Paying yourself management fees from a sole proprietary LLC owning a real estate property

Forum|Forum|1 year ago
January 10, 2025
3 replies
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Background:

I own a rental property through a single member LLC (say LLC-A). Currently, I am self managing all the operations. I am planning to setup an S-corp (say LLC-B) to manage this rental property and a new property I will be acquiring this year. LLC-A is a disregarded entity for tax purposes and I report the rental income/expense on Sch-E. The income from LLC-B will be reported on Sch-C where all of it will go to my solo 401K leaving zero tax liability.

Problem:

I dont understand why the strategy above is a bad one. I have read many articles from various CPAs advising against it, including my CPA. Whereas I consider it as an excellent strategy. Below is an example which makes me believe why this is a great strategy:

Example:

1) Say I charge $47000 for full 1 yr of management, repair, and clean fees. This is a writeoff on sch-E.

2) $47000 I report as income on Sch-C. Here I am exposed to SE taxes. However, I already maximize social security taxes from my W2 income. Hence, I only pay medicare taxes which will be ~$1100.

3) After paying this medicare taxes I move the remaining amount to my solo 401K making sch-C income zero and tax free.

4) If I did not pay myself, I would have likely ordinary tax on $47K income on Sch-E (even after depreciation, interest, insurance, etc), whereas by moving $47K to sch-C it goes to my retirement account with only medicare taxes due right now. On sch-E this $47K is a writeoff making income zero or creates loss which is carried forward till absorbed by capital gains at sale.

What am I missing? Why everyone is advising me against it including my CPA? Please help me understand. Where am I going wrong?

Regards,

Nick

Side notes:

1) Choosing $47K above as I contribute $23K from my W2 and $70K is max 401K contribution limit for 2025.

2) $47K as management fee for 1 property is high, but for 2 properties it will be <15% of the total rental income which is quite standard.

3) I know only self-employment income can contribute to solo 401K, and management fees ARE a valid self-employment income.

4) Business purpose for LLC-B is literally to manage two rental properties. I don't get it how IRS can classify this as serving no business purpose. After all somebody has to manage the properties, pay utilities, find tenants, pay city fees, etc. LLC-A files sch-E and cant be expected of doing anything as its a passive income and treated as such.

Not A Product Question

Best answer by M-MTax

why there is no economic substance: Property management is a valid active business, and by making the setup above I am correctly segregating passive activity reported on Sch-E and active activity of property management through LLC-B.

What you stated above is exactly why there is no economic substance. You are segregating passive activity from business activity of property management solely for tax purposes. Can you state any reasonably valid, non-tax, reason for doing so? You can easily manage the properties without creating a separate S corporation, which you alone own and control, for management purposes. I mean, you're actually doing that now.

M-MTax

You brought up a number of hot issues but the one in bold below may be problematic.

"Say I charge $47000 for full 1 yr of management, repair, and clean fees."

$47k worth of management fees would only be justified if you had $250k in gross rental income at the very least. The standard management fees are typically around 10% and sometimes less than that depending upon the property. Some firms charge fees as high as 20% but that figure is usually limited to short-term rental properties (even at 20% - about maxed out - you'd need close to $500k in gross rental income).

I think you need to tackle the threshold question of whether $47k in management fees is reasonable. You might also want to note that the IRS can blow up your entire schema by concluding that the legal structures and fee payments lack economic substance (i.e., they have no purpose other than tax avoidance).

nickamAuthor

@M-MTax

Thank you for your kind response. I will keep this mind.

However, $47K is justifiable management fees. I am going to get a service quote from some of the large rental properties in my area to back this up.
The total rental income expected is just over $360K and management fees depending on the level of involvement range from 8-15%. I believe you agree with me here.

VolvoGirl

Employee

Your post is confusing with schE & C & S corp. If you set up a SMLLC S corp you do not report it on schedule C. You file a separate business return 1120-S for it. Then you would get a W2 or K-1 to enter into your personal return. I'll page @dmertz for info on the 401k.

nickamAuthor

@VolvoGirl

Many thanks for your response.

You are right I did create some confusion.

Lets see if I can clarify:

S-corp receives management fees --> issues W2 to me --> From this 100% goes to solo 401K + 25% contributed by S-corp

Total taxes in this transaction --> Medicare taxes which might total (employer + employee) to around 3.8% max. This is significantly less than $47K of original income going into Sch-E.

I am aware of the filing requirement for the S-corp itself. That is just bunch of forms. Main issue is the actual income that flows through it.

Mike9241

I am planning to setup an S-corp (say LLC-B) to manage this rental property and a new property I will be acquiring this year. LLC-A is a disregarded entity for tax purposes and I report the rental income/expense on Sch-E. The income from LLC-B will be reported on Sch-C where all of it will go to my solo 401K leaving zero tax liability.

An S-corp must file an 1120S tax return. The income is not reported on Schedule C but on page 2 of Schedule E. For a moment disregarding that the IRS may blow the whole thing up saying there is no economic substance, the S-corp is now conducting a business - managing property - you would have to take a reasonable salary that would flow to your 1040. You would be paying FICA and Medicare taxes and your retirement plan contributions would be limited. Should the IRS blow it up any money in that retirement account would be immediately taxable.

dmertz

Employee

As Mike9241 said, nothing about the S corp goes on your Schedule C. You are an employee of the S corp. As a disregarded entity, the sole proprietorship can't be a shareholder in the S corp. You as an individual would be the shareholder.

If you are proposing switching from a sole proprietorship to an S corp, the sole proprietorship would have no income or expenses, nothing to report on Schedule C. Under the circumstances, your sole proprietorship and the S corp having the same ownership would mean that they would be a controlled group for the purpose of a retirement plan, so with your only compensation coming from the S corp, your retirement contributions would be limited to the amount of your compensation paid to you by the S corp and reported on your W-2 from the S corp.