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 [email protected] or
(412) 308-2095.