After consulting meetings with some great real estate agents both at American Land Brokers and those working with other brokerages, I, Mark, have found myself advising 3 agents to convert their real estate business to an S Corporation to save them between $7,000 and over $12,000 per year in Self-Employment taxes (not to mention other businesses I have worked with who have saved up to $50,000!). American Land Brokers has joined forces with Mark Sharman, CPA, PC to make sure our agents are set up for success in these areas, and we would like to share our success with other agents as well!
I happen to know that the agents I met with this week are not the only real estate agents who could use some help reducing their tax liability. Many agents have never even heard about this tax strategy, and many who have heard either don’t understand how it works or how to implement this strategy. The result is that these real estate agents end up digging deep into their pockets every year to cover a tax burden they could otherwise avoid.
If this sounds like you and you want to learn more about one of the best tax saving strategies for real estate agents, read on!
The Story of “Annie Agent”
“Annie Agent” is the typical real estate agent I meet who simply wants to make a living for her family. Annie started as an agent a few years ago. She works hard at building her network and helping her sellers get their houses sold at the best prices along with her buyers finding their dream home. Her first year was a struggle as she netted just over $50k, but she really took off in her second year and took home over $150k. This year, she is on target to exceed her goal of $200k in commissions.
However, each year when Annie finishes her tax return on TurboTax for her Single-Member LLC on the Schedule C of her personal return, she sees a gut-wrenching bill that has been growing from $7,000 to last year’s bill over $20,000! She is cringing thinking about how much she is going to owe this year, hoping that the tax bill won’t wipe out all her savings.
Annie finds a good CPA who tells her that the answer is an S Corporation! Annie says, “Great! What do I need to do?” The CPA says it will cost her $2,000 just to get the S Corporation formed, $500 more for the payroll accounts that need to get set up, and thousands more a year for the necessary payroll processing, payroll tax returns, and income tax returns. All of a sudden this “answer” doesn’t look to good to Annie, and it may not look great to you either until you understand what this “S Corporation” deal is and see what Sharman CPA can do to make this worth your while.
It All Comes Down to Types of Income
In approaching this tax strategy, we must first lay the foundation by explaining the different types of income. The income we are interested in here is active income and passive income.
Active income is income that is derived from the activities of the taxpayer and is taxed at ordinary rates, including W-2 wages, salaries, and income from work as a sole proprietor or partner in a partnership. The idea here is that this is income you are actively working for (other types of income is classified under the term “active income,” but for the purposes of this article, we will use this term to refer to these income types).
Passive income is income that is generated from activities in which the person is not actively involved. This can include rental income, income from limited partnerships, and from stocks and bonds (although some would argue that the latter are considered “portfolio income.”)
So why do we need to understand these terms? Because the way your income is classified – either active or passive – on your tax returns, has significant implications on how the income will be taxed. In short, active income is taxed at higher rates than passive income, particularly when it comes to the Self-Employment Tax.
Self-Employment Taxes on Business Income
Let’s break down the main problem by going back to what Annie was facing in the story above.
100% of Annie’s net income from her Single-Member LLC Real Estate Business on her 1040 Schedule C is considered active income. Not only will Annie pay her normal Federal and State taxes on this income, but on top of that, he will pay 15.3% in Self-Employment Taxes as well.
Self-Employment tax includes the Social Security and Medicare taxes that are normally split between an employer and the employee on W-2 wages. Because this income is classified as active income, the same Self-Employment tax that would normally be taken out of your paycheck also needs to be paid on this income.
The problem is that most real estate agents don’t understand what this tax is, why it applies to them, and most importantly how to reduce the amount of Self-Employment tax that they owe. If this is you, read on!
Converting Active Income to Passive Income
If you haven’t already guessed it, the key to this whole strategy comes in because Self-Employment taxes are not assessed on passive income. This strategy is the most effective way for you to convert your real estate business income from active to passive income. So let’s break this strategy down so that you understand its moving parts and how to do this successfully without landing in an IRS audit.
Step 1 – Evaluating Your Situation
Even if converting active income to passive income is the goal, the S Corporation is not always the right way to go about it. First, your business, tax and investment situation needs to be evaluated to determine what entity structure is appropriate. The S Corporation comes with different restrictions and conditions that may preclude its use in your situation. You do need to speak to a knowledgeable CPA about your circumstances before moving ahead.
Step 2 – S Corporation
Convert your business to an S Corporation. This first step can be done through either opening a new business or converting your existing business to an S Corporation (see here and here for the IRS forms to make this happen – but you need to make sure you are filing the correct form).
Step 3 – Reasonable Compensation
This step concerns what the IRS terms Reasonable Compensation. The IRS requires that a shareholder-employee of an S Corporation (which the business owner would be) is required to be paid reasonable compensation in return for services that the business owner (now employee) provides to the S Corporation. After this reasonable compensation has been paid, the IRS allows you to take non-wage distributions which are considered passive income.
If you are tracking with the terms, you may notice that this reasonable compensation is classified as W-2 wages, and W-2 wages, as we noted above, are considered active income that you have to pay Self-Employment taxes on. You may be thinking that the whole point was to get out of paying these taxes, so why are we finding out complicated ways to pay the same tax?
The reason is because the market rate for your reasonable compensation may be significantly lower than your total taxable income. In many cases with the real estate agents I work with, I have gone through the detailed process of calculating the work they perform and the value of each function and found that their W-2 wages were between 20-50% of their total business income.
This is a critical step that cannot be overlooked in this strategy. Many have overlooked this and have not managed the reasonable compensation well and have had their passive income reverted to active income by the IRS.
Step 4 – Payroll and Payroll Tax Return Processing
The third step to saving on Self-Employment taxes is running monthly payroll and quarterly payroll tax returns. This means setting up withholding and unemployment accounts with the State (for Colorado, where I am located, go here).
Each quarter you will need to file Form 941 with the IRS, State Withholding tax return (Form 1094 with Colorado if you are located in my state), and the Unemployment Insurance Tax Return (here for Colorado). Annually, you will need to file W-2’s and Form 940 along with other annual state filings.
Running payroll consistently and correctly is another important step that often gets overlooked or messed up, causing a big headache!
Step 5 – S Corporation 1120s Tax Return
The final step to big savings on your Self-Employment taxes is making sure that your business tax returns are filed correctly as an S Corporation 1120S tax return and not a Schedule C or 1065 Partnership return.
Overwhelmed Yet? Don’t be!
If you’ve made it this far and your eyes haven’t glazed over, you might want to look into accounting as your next career! I get it, what I have laid out above has its complexities and can be daunting. Remember Annie’s story above where the CPA offered to help her out by charging her thousands of dollars to get it all done? Well, that’s because there is some complicated work involved.
But this is why American Land Brokers has partnered with Sharman CPA, because what we have to offer really shines. I have streamlined the process of converting businesses to, or setting up S Corporations, figuring out reasonable salaries, setting up payroll accounts, processing payroll and payroll tax returns, and filing 1120S tax returns.
The average real estate agent that we work with saves between $5,000 and $20,000 a year, and more when we are talking about multiple owners. For most of these agents, the total annual out-of-pocket for all of these services above is less than $1,500 – which is far less than just the S Corporation formation costs with some CPA Firms, let alone their annual payroll processing and payroll and income tax fees.
Clearly, the tax savings has to outweigh the cost of the services for setting this up, which is why I have worked so hard to make this process as efficient and cost-effective as I can.
How Things Ended with Annie
Annie Agent is like many of our small business real estate clients we serve. She found the right balance between maximizing tax savings through an effective S Corporation structure, payroll management, and income tax return services. She saved over $10,000 and it only cost her $1,250!
Going forward, she also had us help her with her quarterly bookkeeping for $250/Qtr which helped her save a week of work trying to keep everything organized. She was able to take the time we saved her to bring in another closing! Now she is working on tax planning to help her save even more and build up her savings for her first investment property.
What You Need to Do
Don’t delay in getting your real estate business structured to reduce your tax liability. If you would like to see how you can get the best solution for your business and personal tax situation, I would like to offer you a free consultation to help you understand what needs to be done to save you money. If you decide you don’t want to work with me, then you will at least leave our conversation with a greater understanding of your business and your tax situation.