S Corporations

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We scattered little comments here and there about S Corps. Here is a quickie recap when it comes to rental properties and real estate investments owned by S corporations.

Generally, you do not want to have appreciating assets in an S corporation environment. Should you want to revoke S Corp election, or your election is deemed ineffective because of conflicting language in the Operating Agreement or side-pot deals with your business partners, assets are distributed to the shareholders at fair market value. This can create capital gains without cash, which is typically bad. Even in Canada (joking, Canadians are ok at math).

Also, keep in mind that the primary purpose of an S corporation election is to change the color of money. Earned income goes in which is normally taxed at both the self-employment tax and income tax levels. However, with an S Corp, only wages paid to the shareholder are subject to Social Security and Medicare taxes (self-employment taxes). As such, the lower the wages within the confines of reasonable shareholder salary the better from an overall tax perspective.

Next, rental income is usually passive income and therefore not subject to self-employment taxes which are also known as Social Security and Medicare taxes. Armed with those two concepts, you can see that an S Corp election is not necessary on rental income.

Entities taxed as an S Corp are still recommended for earned income which might come from brokerage commissions, management fees, and fix and flips. We mention this since real estate investors take all kinds of shapes and colors; some are pure rental property owners while others are involved in all sorts of investment madness.

Sidebar: S Corps are subject to hobby loss rules in a sense. In other words, if your S Corp loses money each year, the IRS might consider the activity a hobby or an activity not in pursuit of a profit. What are we talking about here? You have an S corporation that earns very little. You contribute additional paid in capital each year to create shareholder basis so you can deduct your automobile or other owner-friendly deductions. You create a tax loss, and since you have basis, you can deduct that loss on your individual (Form 1040) tax returns. Scam. Harsh? Not at all.

For more riveting information and a deep dive as they say into S Corporations and self-employment taxes, please see our book titled, Taxpayer’s Comprehensive Guide to LLCs and S Corps.