In recent years, the increased availability of information has made a broader range of people more interested in both active and passive investing. Individual investors can now open a self-directed retail brokerage account online to get started in a matter of days. Information about making investments in real estate, startups, and other businesses can be easily found online. Consequently, there is growing interest in understanding how to earn passive income from active investment decisions.
When you first get started with investments, your ownership structure is relatively insignificant. However, as your capital contribution becomes more significant, you may want to invest in assets that have the potential to trigger losses that exceed your initial investment. In the world of business, individual investors are subject to the potential for unlimited losses while incorporated entities have the potential to limit liability to the amount of investment capital.
Therefore, investors have to consider the possible advantages of incorporation to enjoy the potential to limit losses. Additionally, investing your wealth through an entity can potentially lead to tax advantages and improve your ability to access certain types of assets. If you plan to make investments with your capital, you should read on to discover what ownership structure could be most advantageous in your situation.
Why Invest as an Individual?
There are many advantages to making investments as an individual. For new investors, the most significant advantage is that you can get started right away with no legal hassle. Passive investors can simply open an investment account to get started right away. Most reputable brokerage account providers will handle all legal considerations on your behalf.
In the U.S., only individuals can directly take advantage of 401(k) plans and other tax-advantaged investment accounts. Most investors who are simply trading securities to earn passive income for retirement get the most benefits from using tax-advantaged accounts. If you already have a retirement account, you can convert it into a self-directed account that lets you take full control over the portfolio of assets that you invest in.
The most common securities that self-directed investors gain exposure to are stocks and bonds. Additionally, the IRS has rules that can enable you to buy real estate, promissory notes, and even cryptocurrencies when you use a self-directed retirement account. However, unlike with corporations, individuals with retirement accounts are restricted to making investments in the limited range of asset classes that the IRS permits. Most of these assets are only useful for a passive investor. For instance, you can only invest up to $50,000 of your retirement funds into your own business unless you use Rollovers for Business Startups that are only applicable in a minority of instances.
Although retirement accounts are usually the most advantageous option, other investors prefer to keep their money in personal accounts to enjoy total flexibility. Individual funds can be invested into almost any asset class. You can also invest your money abroad with few restrictions.
Individual investors retain full control over how their money is utilized. When you invest as a corporation, your options are limited if you have a business partner. Some states insist that corporations have a specific purpose, so you could have to take your money out of your corporation to invest in other assets. When you withdraw your money, there could be significant tax consequences.
Few investors know that many of the tax advantages that corporations enjoy can be realized by individual investors. For instance, the section 962 election can enable individual investors to be treated as C-corporations for tax purposes. Therefore, individual investors are often able to get the same benefits that corporate structuring can provide when they plan ahead.
Finally, keep in mind that tax and corporate structuring is highly complex. Unless you have a substantial budget for legal fees and are aware of a highly competent tax attorney who you can trust, the cost of setting up a corporate structure to take advantage of complex laws often exceeds savings that could be realized.
Problems With Making Investments as an Individual
There are, however, many cases when the benefits associated with corporate structuring are more beneficial for passive investing. Not all corporate structures are complex. Many tax savings and liability avoidance strategies can be utilized by filling out a few simple forms.
Before diving deeper into some of the corporate structures that you could use, it is important to understand some of the problems associated with passive investing as an individual. Some of these issues include:
No ability to delegate: With a corporation, you can easily set up an authorized agent to sign documents and take other actions on your behalf.
Limited ability to deduct losses: Under the IRS code, investors are ordinarily unable to deduct more than $2,500 in investment losses on their tax returns. With a proper corporate structure, deductions can be unlimited and pass through to you as an individual.
Higher taxes: For certain types of investments, corporations can help to build wealth by reducing the effective tax rate that you have to pay on your investments. Corporations are especially beneficial when making investments in real estate or commercial assets.
Unlimited liability: As mentioned earlier in this article, you are liable for unlimited losses when you invest as an individual. When making investments in businesses or real estate, you should always use a corporation to avoid catastrophic losses when legal issues arise.
No ability to form partnerships: Taking on partners can multiply the returns that you could realize when making investments. Corporations are almost always necessary when doing business with other people.
Making Investments as an LLC
Limited liability companies are the most common form of corporation that investors utilize. When wealth building, the most significant advantage of an LLC for ordinary investors is the ability to get started quickly and at minimal cost. Most states let investors open an LLC by filling out a simple form and paying a filing fee of less than $200. Once your LLC has been opened, you can easily open a bank account and usually get a brokerage account with no hassle.
If you are trading actively managed investments, LLCs can help to reduce your tax liability. Investors can file IRS Form 2553 to have their LLC taxed as an S-corporation. As long as you pay yourself “reasonable compensation,” you can pay yourself dividends that are subject to neither the 15.3 percent payroll tax nor the 3.8 percent net investment income tax. For passive income investments that are not subject to the payroll tax, the 3.8 percent NIIT can be avoided in some cases with an LLC.
Another major advantage of LLCs is that you can easily take on partners to make investments by pooling capital. LLCs give you and your partners an enhanced ability to control operating agreement terms. You also do not need to have board meetings unless your LLC is taxable as an S-corporation.
As a passive investor, you should be aware that limited liability protection is one of the most substantial benefits of using an LLC. Opening an LLC is very easy, so investment professionals almost always recommend working through an LLC to avoid exposure to unlimited losses. There are cases when courts can “pierce the veil” to make LLC shareholders personally liable, but this legal mechanism is only used in rare cases.
In many states, the assets within an LLC cannot be seized by creditors. Instead, creditors can only put a lien on your shares. Leins require you to remit any dividends to lienholders, but you still remain in control of all assets within your LLC and can continue to pay yourself a salary.
Making Investments With a C-Corporation
In some cases, investing as a C-corporation can be a more advantageous wealth-building strategy than making investments through an LLC. C-corporations are relatively expensive and complex to create, and they have many rules that you have to comply with. Additionally, you have to pay both capital gains taxes and corporate taxes when operating through a C-corporation.
If you invest in foreign corporations, it is almost always more beneficial to own these assets through a U.S. C-corporation. Remittances to your C-corporation from abroad are not taxable. Instead, you will only have to pay the 10.5 percent GILTI tax on the corporate earnings of your foreign corporation and the 20 percent capital gains tax at the shareholder level when you eventually distribute dividends from your C-corporation. Many tax strategies are available to almost completely eliminate GILTI tax liability. In contrast, individual investors ordinarily have to pay a GILTI tax rate of 21 percent plus a 37 percent tax on the remainder.
It is a common myth that only C-corporations are considered separate persons under the law. As legal corporations, LLCs and S-corporations are also considered separate persons. However, C-corporations give you the strongest level of liability protection. Many mistakes that can lead to the piercing of the corporate veil when using an LLC do not entail similar consequences when operating through a C-corporation. In practice, C-corporations can also obtain their own credit score and can often borrow in their own name.
There are a monumental range of deductions and tax credits that can be claimed only by C-corporations. When making investments in real estate, careful tax planning can often almost completely eliminate your corporate tax liability.
C-corporations can also have an unlimited number of investors and can even go public. However, funds in a C-corporation are required to be distributed unless you have immediate plans to use them for active business activities, so these corporations are usually not advantageous if you are looking to invest in publicly traded securities. The bottom line is that you need to do your research before deciding on the right type of structuring, but making the right decision can save a significant amount of money while minimizing legal liability.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.