personal property to satisfy debts. In addition, as a sole proprietor, you file your business income and expenses on Schedule C, meaning you must pay self-employment tax.
Other entity types all provide limited liability, meaning your liability is limited to the amount of your investment in the entity, and your personal property is protected. Other entity types also reduce your tax liability to varying extents. The entity type you choose therefore depends mostly on your tax liability.
Limited Liability Corporation
One popular entity type among house flippers is the limited liability corporation (LLC), as it combines the best aspects of the other types – S corporations, C corporations, and partnerships (general or limited). Your LLC’s income and expenses pass through to your personal income tax. In fact, a real estate LLC permits more losses to pass through compared to those permitted under a C corporation. An LLC confers limited liability among all its members. If you invest $50,000 in your LLC, that’s the amount creditors can attack. All your other wealth is secure (unless the creditor is a divorcing spouse or the IRS, but that’s another story). Most states permit single-owner LLCs. Here’s an example of how taxes would work.
LLC Example
XYX LLC earns $100,000 by flipping a property. The sole member, Bob, will have to pay 15 percent self-employment tax ($15,000) on his personal return’s Schedule C, plus approximately $28,000 in federal taxes, leaving him $57,000 after tax income.
Subchapter S Corporation
An S corporation is much like a regular C corporation except that profits and losses pass through to shareholders, and S corporations pay no tax. The non-salary income you receive from the S corporation is not subject to self-employment tax. Liability is limited to the amount invested. You need to file an informational return (1120S) each year, and annually send shareholders K-1 forms that report each shareholder’s percentage of ownership, and thus percentage of profit or loss.
Subchapter S Example
XYZ Corp, an S corporation, earns $100,000 during the year by flipping houses. As sole officer, Bob draws a $30,000 salary. He must pay 15 percent payroll tax on that salary, or $4,500. The remaining $70,000 is distributed as pass-through income, which does not incur any payroll tax, a savings of about $10,000 for Bob. He would have to pay $28,000 in federal taxes on his $100,000 of income, plus the $4,500 payroll tax, leaving him $67,500 after taxes. That’s $10,500 more in his pocket compared to what he’d earn as an LLC.
C corporations are generally not used by tiny flippers, since they incur double taxation (at the corporate and personal levels). But large builders and developers might go the C corporation route because of the many tax breaks.
The best advice is to discuss your options with a CPA or other financial adviser and pick the entity type that benefits your situation the most.