If you’re a real estate investor, you’ve likely heard of SMLLCs, which stands for “single-member limited liability companies.” An SMLLC holds properties in order to distance the investors from various liabilities. But before setting up such an entity, it’s important to also consider the tax ramifications
SMLLCs are similar to corporations in that they limit owners’ personal liability for the debts and actions of the entity. Creditors of the SMLLC can’t go after investors’ personal assets; they can pursue only SMLLC assets.
Investors with more than one property can use multiple SMLLCs to segregate potential liability exposure for each property. They also offer some of the benefits of partnerships, without requiring at least two parties.
Avoiding double taxation
For federal income tax purposes, an SMLLC can be treated as either a corporation or a single-member disregarded entity. To be treated as a corporation, the SMLLC must file IRS Form 8832 and elect to be classified as a corporation. Classification as a C corporation, however, often isn’t desirable because it can result in double taxation —if the SMLLC is treated as a C corporation, it’s taxed on income it generates, and then the single member/owner is taxed on dividends he or she receives.
If the SMLLC elects to be treated as an S corporation, double taxation is avoided. In such cases, the single member/owner is subject to tax on all of the S corporation’s earnings, often through a combination of salary and flow-through income. S corporations generally aren’t taxed at the federal level, but state tax may be imposed.
If an SMLLC doesn’t elect to be a corporation, the IRS will classify it as a disregarded entity taxed as a sole proprietor. Single members/owners report the entity’s income, gains, losses and expenses on their tax returns. The entity doesn’t file a tax return, thus avoiding double taxation.
Partnership interest in SMLLCs
When using an SMLLC to own a partnership interest, there may be negative tax repercussions that wouldn’t necessarily be the same if you owned the partnership interest as an individual. Take losses, for instance.
With partnerships, real estate investors often incur losses in the early stages of a real estate development. If losses exceed the amount of equity invested and you’ve invested directly in a partnership, you generally can deduct the losses up to the amount of your equity investment plus your allocable share of any partnership liabilities. These losses are deductible on your personal tax return, although some might be “suspended” for use in future years. The IRS also allows you additional tax basis for the share of liabilities that you’ll ultimately be responsible for as a partner, regardless of whether you have adequate assets to pay those liabilities.
If you establish an SMLLC, however, allowable losses are limited to the amount for which you’re personally responsible. So, unless you’ve personally guaranteed the SMLLC debts, you’re allowed additional tax basis only for the partnership’s liabilities up to the fair market value of the SMLLC’s assets. Also, losses from the partnership are deductible only up to your equity investment in the SMLLC plus the fair market value of other assets owned by the SMLLC.
Also keep in mind that, if you’ve claimed tax losses that exceed your equity investment in a partnership — and you no longer have allocable liabilities from the partnership — the contribution of the partnership interest to an SMLLC can produce a taxable gain.
In addition, consider the tax treatment of distributions. Normally, you can take distributions out of a partnership up to the amount of your tax basis without causing a taxable gain. The tax basis equals your equity investment plus allocable liabilities adjusted for earnings and losses of the partnership and prior distributions. If the partnership interest is held by an SMLLC, though, the allowable distribution may be significantly more restricted.
Ponder the issue
These are only some of the factors to consider as you ponder whether an SMLLC can help you achieve your goals. So, please contact your tax advisor for more information. He or she can help you decide if SMLLCS are right for you.