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Tax Smart Real Estate Investors Podcast
MLRE: S Corps, C Corps & Syndications: The Structuring Mistakes Investors Make
00:19:25
Should your real estate syndication use an S corp…
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- [00:02]
A
Welcome to the Major League Real Estate Podcast, a podcast for large scale real estate portfolios. My name is Nathan Sosa and I'm your host. Together with my co host Tom Castelli, we talk about tax and legal strategies and we bring on operators of large portfolios for in depth discussions on how they grow their business and this tax strategies behind what they do. We hope you enjoy. Hey everyone, welcome to another episode of the Major League Real Estate podcast. I, of course I've got my co host on here with me, Tom, and we're going to talk about S Corp, C Corps and syndications. Honestly, why they all don't mix together. And so we'll talk about that in one second after this break. Real estate syndication tax is confusing to you. Well, that's why hopefully you listen to the podcast today. Also you should go to our website, www.the realestatecpa.com and you'll be able to get access to the ultimate guide to Real Estate Syndicators and Sponsors which breaks down everything from preferred returns to depreciation strategies. Whether you're a GP or an lp, avoid costing mistakes and maximize your returns. Download the complete guide free and get the tax credit you need to succeed. So let's do our temp check with Tom. Tom, how are things going on? It's kind of warm across the country, but what'd you do this weekend? I want to hear a download of what Tom focused on this weekend.
- [01:13]
B
Yeah, so this weekend I bought a MacBook. I said I would never buy a MacBook. I would be a Windows person for life. But Apple finally broke me into their ecosystem fully. Now I am fully appled out and that's the big thing I did this weekend. The weather though, here in Miami is where it should be. It's a low 72 today and a high of 83. Currently 82 degrees. That's how I like it. It's starting to heat up. When I went grocery shopping this weekend, it was actually hot. I'm like, Jesus, hot. So when you guys all come down to Florida, you'll know. But yeah, this weekend was relatively uneventful outside of the MacBook. Okay.
- [01:53]
A
Should have gotten Mac Mini. No, I'm joking. Like in the AI world, got to have a computer that doesn't sleep or ever close it. But yeah, I love Apple computers, love Apple products. It's fantastic across the board in my personal opinion. So glad you've joined the right team there. And so with that being said, talking about joining the right team, we need to join the right team from a structured Perspective, not. Not where we lose tax savings or at least don't have to like ask so many questions. Right, Tom, So we're going to talk about again, S Corp, C Corps and syndications, why these can work and why they don't necessarily work at the end of the day. Right. So we'll go over that and why this matters. And so syndicators constantly ask, should I create an S Corp? Should I create a C Corp? How do I invest into my own syndication? Right. How do I invest my own syndication? What vehicle should I be using? What makes sense for us to structure a GP entity? Maybe you're co investing. Maybe GP entity is a co investing type entity where you have multiple people coming into it from across the board. And so the answer is normally it depends. Except when it comes to S Corps generally, in my opinion. So that's why we'll talk. Go through that today. And so, Tom, just out of curiosity, could you explain why most syndications wind up going as LLCs taxed as partnerships?
- [03:03]
B
Yeah, that's a great question. And I'll kind of break it down. So partnerships offer a lot of flexibility in what you can do, especially when you allocate certain things like depreciation losses, credits could also offer a lot of flexibility when you're trying to exit later on if you want to do a drop and swap. So you want to drop out the property from the partnership into a tick structure so people can go their own separate ways. With the 1031, there's just a lot of flexibility. Also with basis and debt, there's a tremendous amount of flexibility when it comes to partnerships that just don't exist. And if you just tuned into the taxpayer REI episode we did on Tuesday, we broke that down a little bit. But there's just not a lot of flexibility in what you could do in an S Corporation. So at least at the property level, the LLC or the entity that is holding the property itself, you typically almost always want to avoid an S corporation.
- [03:54]
A
Right? Right, right. Precisely, Tom. Right. Like debt is a big factor, right? It's like it's a massive factor, especially in partnerships, on the allocation of it and also the allocation of losses. You cannot have special allocations in S Corporations or C Corporations, Right? You cannot. There's different reasons for why that is. But the S Corp basically says, hey, I can't allocate, and I can only allocate based on stock percentage. Right. While in a partnership, we get to be so creative with it right now, there's rules and hard rules we have to follow. When it comes to deficit restoration obligations, there is qualified income offsets, right? These things we have to have in our operating agreements, in the tax tax code to actually follow and be compliant and actually do what's correct. But we actually have options before we get to those trigger points, right? We're like, who can get what? How can we allocate pref returns like doing 8% prep or something like that? That's all possible. It's all possible in a partnership, LPs, LLPs, et cetera. And none of that is possible in an S corporation.
- [04:53]
B
Yes, that is the problem. That is the problem. So we want to avoid that.
- [04:58]
A
Right. And the other problem is basis. Right, Tom. So stock basis specifically. Okay, so let's just roll through an example year 1a properties, like so syndications raised money and they have now invested into a property. It's spit it out is right in that sense. So we've gotten through year one. Right. If this was an S corporation, Tom, what issues would get run into if the syndication was actually an S corporation? And let's say it's done a cost irrigation study too. Let's throw that in there. Yeah.
- [05:23]
B
So, so first of all, you're not in an S corporation. You only get the basis of the amount of money you put into the S corporation physically put in. So you put in 50k for example. That's it. You're not get allocated any debt and that can limit the amount of losses that you're trying to take out of the S corporation. And it could get trapped in the S corporation. Whereas that's not always going to be the case with a partnership.
- [05:44]
A
100%, Tom. That's the crux of it, in my personal opinion, is that we talk about, we hype up real estate losses and we talk about how important they are and how it's like one of the most taxes, tax advantage things is that real estate is super tax advantaged because of depreciation. But if we then use a investment vehicle that limits those losses, well, now we've lost basically a large chunk of the investment piece. You don't have to worry about stocks having appreciation. Like there's no depreciation for stock. And so that's why with real estate, it depreciation, it offsets your cash flow, which is something we don't really get as much from a stock. And so that's why like now you've totally limited that piece. Now you've actually hurt yourself from an investment standpoint because you don't get that really important asset to utilize on Right. And the other thing we talk about is that 99% of the time real estate income is not self employment tax. Now this can change for RV parks and this can change for hotels. Right. I've seen a couple of those types of syndications rolling out there. And it's different if you're a developer, right. Sometimes people spin up really large development just like structures and so that's different. We'll still talk about why that doesn't make sense actually in this indication context to do the S corporation. But most real estate income is not somebody's self employment tax. Right. So we don't have to even worry or consider that piece. Right. S Corps are only effective when you're trying to limit or mitigate self employment tax. That's when it makes sense. Most of the time your income threshold is also going to be way over. So you're just really looking at like a 4% tax is what I say. The 3.8% Medicare tax. Right. That's when that you want to consider that too. But yeah. Tom, any other thoughts on that piece?
- [07:09]
B
You know, no. I think the bottom line is at the very least for the property level LLC or entity, S corporations typically do not make sense, like we talked about on the Tax Smart REI episode on Tuesday, that if you're getting a recommendation to put the property in S corporation, then you should be getting a second opinion.
- [07:29]
A
Right, Tom? 100%. And then also like people ask questions about QBI all the time too. It's like, hey, how can I structure that? I heard here in S Corp lets me do that better. But look, you're not going to really do that. Real estate is not really effective to maximize. Can. But more times than not it's not really effective. Now when is it effective? Let's say you have a management company that's sitting over here that's accruing management fees from managing all the syndications that you have, right. All the investments you have, all the deals that you that have been spun up, having that structure. That makes sense actually. Why? Because that is a service fee. That is not an asset that's being held. That's the big difference there, right? If it's service based, right. You're like, you are a people to people. That is when S Corps can be effective. If it's going to be management of a piece of real estate and assets or a physical asset that's or even I say say that in this day and age, or just something in some kind of asset that's not a human being that's when it makes sense to not do the S Corp. The other reason not to do S Corps in syndication context is if you're super limited on how you do it, right. You're super super limited on who can invest with you. You can't have other C Corps, you can't have certain types of trusts. You can only have 100 shareholders. Right. There's so many issues that we get into, like who's allowed to invest and how we don't. Because if we don't, if, let's say we break one of those rules, we then become a C corporation. Right. You also have to get signatures. I forgot about this part. You have to get signatures every time you admit a new shareholder. Right. You don't have to do that. You don't do any of that in the LLC structure. Right. That's why it just doesn't make sense to do an S Corp and syndication. I actually have never like. I'm glad we're talking about Tom, cause I was just curious how crazy it would have to be having a syndication run as an S Corp. Just how nuts that would be. There are ways to somewhat work around 100 shareholder rule, but it's really complicated and only works like in a family office setting that I've seen.
- [09:11]
B
Yeah, yeah. The real reason I see people wanting to use an S corporation in the syndication context is often at the GP level entity because they're receiving fees and things like that. That could be something like the self employment tax.
- [09:23]
A
Yep, you're totally right, Tom. And even then, sure, we think about that. But let's say you're a GP and you're like, I really need the losses because I need my management fees. Okay, great. Totally makes sense. You're like, well, my spouse, I have other income that's coming in on my 1040. Right. Or my personal tax return. You go, okay, great. Totally makes sense. Like, I understand you want to sign maybe a deficit restoration obligation, a dro Maybe you want to get that. Or maybe you want to find more, some creative ways to get more depreciation allocated to you than normally would be allowed in the operating agreement. Totally makes sense. You lose all the benefits if you do it through an S Corp GP entity.
- [09:57]
B
Yeah, okay, maybe it doesn't always make sense to do that.
- [10:00]
A
Right? It doesn't. It doesn't. And we run into this again, we run into the same issues where you're going to now have to be. Let's say you have a CO GP type entity where you have different types of investments. You're again Limited, what I mentioned before, if you let's say there's private venture capital that wants to invest in it with you and then you want to flow that money into the actual fund itself, that also creates another issue, right? Because you can't do that. You can't have a C Corp structure, an S Corp that invests downwards. Right. This doesn't make sense. It creates lots of issues. And Tom, you have to set this up on the front end because if you don't set up on the front end then you're going to, it's going to be, it's super costly and expensive to try and restructure everything back to an LLC after that part. Right. Becomes really, really non tax advantage in my personal opinion to do that type of stuff. So the other thing too people ask about promotes how that gets allocated. There is actually some creative ways you can work around that where it can actually avoid the Holdco GP and then jump up to the individual and the individuals get the promote. That's a little bit more complex. So you, you'd want to like have a conversation with us below and like I don't know if definitely to talk about that. Like it's super complex structure actually to try and get that and accomplish it. It's been approved in tax court. The IRS is still not happy about it. So it's something that's been hotly debated. But those are some of like the key issues we see there. But C Corp's in a syndication context, that's another one that I actually do see in the quote unquote wild pretty frequently. And so people ask like, hey, should I be a C Corp? Right. The answer is it can work, but it just depends on your overall thoughts. Tom, what are some things that you see where C Corp makes sense, don't make sense. What are the overall issues that actually C Corps have?
- [11:32]
B
Yeah, so when you're dealing with C corporations, the first thing is you're dealing with double taxation, right? There's the corporate level tax which currently capped at 21%. It used to be much higher than that. And then on top of that, when you actually make distributions to the shareholders, you're then taxed as dividends. So you have a double layer of taxation. That's like the first major issue. Secondly, losses are trapped within the C corporation so they're not getting passed down through to you. And a big benefit of investing in real estate through partnership or typically or if you own it yourself, but we're talking about partnerships in syndication context is that the loss can actually get passed through to you as an individual and then you can use them to offset gains or other passive income. Or if you qualify as a real estate professional, they could be non passive. You can do that in a partnership, but you can't do that in a C Corporation. All that is trapped. Okay, so that is an issue. Could also be issues with 1031 exchanges and the double taxation issues. So that's why it doesn't make sense. There could be more. But when it comes to the property holding entity, C corporations typically do not make sense.
- [12:37]
A
Right, right. It just doesn't make a lot of sense. Benefits to C Corps in comparison to S Corps is that like you can allow foreign investors actually. So like if there's like someone that's not a U.S. citizen, you're allowed to invest that way or that structure like that's totally possible. Which is great, you have more optionality but actually ruins your promote too because now you're like the whole point of having a promote structure. So you're going to get capital gains rates. Well, C Corps are already taxed at 21% right. So you're not actually getting that advantage of your gain being subject to the capital gains. Because actually C Corps don't have capital gains tax. Everything's taxed at 21% which is still super low for everybody else. But you're not taking advantage of the promote. Real age doesn't make sense. So like that's just like an example of where like C Corp's there's intriguing factors to it but ultimately you always run into that double tax issue where it's going to happen. And sometimes people go ask me then what about qualified small business stock QSBS 1202. Right. They hear that, they see that really problemated across social media and they say well that's actually going to be. It's going to be why it's going to wind up being kind of an issue sort of X, Y and Z. Right. And so like, but actually real estate entities can't wind up qualifying for 1202. That's the issue that we run into. Right. So it's actually, it's not even worth going down that path to discuss it because real estate can't even do it. Developer, etc. Right. Like it doesn't make sense to you to actually do that. Now sometimes a management company can be involved there and we can have conversations about that for 1202 purposes. But even then you want those profits from the management fee to invest in other deals reinvest back into your funds. Right. Like have capital to then deploy into setting up the next fund. Right. There's so many things across the board, there's that are important. So again I will say S Corps are almost never. C Corp's are a. Maybe LLC is. Are always a must. Right Tom, Is that, is that a good way to think about it?
- [14:25]
B
Yeah, I would say that, that that is very fair. Bottom line is when you're dealing with real estate, syndication, you're dealing with mostly LLC taxes, partnerships. That's the vehicle that you're using. There's this many reasons for that. Where an SC corporation could make sense though to be fair in some of these contexts, is that there's sometimes foreign investors that this could help them be exempt from certain tax issues. So using a C Corporations, they call it the C Corp blocker can make sense. Or sometimes if you're investing through like a self directed IRA or a 401k or self directed IRA, excuse me, 401ks generally are not subject to UBTI when it comes to real estate. But it could be a good way to block that too. Block your exposure to ubti, that small tax you have. But that's usually the limitations of where C Corporation tends to make sense.
- [15:15]
A
Yep, yep, totally agree with you, Tom. So some do's and don'ts we have on here do default to LLC as partnerships. Right? That's what we want that to be our default for operating syndications. Right. Any fund probably needs to be that. So consider the S Corp for the GPS for your management company. If you're not bringing third party management, you've got your own team that's taking care of that. That's when it makes sense where the SE tax savings actually comes into play because you probably got a smaller investor pool, probably smaller things going on there. So just FYI. And then like Tom just mentioned, I want to say again, the C Corp blocker does make sense, especially if like you want to have foreign entities or individuals investing. Basically just when I say that that just basically means anyone that's not a U.S. resident, right? That specifically means. So like you get someone investing from Canada, from Europe, right. There's a lot of rules there that we won't go into today. But just FYI there and then also there's like so much basis limitations. So if you have an investor coming to you saying hey, I'm going to invest into my. Like you hear offhandedly that your LP is going to invest with an S Corp, you tell them to not do. That's FYI, you tell them to don't do that. So that's one. Don't actually don't use a C corp as a promote vehicle either. It doesn't make sense. You're not going to get tax savings from that and then you're actually going to get double tax because then when you pull it out, right, it's a taxable dividend that we mentioned earlier. So that's an, that's a big issue. S Corps don't drive automatic tax savings. The SE tax is just not there for real estate typically. Now like I said, this is not applicable to every single structure. So maybe it's worth having the conversation, but it'll generally be a pretty quick one in my opinion. And so also like, like we mentioned earlier, the shareholder rules, don't forget about that. And then actually Tom didn't even mention this earlier. There are state level implications. New York and New Jersey have like a special surtax for S Corps. Right. And so actually something, something you got to think about there too.
- [16:59]
B
Yeah, there's definitely issues with S Corps in New York for sure. Definitely want to take that into consideration.
- [17:05]
A
Yeah. And so, and one thing I want to mention too is entity structure is not a one time conversation. I think there's something that should get revisited consistently over a long period of time. Maybe you've got a small pool of investors and maybe doing some kind of an S Corp structure does make sense. Right. I say now that's like a 1% type conversation. As in like there's only like 99% of the time don't 1% possibly do. That's what I will say there is that like entity restructuring and conversations are continuous and continual. So just FYI on that note is that like this is a conversation that like hey, entity restructuring should be revisited each year. It's not something that we just, that we just use once and then stick with it. Right. Because things in businesses change over time and what used to work for one business might not work any longer. Right. When you're first a startup, you don't need to have a partnership. Right. You just start as a sole, sole proprietorship and then move into a partnership. Potentially when you run and start running a business, have partners, Right. If you're syndicating deals, maybe it makes the most sense to not have an S Corp for your management company and then down the road it makes sense to go and pivot to that. So just kind of an FYI sometimes these things evolve and we should have conversations then. But to start overall, broadly 99% of the time you don't need an S corporation, right, Tom? Yeah, you don't. You don't. All right, well, guys, if you have any questions about this, feel free to shoot Tom and I an email. Click the link in the show notes too. If you want to have a deeper conversation about your operating agreement, your structure, just reach out to us. We'd love to have a conversation with you on how you deposit on these type of things. And everyone, thanks so much. This has been an episode of the Major League Real Estate Podcast.
- [18:38]
B
Till next time,
- [18:41]
A
thanks for listening to the Major League Real Estate Podcast. There are three ways you can connect with us. If you're interested in getting email updates on upcoming shows, go to ww.the realestatecpa.com and subscribe there. If you'd like to explore a tax and accounting relationship with our CPA firm, you can go to www.therealestatecpa.com mlre and fill out a web form to get started. And if you'd like to connect with Matt or I on social media, you find us on LinkedIn or Twitter. Just search Nathan Sosa, CPA Matt Hamilton, CPA, and shoot us a request. We'd love to connect.
- [19:18]
B
See you guys.