Many business owners dive into real estate investments as a hobby or source for additional income. Essentially, the dollars earned from selling properties or collecting tenant rent create a “salary” from a job entirely separate from the executive’s career. But what happens when this extra income becomes a tax burden?
“A lot of people set up an LLC because of what it stands for: ‘limited liability’ corporation,” says Ed Chess, vice president for Brentwood Advisors LLC, the wealth management arm of Brentwood Bank in Bethel Park, Pennsylvania. “Business owners think of an LLC as a defense strategy, but you can use the entity as a tool to do other things.”
Here, Chess provides information on who should take advantage of the LLC as an income shelter, and how its peripheral benefits, such as the Self Employed Pension (SEP, pronounced “sep”), can protect earnings and help shape a sound financial future.
Why set up an LLC for a side business or hobby?
The primary reason business owners set up an LLC is for a ‘corporate veil,’ which protects a business owner’s personal assets should the business have its finances scrutinized for any reason. However, there are other benefits that LLCs offer for sole proprietors who do not have the luxury of opting into company-sponsored retirement savings programs. If a one-man show wants to put away money for retirement, the owner has to organize the program. In this case, that program likely is a SEP, and an owner can set quite a bit of income aside in this account. The same situation can apply to any business executive who has a real estate investment side business.
How does a SEP shelter income for sole proprietor LLCs?
A SEP allows you to create a retirement vehicle for yourself, and you contribute pre-tax dollars or deduct the amount on your tax returns. Your accountant can assist with these details. You do not pay taxes on dollars saved in your SEP account until after you start drawing an income from the account after retirement, in most cases. If that extra income you earned through your LLC bumps your income into a higher tax bracket, you can alleviate tax burden by contributing generously to your SEP. Because you have an opportunity to contribute a significant portion of pre-tax income to the SEP (25 percent of $225,000, or up to $45,000, according to 2007 contribution limits), you can protect this income and also prevent the remainder of your income from being taxed at the higher amount. This strategy is commonly used in sole proprietors’ main businesses, but many people do not think to utilize a SEP for an LLC that is formed for a side venture or hobby like real estate.
What prerequisites are necessary to use an LLC as an income shelter?
There are a couple of steps you must follow to take advantage of the income shelter an LLC provides. First, you must structure your venture as an LLC that pays you, the ‘owner,’ a wage. You must file a W-2 form with your taxes and claim a salary probably a modest one. Your accountant will direct you on the appropriate amount.
Now, because you have an ‘employee,’ which is you, who will need to save for retirement, you can opt for a SEP. This retirement vehicle is your key to sheltering income that you don’t need to access right away.
Can you give an example of a client who will benefit from an LLC?
Say the vice president of a corporation decides to invest in a real estate property with four or five tenants who pay rent. He may set up an LLC to shelter some of the income from his investment in a SEP. Or, say a local police officer owns a duplex rental house. He doesn’t need the income from the house right away. So instead, he can create an LLC entity for this ‘business,’ and set aside a portion of the income for retirement through a SEP. A third scenario is someone who consolidates business debt and refinances a mortgage. As an LLC, he can take a deduction on the interest, but he still has to offset his income. By setting up a SEP, he can shelter up to 25 percent of remaining income that he doesn’t need immediately.
What are some questions executives should ask their bank advisers to learn whether an LLC is the right match for their investment businesses?
Most importantly, partner with a bank adviser who can look at the big picture, which includes business and personal matters. Many who decide to invest in real estate consider it a personal venture, not a business. If their banker only discusses commercial matters with them and presents options that relate to their primary business, which could be anything from manufacturing to retail sales, the adviser is missing a major piece of the puzzle: this side venture that could be set up as an LLC entity to shelter income. So choose an adviser that is willing to make suggestions that apply to every facet of your financial life.
ED CHESS is vice president for Brentwood Advisors LLC in Bethel Park. Reach him at firstname.lastname@example.org or (412) 308-2095.