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
- 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.
The great 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 operations 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 own personal tax return, IRS Form 1040.
If you earn a profit, the money is added to 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.
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.
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/or services to the partnership and in return receive a share of the profits the partnership earns. 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 a partnership is property of the partnership and not of the partners individually. This 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.
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 profit, 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. Form 1065 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.
Partnerships don’t provide the individual partners with any limited liability. Partners are personally liable for all partnership debts and lawsuits, just like sole proprietors. This means that you’ll be personally liable for business debts your partners incur, whether or not you know about them.
A corporation is a separate legal entity you can organize and conduct as a business and share in the profits or losses. 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.
In theory, every corporation consists of three groups: those who direct the overall business, called directors; those who run the business day-to-day, called officers and those who just invest in the business, called shareholders. However, in the case of a small corporation, these three groups can be (and often are) the same person; that is, a single person can direct and run the corporation and own all the corporate stock. So if you incorporate your one-person real estate business, you don’t have to go out and recruit and pay a board of directors or officers.
If you incorporate your real estate business, it becomes the “owner” of the business—that is, it owns or leases all the necessary assets to run the business and hires employees and independent contractors to provide services to clients. It collects all the money clients pay, and pays all the bills including employee salaries and benefits. You own the corporation in the form of stock ownership. And you will ordinarily work as an employee of your corporation.
In many states, a corporation can obtain a real estate broker license in its own name. Most states require that some or all of the officers and/or directors of the corporation be licensed brokers.
Forming a corporation
You create a corporation by filing the necessary forms with, and paying the required fees to, your appropriate state agency—usually the office of the secretary of state or corporations commissioner. Each state specifies the forms to use and the filing cost. You’ll also need to choose a name for your corporation, adopt corporate bylaws, set up your corporate records, and “capitalize” your corporation—issue stock in return for money, property and/or services provided to the corporation.
In some states, real estate brokers and agents must form a special type of corporation called a professional corporation. A professional corporation has the basic attributes of a regular corporation with certain restrictions about ownership and the type of work it can do. Typically, a professional corporation must be organized for the sole purpose of performing professional services and all shareholders must be licensed to render that service. Thus, for example, in a real estate broker corporation, all the shareholders must be licensed brokers. A professional corporation is a state law classification—it has nothing to do with the IRS or taxes.
For tax purposes, there are two types of corporations: S corporations and C corporations. S corporations are pass-through entities are taxed similar to partnerships. C corporations are separate taxpaying entities. C corporations must pay income taxes on their net income and file their own tax returns with the IRS. They also have their own income tax rates (which are lower than individual rates at some income levels).
Because a C corporation is a separate tax-paying entity, it may provide its employees with tax-free fringe benefits, then deduct the entire cost of the benefits from the corporation’s income as a business expense. No other form of business entity can do this. When you form a corporation, it automatically becomes a C corporation for federal tax purposes. But you have the option of choosing S corporation taxation by filing an election with the IRS.
Limited liability provided by corporations
The main reason real estate brokers choose the corporate form is to limit their personal liability for business debts and lawsuits. In theory, the owners of a corporation—the shareholders—are not personally liable for corporate debts. However, in realty, owners of small corporations are often required to personally guarantee their corporation’s debts, so such limited liability is often more mythical than real.
Moreover, the single greatest liability exposure most real estate agents and brokers face is for malpractice—lawsuits by dissatisfied buyers or sellers alleging things like fraud, misrepresentations, negligence, failure to disclose and other violations of the agent’s or broker’s legal and fiduciary duties. Forming a corporation will not protect you against personal liability for your own malpractice or other personal wrongdoing.
If your business doesn’t have enough assets to pay a judgment obtained against you, your personal assets can be taken. Thus, your personal assets will always be on the line if you are sued for malpractice. This is why real estate sales professionals should always have errors and omissions insurance.
As a rule, a real estate broker is legally responsible for the actions of the real estate agents (salespeople) who work in his or her office. Forming a corporation or limited liability company may help limit the extent the broker can be held personally liable for malpractice committed by independent contractor agents or employees as long as the broker wasn’t personally involved in the alleged wrongdoing.
Many states require that real estate brokers have malpractice insurance to obtain this limited liability. Other states limit the amount of limited liability incorporating can provide a broker. The rules vary from state to state—you should learn yours to determine if incorporating makes sense to limit your personal liability for others’ malpractice
Limited Liability Company
The limited liability company, or LLC, is a unique hybrid: a cross between a partnership and corporation. It provides the flexibility, informality and tax attributes of a partnership and the limited liability of a corporation. For many, this is the best of both worlds, and LLCs have become very popular in recent years. Many real estate professionals have formed LLCs. However, some states—California, for example—bar most real estate brokers from using them.
To form an LLC, one or more people must file articles of organization with their state’s business filing office. Although not required, it is highly desirable to adopt a written LLC operating agreement laying out how the LLC will be governed. If you don’t prepare an operating agreement, the default provisions of the state’s LLC Act will apply.
In most states, all the owners must be licensed to perform the professional services carried on by the LLC; and ownership cannot be transferred to unlicensed individuals. Thus, all owners of an LLC formed to operate a real estate brokerage must be licensed brokers, and no owner may transfer his or her ownership in the LLC to a non-broker.
LLCs owned by two or more people are ordinarily taxed the same as partnerships. LLCs with only one owner, are taxed like sole proprietorships.
The advantage the LLC provides over partnerships and sole proprietorships is that it provides its owners the same degree of limited liability for business debts and lawsuits as do corporations as described above. However, they are favored over corporations by many small business owners because they are easier to form and operate, requiring less legal formalities.
MileIQ’s blog does not constitute professional tax advice. You should contact your own tax professional to discuss your situation.