As discussed in the first part of this series, C corporations are tax-inefficient forms of business. C corporation income is taxed twice—once when it is earned, and again when it is distributed to the shareholders. To avoid this double taxation, most newly formed businesses use pass-through entities like S corporations or limited liability companies (LLCs) to own real estate.
But a few decades ago, S corporation requirements were more onerous and LLCs didn’t exist. Because of this, and for other reasons, many C corporations still own real estate.
Part I of this series discussed two strategies to get real estate out of a C corporation:
(1) distributions to shareholders and (2) sales to shareholders or other third parties.
This article discusses the use of conversions to move appreciated real estate from C corporations into more tax-efficient business structures. A conversion changes the tax classification of the C corporation to either an S corporation or to an LLC. This can avoid double taxation of future appreciation in value and, in the case of subchapter S elections, may avoid double taxation altogether.
Converting a C Corporation to a Subscriber Subchapter S Corporation
The least expensive way to convert a C corporation to a pass-through entity is to make a subchapter S election. A subchapter S election can be made without changing the corporation’s form. The shareholders simply file Form 2553 (Election by a Small Business Corporation) by the 15th day of the 3rd month of the corporation’s current tax year. Once the election is filed, the former C corporation becomes a subchapter S corporation and—with the exceptions discussed below for passive income and built-in gains—does not pay an entity-level tax.
This allows the corporation to avoid a corporate-level tax on earned income or gain from the sale of its assets. All of the corporation’s income is reported by the shareholders on their personal income tax returns. Not all corporations qualify to elect subchapter S status. In order to qualify as an S corporation, the business entity must meet several requirements:
Capitalization Requirement – The corporation must not have more than one class of stock. Although differences in voting rights are disregarded, there can be no economic differences like dividend or capital-return preferences.
Passive Income Requirements – If the corporation has pre-conversion earnings and profits, excess passive income is taxable to the corporation and thus subject to double taxation. If an S corporation is taxed for excess net passive income for three consecutive years, the Internal Revenue Service will automatically terminate its subchapter S status.
Shareholder Requirements – The corporation must have no more than 100 shareholders, and each shareholder must be either a U.S. citizen or resident. Some estates, trusts, and tax-exempt organizations may also be shareholders.
Whether a subchapter S election will completely avoid double taxation of real estate often depends on how long the corporation holds the real estate. Businesses that convert from C corporation to S corporation status are potentially subject to built-in gains tax if the property is sold during a ten-year period.
Upon a sale of the property during the built-in gains period, an entity-level tax is levied on the excess of the fair market value of the corporation’s assets over their basis at the time of conversion. This built-in gains tax applies to any appreciation that occurred prior to the conversion. If the corporation can hold on to the appreciated real estate for a 10-year period, it may completely avoid double taxation on the sale of the property.
Even if the client plans to sell the real estate within 10 years (or doesn’t know when the real estate will be sold), the immediate benefit of eliminating the double taxation of current earnings is often reason enough to file a subchapter S election. If the corporation meets the requirements for subchapter S status, there is often no downside to filing the election.
Converting a C Corporation to a Limited Liability Company
As stated above, some entities are not eligible to file a subchapter S election. If the corporation does not meet the eligibility requirements for electing subchapter S status, it may be converted to an LLC. Unlike a subchapter S election, though, a conversion from C corporation to LLC has immediate income tax consequences that must be carefully evaluated.
Still, if taxes cannot be fully avoided on a transfer of real estate, the second-best alternative is to minimize them. Depending on the circumstances, long-term savings resulting from conversion to an LLC may justify the up-front tax cost.
As mentioned above, a subchapter S conversion can be accomplished without a change to the corporate form. Conversion to an LLC is more complex. There are four ways to convert a C corporation to an LLC:
Assets-Over Conversion – The corporation transfers its assets to the LLC in exchange for interests in the LLC. The corporation then transfers the LLC interests to the shareholders in liquidation.
Interest-Over Conversion – The shareholders transfer the shares of the corporation to an LLC, which becomes the sole shareholder of the corporation. After the transfer of stock to the LLC, the corporation liquidates and distributes its assets to the LLC.
State Law Merger or Statutory Conversion – The corporation merges into or elects to become an LLC under provisions of state law. (This option is only available in states with enabling legislation.)
No matter how the conversion is structured, the share-holders leave the transaction with LLC membership interests that they received in exchange for their stock in the former corporation. This exchange of stock for membership interests—whether direct or indirect—is generally taxable to both the shareholders and the corporation. This requires a careful comparison of the tax cost of the conversion and the tax cost of a future sale of the real estate in the absence of a conversion.
If the real estate has not appreciated substantially (or is currently distressed but expected to appreciate in the future), the future tax savings may outweigh the immediate tax cost of the LLC conversion.
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