Table of Contents
Disclaimer: We are NOT tax experts or lawyers; we recommend consulting with a lawyer or a tax professional before making any decisions.
In this post, we’ll explain the different types of business entities: Sole Proprietorship, Partnership, LLC, and Corporation. In the next couple of posts, we’ll cover the pros & cons and guide you through the process of setting up an LLC (if you choose that route).
Key Definitions of Rental Business Entities
Personal Liability Protection: This means that personal assets under your name (e.g., savings/investment accounts, property, cars, etc.) are protected. If unexpected renovations become necessary and you underestimate the financial burden, creditors can’t go after the owner’s personal assets.
Personal liability protection isn’t perfect, there are situations where your personal assets could be at risk. Examples include (non-exhaustive list):
The owner fails to adequately maintain one of its rental properties and a guest staying at the property suffers an injury due to negligence, leading to a lawsuit.
The owner neglects to purchase the right insurance coverage for its properties, a guest sustains injuries due to a slip and fall accident on a wet floor, the damages awarded in the subsequent lawsuit exceed the LLC's assets.
To secure financing for additional properties, the owner(s) provide personal guarantees to lenders.
Pass Through Taxation: This simplifies tax reporting and means that the owner(s) don’t file a corporate income tax return with the IRS. Business profits and losses are “passed through” to the owner’s personal tax returns and owners only pay taxes on the remaining profit and aren’t subject to double taxation. This can offer tax advantages, such as the ability to deduct business expenses related to the rental property.
Sole Proprietorship
This is a good option for: a single owner who wants minimal setup work and is ok with more risk.
A sole proprietorship is an unincorporated business owned and operated by one individual with no legal distinction between the business and the owner. This means that if someone were to look up your rental, they could see that it’s under your personal name and owned by you. The owner is entitled to all profits and is responsible for all the business's debts, losses, and liabilities.
Sole Proprietorship Key Attributes:
Suitable for a single owner
Free & easy setup
No personal liability protection
Pass through taxation
Partnership
People set up their rentals as partnerships when the business is owned by two or more individuals, known as partners. There are two different types of partnerships relevant for rentals:
General Partnership (GP)
This is a good option for: two or more owners who both manage the property and want minimal setup work and are ok with more risk.
A general partnership is basically the same as a sole proprietorship, where the house is owned and listed under your name (no distinction between the business and the owner), offers pass-through taxation, and doesn’t provide personal liability protection. The only difference is that this house is owned by more than one person (e.g., sibling, spouse, parent, friend, etc.).
Limited Partnership (LP)
This is a good option for: two or more owners/investors where at least one person doesn’t manage the property and are ok with more risk.
Setting up your rental as a limited partnership means there are general partner(s) (i.e., someone who manages the property) and limited partner(s) (i.e., someone who contributes financially without engaging in management). Limited partners are only liable to their investment, whereas general partners have unlimited personal liability, which means personal assets can be leveraged if sued.
Partnership Key Attributes:
Suitable for a two or more owners
Easy setup with minimal fee ($10 in Seattle)
More complex tax filing
No personal liability protection
Pass-through taxation
LLC (Limited Liability Company)
Setting up an LLC or Limited Liability Company means that your rental is a legal entity separate from your personal name. An LLC is generally a less complex business entity than a corporation and offers owners a variety of benefits that may not be available to other types of businesses. There are two types of LLCs relevant for rentals:
Single-Member LLC
This is a good option for: a single owner who wants their personal assets to be protected.
Similar to a sole proprietorship, a single-member LLC is owned and managed by a single person, but it is listed under a business name (not your personal name). Unlike a sole proprietorship, a single-member LLC provides personal liability protection, meaning that the owner's personal assets (e.g., savings accounts, cars, etc.) are generally protected if issues arise - see exceptions in the key definitions section above.
Multi-Member LLC
This is a good option for: two or more owners who want their personal assets to be protected and don’t mind a little extra work.
This option is basically the same as a single-member LLC (i.e., personal liability protection, the property is owned by a business entity, pass through taxation). The two main differences are that the property is owned by two or more people and multi-member LLCs are required to submit a 1065 form (partnership tax return) in addition to their personal tax returns.
LLC Key Attributes:
Property listed under business name
Fee to set up an LLC
Multi-member LLCs have more complex tax filing
Personal liability protection
Pass-through taxation
Corporation
Similar to an LLC, a corporation is a legal entity separate from its owners, but with a corporation a more formal ownership and management structure is required and is subject to specific regulatory and tax requirements. Below are two types of corporations relevant for rentals:
S-Corporation
This is a good option for: owners that are spending a significant amount of time on their rental (enables lower self-employment taxes) and/or will eventually want to scale.
S-corps are typically used by service based businesses, small to medium sized businesses, technology startups, and eligible family owned businesses to take advantage of pass-through taxation.
Similar to LLCs, S-corps offers personal liability protection and pass-through taxation, but with the added bonus of the potential for lower self-employment taxes since S-corp owners can receive a portion of their income as distributions rather than salary, thus avoiding some self-employment taxes on that portion. Currently, the self-employment tax rate is 15.3% of self-employment income; if you’re curious about the tax trade off between an S-corp and an LLC, you should talk to a tax professional.
S-corps have more structure than LLCs as they typically require a board of directors. They also enable a business to sell shares, but are limited to one class of stock and 100 shareholders, all of whom must be U.S. citizens or residents.
C-Corporation
This is a good option for: owners that have high growth potential, need additional funding, and/or plan to go public or global; examples of C-corp companies include Microsoft, Walmart, Starbucks.
When you think of big businesses with significant assets, operations, and shareholders (e.g., Microsoft, Walmart, Starbucks, Apple, etc.) you’re thinking of a C-corp. C-corps are the standard structure for companies that intend to go public, expand globally, and/or reinvest profits into growth. C-corps are taxed separately from your personal taxes (no pass-through taxation and possible double taxation through dividends) and offer strong liability protection. This is the most complex and rigid entity structure, but allows for unlimited growth.
Corporation Key Attributes:
Property listed under business name
Fee to set up a corporation, you’ll likely need a lawyer as well for c-corps
More complex tax filing
Personal liability protection
Our Thoughts
We struggled to understand the different business structure options out there in the context of rentals, so hopefully, this post helps lay the groundwork for our next post , where we will go into the pros and cons of each business entity to help you make a more informed decision. If you want more details, we used the US Government IRS site as a baseline. As mentioned, it is best to consult with a lawyer or a tax professional before making the final decision.
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