Small Business Tips
Choosing the Legal Form for Your Real Estate Business
Most real estate agents are independent contractors‚ self-employed business owners who are affiliated with a licensed real estate broker in their state. As such, they are running independent businesses, even though they must work under a licensed broker's supervision.
This post will help guide real estate agents and brokers on how to choose the correct real estate legal forms.
Of course, real estate brokers are also running businesses‚ they, usually own a real estate brokerage firm, either themselves or with other brokers, for which one or more agents work. Every business has a legal form. If you're working as a broker or agent right now, you are almost certainly involved in one of the following types of business entities:
- Sole proprietorship
- Partnership
- Corporation, or
- Limited liability company (LLC)
The sole proprietorship and partnership are the "default entities" they come into existence automatically unless a business's owners take the steps necessary to form one of the other entities.
Sole proprietorship
The vast majority of real estate agents who work as independent contractors for a real estate brokerage are sole proprietors. Many one-owner brokerage firms are also sole proprietorships. Often, real estate professionals attain this legal status without even realizing it: Quite simply, if you start in business by yourself and do not incorporate or form an LLC, you are automatically a sole proprietor.
A sole proprietorship is a one-owner business. Unlike a corporation, LLC, or partnership, it is not a separate legal entity. The business owner (proprietor) personally owns all the assets of the business and is in sole charge of its operation. Most sole proprietors run small operations, but a sole proprietor can hire employees and nonemployees, too. Indeed, some sole proprietor brokers have large firms with many employees.
Forming a proprietorship
The sole proprietorship is by far the simplest and cheapest way to legally organize any business. You don't have to do anything special, or file any papers to set up a sole proprietorship (other than the usual license, permit and other regulatory requirements your state or locality imposes on any business). Of course, you also need to comply with your state's real estate licensing requirements.
For a real estate agent who works as an independent contractor for a real estate broker, the sole proprietorship form is a good choice due to its simplicity and inexpensiveness.
Taxation of sole proprietors
As far as taxes are concerned, it's an excellent choice because it provides pass-through taxation, which most agents prefer. You also won't have to file a separate tax return for your business, which saves time and money. When you're a sole proprietor, you and your business are one and the same for tax purposes. Sole proprietorships don't pay taxes or file tax returns. Instead, you must report the income you earn or losses you incur on your tax return, IRS Form 1040.
If you earn a profit, the money adds onto any other income you have (for example, interest income or your spouse's income if you're married and file a joint tax return) and that total is taxed. To show whether you have a profit or loss from your sole proprietorship, you must file IRS Schedule C, Profit or Loss From Business, with your tax return. On this form, you list all your business income and deductible expenses.
Liability concerns
However, sole proprietorships do have one big drawback: They offer no limited liability. A sole proprietor is personally liability for all debts and other liabilities. This means that a business creditor‚ a person or company to whom you owe money for items you use in your business‚ can go after all your assets, both business and personal. This may include, for example, your personal bank accounts, your car and even your house.
Similarly, a personal creditor‚ a person or company to whom you owe money for personal items‚ can go after your business assets, such as business bank accounts and equipment. If you're a sole proprietor, you'll also be personally liable for business-related lawsuits.
Corporations and LLCs provide limited liability, which is the main reason why many small business owners use them. However, if you're running a one-person operation, the limited liability you'll obtain by forming a corporation or LLC is often more illusory than real. Thus, sticking with the unflashy, simple, and cheap sole proprietorship is a perfectly rational choice.
General partnership
If two or more brokers decide to co-own a brokerage firm and split their income and expenses, they cannot be sole proprietors because they are not running a one-person business. Instead, they automatically become partners in a general partnership unless they incorporate or form a limited liability company.
Forming a partnership
A partnership automatically comes into existence whenever two or more people enter into a venture together to earn a profit and don't choose to form some other business entity. As with sole proprietorships, it is not necessary to file any papers to form a general partnership. However, it's highly advisable to have a detailed written partnership agreement establishing how the partnership will be financed and governed.
A partnership is a form of shared ownership and management of a business. The partners contribute money, property and services, and in return receive a share of the earned profits.
Unlike a sole proprietorship, a partnership has a legal existence distinct from its owners‚ the partners. It can hold title to property, sue and be sued, have bank accounts, borrow money, hire employees and do anything else in the business world that a human being can do. Indeed, in some states, a partnership can obtain a real estate brokerage license in its own name.
Because a partnership is a separate legal entity, property acquired by the parties is owned by the partnership and not the partners individually. This arrangement differs from a sole proprietorship where the proprietor-owner individually owns all the sole proprietorship property.
As a general rule, all the partners in a partnership that operates a real estate brokerage must be licensed real estate brokers. Check your state's real estate broker licensing rules for details.
Partnership taxation
Under partnership tax treatment, the business entity is a "pass-through" entity for tax purposes‚ that is, it ordinarily pays no taxes itself. Instead, the profits, losses, deductions and tax credits of the business are passed through the business to the owners' individual tax returns.
If the business has a windfall, the owners pay income tax on their share on their individual returns at individual income tax rates. If the business incurs a loss, it is likewise shared among the owners who may deduct it from other income on their individual returns, subject to certain limitations.
Unlike a sole proprietorship, a partnership is considered to be separate from the partners for the purposes of computing income and deductions. The partnership files its own tax return on IRS Form 1065.
Form 1065 is not used to pay taxes; rather, it is an "information return" that informs the IRS of the partnership's income, deductions, profits, losses and tax credits for the year. The form also includes a separate part called Schedule K-1 in which the partnership lists each partner's share of the items listed on Form 1065. A separate Schedule K-1 must be provided to each partner.
Each partner reports on his or her individual tax return (Form 1040) his or her share of the partnership's net profit or loss as shown on Schedule K-1.
