Like an LLC, a corporation also benefits the real property owner by insulating personal assets through the limitation of personal liability. However, in terms of taxation, the corporation typically uses a more complex structure than an LLC and depending on the type of corporation selected, may result in double-taxation.
Protecting Real Property with Corporate Liability Protection
As a general definition, the corporate veil is a layer of protection that exists between the assets of a corporation and the assets of the shareholders of the corporation. When a company is incorporated, the default position that the law takes when looking at the assets of the corporation is to treat them as separate from the assets of the owners of the corporation for purposes of litigation and satisfying a judgment. One of the primary benefits of operating a business as a corporation is that if the business incurs debts or liabilities—including both expenses or adverse judgments—a court will only look to the corporation’s assets and not the shareholders’ personal assets, such as a house, a car, or a savings account.
In the context of real property investments, this means that liabilities arising from the property will not transfer to the owner’s personal assets such that these can be reached to satisfy corporate obligations. Moreover, where the individual owner incurs liabilities—such as if he or she is at fault in causing an automobile collision—this will protect the corporate assets (including the real property) from being attacked in the event that the property owner is sued individually.
The way in which a corporation is taxed will depend upon what kind of corporation it is. Generally, if the owner is active in the corporation, he will be considered an employee of a corporation, and he or she will be paid a “reasonable salary”. The owner then pays taxes on this income as if the owner were a normal employee obligated to report and pay tax on a personal tax return. It is always a good idea for an owner to work with a seasoned CPA when deciding how to compensate him or herself from the corporation, in order to maximize tax savings and reduce FICA taxes.
After the allocation of a salary to the owner as well as the payment of business expenses, the corporation will be responsible for paying taxes on the remaining annual profits. The corporation’s own tax return, Form 1120, will be filed with the IRS and will involve the corporation paying a special corporate rate of taxation. On account of the corporation existing as a separate legal entity from the owners of the corporation, all profits that are not tax-deductible as business expenses will be taxed at this corporate rate.
This “double-taxation” can be a serious drawback to the use of a corporation to protect real property investments where the only corporate owner (i.e. shareholder) is an individual. Therefore, owners of a corporation can instead elect to be treated an “S-Corporation,” wherein the corporation is treated in a similar manner to a partnership or an LLC for tax purposes. S-Corporations require adherence to a defined set of guidelines and prohibitions, but may often be the better avenue for an individual property owner to explore the benefits of limited liability.
Besides the potential for double taxation, the corporation also differs from an LLC in that its owners must adhere to certain corporate formalities in order to maintain the corporate status as a separate legal entity. A corporation requires the keeping of solid records because of the more complex corporate tax return as well as the following of corporate formalities pertaining to decision-making. Essentially, the corporate business structure emphasizes and mandates sound organization.
As a result, corporations must specifically adhere to the following:
- Hold annual shareholders’ and directors’ meetings;
- Keep minutes of shareholders’ and directors’ major decisions;
- Make sure that corporate officers and directors sign documents in the name of the corporation;
- Maintain separate corporate bank accounts from the owners;
- Keep detailed financial records; and
- File a separate corporate income tax return.
Consequently, where a corporation is chosen as the right entity type for a real property investor, it is important to associate with a Business Law attorney experienced in the formation of a corporation, the performance of corporate duties, and the maintenance of corporate records who can serve to oversee that the company maintains its corporate compliance requirements.
Part 3 of this series will discuss the use of liability insurance as a means to ensure liability protection when investing in real property.
ODGERS LAW GROUP specializes in business formation and the development of strategic business plans aimed to help maximize protection and reduce tax liabilities. The firm has experience aiding real property owners in the navigation of the legal environment through the use of both entity formation and liability insurance. To learn more about Business Law or to schedule your free consultation with Mr. Odgers, contact us by e-mail, call us at (858) 764-2448, or schedule your appointment online here.