Corporations are taxed under subchapter C of the Internal Revenue Code unless the shareholders elect to be taxed under subchapter S. Of these two tax regimes, subchapter C is more onerous. It taxes all income twice: once when it is earned and again when it is distributed to shareholders. If a corporation taxed under subchapter C (C corporation) sells appreciated property, the corporation must pay income tax on the difference between the amount received and the corporation’s tax basis in the property. When the sales proceeds are distributed to the shareholders as dividends, the shareholders must pay income tax on the distribution. This double taxation makes C corporations the most tax-inefficient form of business.
Like partnerships and limited liability companies (LLCs) taxed as partnerships, corporations that are governed by subchapter S (S corporations) do not pay an entity-level tax. All items of income, deduction, and loss are reported to the shareholders. Because these “pass-through entities” can provide liability protection without double taxation, most small businesses today are organized as S corporations or LLCs taxed as partnerships.
Just a few decades ago, though, LLCs had not been widely adopted and S corporations were more restrictive than they are under current law. At that time, C corporations were often the go-to entity for liability protection. Many of these older C corporations—as well as some new ones that were formed for various reasons—now own appreciated assets. This legacy of tax inefficiency creates challenges for planners.
In the small business context, real estate is perhaps the most common appreciated asset owned by C corporations today. The general increase in real estate values over time, coupled with a depreciated tax basis, can create significant built-in tax liability for C corporations. When appreciated real estate is sold, the corporation will pay Federal tax at the corporate tax rates (which range from 15 percent to 39 percent) on the gain from the sale. When that gain is distributed to the shareholders as a dividend, it will be taxed again at the shareholder level.
When it comes to getting appreciated real estate out of a C corporation, there are no quick and easy solutions. But the tax problem usually gets worse if it is not addressed. The best time to deal with the issue is ten years ago; the second best time is usually now.
Fortunately, today’s market is generally favorable for moving real estate out of C corporations. Real estate values have dropped significantly in many markets. Although we are in what appears to be a recovery, the upward trend is relatively recent. In many markets, we may be as close to the bottom as we will be for some time. This gives taxpayers the opportunity to transfer real estate out of a corporation at a relatively low tax cost. If the business owners act now, future appreciation of the real estate as the market improves can escape double taxation.
o There are three ways to deal with appreciated real estate owned by a ‘C’ corporation:
o Distribute appreciated real estate to the shareholders;
o Sell appreciated real estate to shareholders or third parties; or
o Convert the C corporation into a pass-through entity.
Part I of this article discusses the first two strategies. Conversion of a C corporation to a pass-through entity is covered in Part II. More advanced strategies, such as tax-free 1031 exchanges or classification as a real estate investment trust (REIT), are of limited usefulness to most small business owners and will not be discussed in this series.
DISTRIBUTING APPRECIATED REAL ESTATE TO SHAREHOLDERS
One option is for the corporation to simply deed the appreciated real estate to one or more shareholders. The transfer is treated as a deemed sale that is taxable to both the corporation and the shareholders. At the corporate level, the distribution is treated as a sale to the shareholder for fair market value. To the extent that the fair market value exceeds the corporation’s basis in the real estate, the corporation will have taxable gain. The shareholders that receive the property will be taxed on the full amount of the distribution. To the extent that the corporation has current or accumulated earnings and profits, the distribution will be treated as a dividend.
Whether this deemed-sale treatment will be feasible depends on the circumstances. If the corporation has a low basis in the real estate due to depreciation deductions, the built-in gain may be substantial. To make matters worse, there is no actual infusion of cash to the corporation in connection with the transfer. Unless the corporation has a cash surplus, this can leave a shortage of corporate funds to pay the taxes on the deemed sale. In these situations, an in-kind distribution may not be a viable alternative.
On the other hand, if the property has not appreciated substantially, or if the corporation has a net operating or capital loss to offset the corporation’s gain, the deemed sale may not create a significant tax problem. In that case, the shareholders may decide to “bite the bullet” and make the distribution now, before the real estate market fully rebounds.
SELLING APPRECIATED REAL ESTATE TO C CORPORATION SHAREHOLDERS OR THIRD PARTIES
A second option is to actually sell the real estate. The sale of the real estate will be taxable to the corporation. But unlike the deemed-sale treatment that applies to in-kind distributions of real estate to shareholders, an actual sale will generate cash for the corporation to pay the tax incurred on the sale. Although the proceeds from the sale will ultimately be taxed when they are distributed, there is no immediate tax to the shareholders on the sale.
It will often make sense for a shareholder to purchase the property from the corporation and rent it back to the corporation. The shareholder will take a cost basis in the property, allowing the shareholder to take increased depreciation deductions. In some situations, depreciation deductions can help offset the rental income from the property. (A sale-leaseback between a C corporation and its shareholder implicates several rules that are beyond the scope of this article. It is important to work through these rules carefully when considering this structure.)
Whether a sale of real estate will be a good alternative depends on the situation. At a minimum, the shareholder (or other buyer) must have the ability to fund the purchase. And, like a distribution of real estate in kind, this transaction does not avoid double taxation. The appreciation in the property will still be taxed twice: once to the corporation at the time of the sale and again to the shareholders when the proceeds are distributed.
Part II of this article will explore the tax consequences of converting C corporations to pass-through entities. We will look at both subchapter S elections, which require no change in the corporate form, and conversions to LLCs.
Jeramie J. Fortenberry, JD, LLM
Business Docx Executive Editor, WealthCounsel| WealthCounsel Quarterly
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