Establishing a legal structure for any business is always an important part — and one of my favorite parts because I like solving problems and building things. A well thought out and implemented legal structure can shield you and your other ventures from legal liabilities and sometimes help on your overall tax burden.
It should obvious, but I’m going to say it here anyway: I’m neither an attorney nor an accountant. Neither my attorney nor my accountant has signed off on this particular structure. Don’t take advice from strangers. Use my advice to form your own structure and talk to applicable professionals.
At the top of my structure is my holding company. It is an established LLC and I am the sole member. From it, I run the day-to-day operations of all my ventures and it holds all my assets except when it would be tax adverse (e.g., my personal residence) or for legal reasons. It is at the top of the hierarchy and represents my interests in the flipping venture.
The holding company is the owner of two entities specific to the flipping venture: a flip holding entity and a construction entity.
The flip holding entity is one or more LLCs that will hold the flip asset and debt during the flip project. Each concurrent project property (and its associated debt) will be held in a separate flip holding entity for the duration of the project.
Having each concurrent project being held separately shields the asset within from any liability that may come from other projects or ventures under the holding company’s umbrella. Likewise, the separation of the concurrent projects will protect the other assets and ventures from any liability that may be levied on that project (like default or lawsuit).
These flip holding entities will each elect for subchapter-S classification (or sub-S) with the IRS — the same taxation and treatment as a sub-S corporation or (S-corp). For a normal corporation (called a C-corp), the income is taxed at the business level (e.g., it files its own tax return) and, if those profits are paid out to stockholders as dividends, the dividends are taxed as capital gains — the same income is being taxed twice. With sub-S classification, income flows through to the owners, like a typical LLC, but is not subject to self-employment taxes.
There is a catch, though… While a sub-S LLC is not subject to self-employment taxes, owners who also provide more than a minor service to the company must pay themselves a “reasonable salary” (paying employment taxes along the way) before taking the rest as a dividend. This is still much more favorable than paying self-employment taxes on the entire profit.
Another catch is sub-S corporations (and, thusly, sub-S LLCs) can only be owned by an individual, some trusts, estates, and some exempt organizations (like a nonprofit); corporations and partnerships cannot be an owner of a sub-S LLC. In this particular case, the holding company is a single-member LLC (or SMLLC) and is considered a “disregarded entity” by the IRS — to the IRS, the entity is nonexistent and it only “sees” you.
Because short-term real estate investing is a lot of one-time income (versus long-term investing bringing in smaller but steady amounts of income over time), the sub-S provides a lot of short-term tax relief.
The construction entity is an LLC that the flip holding entities will hire to perform the rehab, buy materials and appliances, and provide labor. My construction manager Ephraim would work directly for this company.
Like the flip holding entities, the primary purpose of a separate legal entity is legal liability. So many things can go wrong during repairs and rehab work, so ensuring protection would be ideal.
A separate entity also opens the door for future ventures: when I finally start playing the long real estate game and having rentals, and maybe expanding the services to beyond the other umbrella companies.