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 our last post, 2.2.1 Types of Rental Business Entities: Sole Proprietorship, Partnership, LLC, and Corporation, we explained the different types of rental business entities: Sole Proprietorship, Partnership, LLC, and Corporation.
In this post we’re going to dive a little deeper into each of the entity types by going through the pros & cons and (spoiler) explain why we decided to set up a multi-member LLC.
Key Definitions
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 Pros and Cons
Pros:
Lower start-up costs, it costs $0 to set up a rental in your name compared to the $526 we spent setting up our LLC (see the next section for the LLC cost breakdown)
Pass through taxation, which means that the owner doesn’t file a corporate income tax return with the IRS and owners only pay taxes on profit on their personal tax return (Form 1040), this simplifies taxes and enables expense deductions
No corporation formalities, which means you don't have to hold regular meetings, maintain corporate records, or comply with specific formalities outlined in state laws
Cons:
No personal liability protection (this is the big one), which means that if someone decides to sue you they can go after your personal assets (e.g., personal savings, investment accounts, property, cars, etc.)
Partnership Pros and Cons
General Partnership (GP)
Pros:
Minimal setup costs, it is $25 to register a Certificate of Partnership in Seattle
Pass through taxation, which means that the owner doesn’t file a corporate income tax return with the IRS and owners only pay taxes on profit on their personal tax return (Form 1040), this simplifies taxes and enables expense deductions
No corporation formalities as partnership aren’t required to hold regular meetings, maintain corporate records, or comply with specific formalities outlined in state laws
Shared responsibility & diverse perspectives - partnerships allow for shared decision-making and workload, potentially leveraging the diverse skills, experiences, and resources of each partner - in our case Amanda’s skillset is organization & communication and Nick’s skillset is execution & financials
Partnerships can pool together capital and resources from multiple individuals, making it easier to finance operations, expand the business, or invest in growth opportunities
Cons
No personal liability protection (this is the big one), which means that if someone decides to sue you they can go after your personal assets (e.g., personal savings, investment accounts, property, cars, etc.)
Each partner is personally liable for the debts and obligations of the partnership, which means that a partner can be held liable for the actions or negligence of the other partner
Increased chance of disagreements since there are two or more partners, differences in opinions, decision-making styles, shared profit disputes, or personal goals among partners can lead to conflicts that may hinder the business's operations or even lead to the dissolution of the partnership
Partnerships rely on the cooperation and commitment of all partners, and if one partner leaves or becomes incapacitated, it can disrupt the business's operations and continuity
More involved tax filing process, unlike a sole proprietorship, partnerships have to file an extra tax form (Form 1065) which will then transfer to your personal tax return (Form 1040), this can also lead to additional costs (e.g., additional form submission and accountant costs)
Limited Partnership (LP)
Pros:
Everything from General Partnership, plus…
Personal liability protection for limited partner(s) since limited partners are usually investors that don’t assist in operations; limited partners’ personal assets (e.g., cars, savings accounts, etc.) are protected
If capital is needed, this option is more attractive to investors than general partnerships since personal assets are protected
Cons:
Everything from General Partnership, plus…
General partner(s) still don’t have personal liability protection
More complex setup requirements compared to general partnerships, which involves legal documentation and regulatory filings
LLC (Limited Liability Company) Pros and Cons
Single-Member LLC
Pros:
Personal Liability Protection, if someone tries to sue you, they can’t go after your personal assets (e.g., car, savings accounts, etc.) - see key definitions section above for exceptions
Pass through taxation, which means that the owner doesn’t file a corporate income tax return with the IRS and owners only pay taxes on profit on their personal tax return (Form 1040), this simplifies taxes and enables expense deductions
Enhances professional image to your potential renters that you are running a legitimate business, would you rather rent a place from Nick & Amanda or from Rental Revelations LLC?
Offers management & operations flexibility, with fewer formalities compared to corporations (e.g., board of directors, extensive documentation, etc.), but offers more structure than sole proprietorships through:
Streamlined estate planning as ownership interests in an LLC can be transferred more easily than real estate holdings - meaning there is less of a chance of your home getting stuck in probate upon passing
Documented operating agreement to outline ownership percentages, roles & responsibilities, and succession plans, providing clarity and guidance for future management and ownership transitions
Easier to transfer ownership since ownership may be added or transferred to new members while still under control of the LLC - this may be relevant if your child starts helping you or your friend helps you with a large expense and you want to offer them a percentage of the rental
Cons:
Higher setup cost, when you start your LLC expect to spend at least $500 setting it up, this will depend on the state in which you set up your LLC in, below is a breakdown of what we paid:
$41 to create a Quit Claim Deed
$205 to record the transfer of the property from personal to LLC
$220 to set up an LLC in Washington, efile with the Secretary of State, and obtain a Articles of Organization or Certificate of Formation
$60 for our annual business license fee
Higher effort to transfer of ownership, we needed to draft, notarize, and file with the recorder's office a Quit Claim Deed to transfer the ownership of our property from Amanda & Nick to our LLC - this took us awhile to figure out, we have a post outlining the steps
Annual requirements such as renewing our business license (this is $60 in Seattle) and conducting annual meetings
Additional Considerations (not relevant for everyone):
Insurance premiums may be higher for an LLC in comparison to homeowners insurance as there are a smaller number of insurance companies that cover rental properties held by LLCs
Refinancing issues, if interest rates go down and you want to refinance your place, the process can be complicated and may involve additional costs and eligibility requirements - we recommend talking to your lender prior to starting the transfer process
Depending on your mortgage terms, a property transfer to an LLC could trigger a ‘due on sale’ clause, which would require you to pay the outstanding balance of your mortgage in full - we recommend talking to your lender prior to starting the transfer process
More difficult mortgage approval process, if you plan on buying a place with your LLC (maybe your second rental) you may run into higher interest rates, more stringent lending criteria, and additional documentation as lenders perceive loans to LLCs as more risky - we recommend having a separate LLC for each rental you have to invoke separate liability protection
Multi-Member LLC
Pros:
Everything from Single-Member LLC, plus…
Shared responsibility & diverse perspectives - partnerships allow for shared decision-making and workload, potentially leveraging the diverse skills, experiences, and resources of each partner - in our case Amanda’s skillset is organization & communication and Nick’s skillset is execution & financials
Cons:
Everything from Single-Member LLC, plus…
Increased chance of disagreements since there are two or more partners, differences in opinions, decision-making styles, shared profit disputes, or personal goals among partners can lead to conflicts that may hinder the business's operations or even lead to the dissolution of the partnership
Partnerships rely on the cooperation and commitment of all partners, and if one partner leaves or becomes incapacitated, it can disrupt the business's operations and continuity
More involved tax filing process, unlike a sole proprietorship, partnerships have to file an extra tax form (Form 1065) which will then transfer to your personal tax return (Form 1040), this can also lead to additional costs (e.g., additional form submission and/or accountant costs)
Additional Considerations listed above also apply for Multi-Member LLCs, but may not be relevant for everyone.
Corporation Pros and Cons
S-Corporation
Pros:
Personal Liability Protection, if someone tries to sue you, they can’t go after your personal assets (e.g., car, savings accounts, etc.) - see key definitions section above for exceptions
Pass through taxation, which means that the owner doesn’t file a corporate income tax return with the IRS and owners only pay taxes on profit on their personal tax return (Form 1040), this simplifies taxes and enables expense deductions
Owners can receive both a salary and distributions (company profits), allowing for tax planning strategies (self-employment tax v. income tax), there is a trade off, talk to a tax expert to see if this would make sense in your situation
Suited for businesses with plans for growth as S-corps have the ability to offer stock and reinvest profits rather than distribute dividends to offer more flexibility in raising funds, managing earnings, and retaining funds for further expansion
Cons:
There are shareholder restrictions, such as the limitation of 100 shareholders who must be U.S. citizens or residents, and the prohibition of other corporations from being shareholders
S-Corporations cannot have more than one class of stock, limiting the flexibility in raising capital and/or structuring ownership interests in comparison to C-Corps as all stock would have the same voting rights
Subject to payroll taxes, this is related to the third pro above and is why you should talk to a tax expert to see if you would benefit or not, shareholders who work for the S-Corporation must receive reasonable compensation, subjecting their salary portion to payroll taxes, which can be higher than self-employment taxes
More involved annual filing requirement, S-Corporations are required to file annual tax returns (Form 1120S) and issue K-1 statements to shareholders (so shareholders can include income to their personal taxes), adding to administrative burdens and cost
C-Corporation
Pros:
No restrictions on the number or type of shareholders allowing for greater flexibility in ownership structure and raising capital through the issuance of multiple classes of stock
Suited for businesses with plans for significant growth as C-corps have the ability to go public and reinvest profits rather than distribute dividends to offer more flexibility in raising funds, managing earnings, and retaining funds for further expansion
Unlike S-Corps, the ability to have different classes of stock increases the flexibility to raise capital and/or structure ownership interests
Better suited for businesses with international operations due to their ability to structure complex ownership arrangements and access international capital markets more easily
Personal Liability Protection, if someone tries to sue you, they can’t go after your personal assets (e.g., car, savings accounts, etc.) - see key definitions section above for exceptions
Cons:
Subject to double taxation, meaning that profits are taxed at the corporate level and then shareholders are taxed again on dividends received from the corporation
More complex tax and regulatory requirements, including annual tax filings (Form 1120), shareholder meetings & board of director requirements, and maintenance of corporate records can increase administrative burdens and costs
No pass-through taxation, which means they can’t pass losses to shareholders, limiting the ability to offset income
What We Did
It is best to consult with your mortgage lender, a lawyer, and a tax professional before making the final decision. Like I mentioned at the beginning of this post, we decided to set up a Multi-Member LLC for our rental, below is our process of elimination (see image to see our raw notes):
Since we both owned the property we immediately put a sole proprietorship and a single-member LLC out of our mind
The extra setup and tax filing costs were worth the security that personal liability protection provided so we didn’t go with a partnership
This was our first rental and extensive growth where we’d need to issue stock wasn’t where our mindset was so we pushed S-Corps & C-Corps to the side for future considerations
That left us with a multi-member LLC
If you are also leaning towards doing an LLC, our next couple of posts will cover how to set up an LLC quickly and economically.
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