For real estate investors, dealers, and operators, the risks associated with property ownership are often as important as the economics associated with the underlying investment. Property owners are also concerned about the tax complexities and costs associated with structured ownership and often assume that, if they are adequately insured, their legal risks are minimal (or even nonexistent). However, insurance does not cover all risks. Policy limits and exclusions can create significant exposure when faced with legal challenges that an owner may not be aware of. A single-member limited liability company (SMLLC) can provide property owners and investors with additional liability protection without creating additional tax complications, because there are no additional federal tax filing requirements.
An LLC is a hybrid entity formed under the statutes of the state in which it is created and has benefits of both partnership and corporate forms of business. It can help insulate its owners from personal liabilities and claims associated with the LLC’s activities. In addition to liability and asset protection, an LLC can also provide anonymity, because the ownership is not readily apparent to third parties. An SMLLC is an LLC with only one owner (member). For federal tax purposes, an SMLLC is generally treated as a disregarded entity (DE). As a DE, the SMLLC’s activities are considered to be carried on directly by the single member, thereby eliminating the need to file a separate federal tax return (Regs. Secs. 301.7701-2(a) and -3(b)).
Because an LLC is treated as a flowthrough entity for federal income tax purposes, there is no tax at the LLC level. For individual ownership of an SMLLC used to own and operate rental real estate, the net income or loss is reported directly on the member’s Form 1040, Schedule E (Supplemental Income and Loss). For corporate ownership, the SMLLC is considered to be a division of the corporation and is reported in the member’s Form 1120, U.S. Corporation Income Tax Return, or 1120S, U.S. Income Tax Return for an S Corporation. If the single member is an LLC or a partnership, net income or loss flows directly to the partnership tax return, Form 1065, U.S. Return of Partnership Income. In each case, no additional federal tax return is required. However, since states vary in their recognition of SMLLCs, state and local tax issues need to be considered.
SMLLCs are also practical ownership structures for real estate investors that engage in like-kind exchanges (Sec. 1031). As previously mentioned, the SMLLC is disregarded for federal tax purposes, and the member is considered to directly own the property. The SMLLC can be used to hold title to the relinquished or replacement property. Regardless of whether the relinquished or replacement property is titled in the member’s name, the exchange will continue to qualify under Sec. 1031; for federal tax purposes the properties are considered to be owned by the member (Letter Ruling 200521002). Similar treatment is afforded to SMLLCs for purposes of the replacement rules of Sec. 1033. Property that is involuntarily converted due to condemnation, destruction, etc., will qualify under the favorable tax-deferred rules (Sec. 1033; Letter Ruling 199945038).
SMLLCs can also present a practical solution for multiple holdings when there is more than one member. For example, an LLC with multiple properties or more than one line of business can set up separate SMLLCs for each property or business. As DEs, the SMLLCs do not have federal filing requirements, and the operations are reported directly by the LLC holding company. In certain circumstances this structure can save significant tax compliance costs.
SMLLCs can be practical vehicles for property ownership, rental real estate activities, and real estate development. They can provide significant insulation from potential liabilities, anonymity to third parties, and favorable tax treatment. With a DE for federal tax purposes, the member can reduce transaction and tax compliance costs without impairing nontax objectives. Most states recognize SMLLCs; however, state and local rules need to be considered. Legal counsel should be consulted prior to establishing an LLC.
Frank J. O'Connell, Jr., CPA, Esq, Crowe Chizek, Oak Brook, IL.
Unless otherwise noted, contributors are independent members of Crowe Chizek.
If you would like additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.