REAL ESTATE BUSINESS

[ACS41]

Client has a 2 member LLC and will be buying parcels of real estate. Each parcel will be bought by a different LLC. Some properties will be developed and sold while others will be rented. The main issue is to structure the business so gains will be capital and not ordinary. Of course this assumes the property is held more than 1 year. A secondary concern is the self employment tax issue.

The attorney suggested establishing an S corporation for the management and maintenance (the LLC members will be providing both management and sweat labor). Under this scenario, the SE tax will be paid when the shareholder compensates themselves through the S corp. This part seems OK to me. A concern is rental income. Can the rental income be run through the S corp if the LLC owns the property? It does not seem logical? If it is run through the LLC are we then creating an active business and therefore ordinary gain treatment?

In summary, is there a way to separate the asset from the management/maintenance to have capital gains as opposed to ordinary gains?

Thank you.

[jainen]

>>separate the asset from the management<<

We always caution landlords not to provide personal services such as laundry machines or child care because it may turn the entire activity into SE income. It is less certain in the case of janitorial and repairs, but where that is a large factor (such as apartment buildings) it is normal to engage a separate property management company. I wouldn't recommend that management be a related party, but it should work if the entities are kept totally separate. The risk is that LLC's tend to get sloppy about acting as a separate entity.

In my opinion, the issue of SE tax is dwarfed by the question of liability if someone gets injured and decides to challenge your corporate shield.

Hire a real bookkeeper to be rigorous about corporate accounting, hold formal stockholder meetings, and follow your state's rules for a corporation exactly. Bill each LLC for specific services provided under enforceable contracts, and pay the bills from separate bank accounts. Report rental income and expense on separate 1065s, not on the corporation's 1120-S. And don't put "Double Dudes Investment, LLC" on the side of the utility truck!

[ACS41]

Your answer looks great to me! Of couse my fickle client would now rather bypass the S corp and use a separate LLC for each property.

It seems that for each LLC used for "owning & operating real estate" (investment rental property) it will generate capital gains and ordinary losses under sec 1231. Each member will take reasonable guaranteed payments to handle the SE obligation.

For each LLC used for fixing and selling, ordinary income and/or loss will be generated since these properties will be considered inventory for sale in the normanl course of business. Each member will also take reasonable guaranteed payments for their SE obligation.

Anything we are not considering?

[jainen]

>>my fickle client would now rather bypass the S corp<<

That's fine with me from a tax perspective, but I doubt his attorney was thinking about taxation when he "suggested" it.

[ACS41]

Your answer looks great to me! Of couse my fickle client would now rather bypass the S corp and use a separate LLC for each property.

It seems that for each LLC used for "owning & operating real estate" (investment rental property) it will generate capital gains and ordinary losses under sec 1231. Each member will take reasonable guaranteed payments to handle the SE obligation.

For each LLC used for fixing and selling, ordinary income and/or loss will be generated since these properties will be considered inventory for sale in the normanl course of business. Each member will also take reasonable guaranteed payments for their SE obligation.

Anything we are not considering?

Though my client is fickle, he will listen. What would you recomend if this were your client. Record keeping (as you mentioned in your original post) should be no issue as the client is an ex CFO & CEO of a bank and I am an accountant who ran his accounting department years ago.

[jainen]

>>the client is an ex CFO & CEO of a bank<<

Not all that impressive in these days--we are seeing that the banking industry has been dominated by soft if not actually slushy records, and even less attention to risk factors. My principal recommendation is that he fire his attorney and find someone else, one who is more in tune with your client's attitudes about business management. Why should he pay for advice he won't follow anyway?