This is a question that we encounter with some frequency in the context of family-owned corporations, and the backdrop against which the issue arises is not uncommon.
In the Beginning
The older generation may have acquired a building many years ago, either as an investment that would generate a stream of rental income from unrelated commercial and/or residential tenants, or as the site for the family’s operating business.
In some cases, the older generation acquired the property in its own name and subsequently contributed the property to a corporation; in others, a corporation was created, funded, and then used to acquire the property.
At that time– well before the introduction of LLCs– the older generation may have been advised that a corporation would afford it a measure of protection against the liabilities that may arise out of the ownership and operation of a building; that direct ownership, or through a general partnership, would expose the owners, and their other assets, to such liabilities. Whatever the reasons may have been for using a corporation, the fact remains that the older generation and its descendants became shareholders of the corporation.
As time went on and the property appreciated (as real estate tends to do), the older generation may have purchased new properties in the same corporation (perhaps by leveraging the equity in the original property), or it may have sold the original property and, through a like-kind exchange, replaced it with several other properties as a way to diversify its holdings.
The Seeds of Discontent
As the years passed, eventually so did the older generation. Either through lifetime gifts or upon the death of its members, the older generation transferred its shares in the corporation to children, grandchildren, and trusts for their benefit.
Disagreements begin to arise among the members of the younger generation. Someone is unhappy with the way in which the properties are being managed. Someone else is disappointed that the corporation is not distributing larger or more frequent dividends. Others believe that the corporation should diversify geographically, or that its holdings should be more (or less) balanced between residential and commercial properties. Still others would like to see the corporation invest in non-real estate assets.
At some point, the friction among the shareholders may become an obstacle to the operation and management of the properties (and forget about Thanksgiving dinner).
Options for Splitting up?
Assuming the parties cannot be reconciled, there are several alternatives by which this friction may be addressed.
Buyout for Cash?
The disgruntled shareholders may be bought out, either by the corporation (through a redemption of shares) or by the other shareholders (a cross-purchase of shares). The price for these shares may have to be paid in some combination of cash and/or promissory notes. The remaining shareholders or the corporation may have to borrow the monies needed to fund the purchase.
In either case, the departing shareholders would experience a taxable event, and may owe taxes if the amount realized on the sale of their shares exceeds their adjusted basis in those shares. Perhaps worse still, in their minds, they would no longer own an interest in the family’s real properties. (To quote Gerald O’Hara, from Gone with the Wind: “Why, land is the only thing in the world worth workin’ for, worth fightin’ for, worth dyin’ for, because it’s the only thing that lasts.”)
Instead of being bought out for cash, the disgruntled shareholders may insist that one or more of the corporation’s properties be distributed to them in liquidation of their interests in the corporation.
While such a distribution is certainly possible from a corporate and real estate perspective – assuming it doesn’t violate the terms of any mortgage or other agreement, and assuming the parties can actually agree on how to divide the properties among them – the distribution would be treated, for tax purposes, as though the corporation had sold the distributed properties for their fair market value. As a result, the corporation may realize a taxable gain, for which it will have to pay taxes.
The departing shareholders may also realize a taxable gain to the extent the fair market value of the property distributed exceeds their adjusted basis in the shares of the distributing corporation.
Moreover, if the corporation is an S corporation, its shareholders (both those remaining and the departing shareholders) will have to report and be taxed on that gain. Although the gain realized will usually be capital gain, it is possible that the deemed sale will generate ordinary income (for example, because of depreciation recapture or the application of a “related party sale” rule).
Is a Taxable Event Inevitable?
Even at the height of their disagreement,the family members will likely concur that the less tax paid, the better. They will thus be encouraged to hear that it may be possible for a corporation that owns real properties to contribute some of those properties to a subsidiary corporation, and to then distribute all of the shares of the subsidiary to some of its shareholders in liquidation of their interests in the parent corporation, without triggering a taxable event for either the corporation or its shareholders– provided certain requirements are satisfied.
Among these requirements, the one that is often the most difficult to satisfy in the case of a real estate business is the requirement that both the parent (distributing) corporation and the subsidiary (controlled) corporation are each engaged in the active conduct of a trade or business immediately after the distribution.
The Active Trade or Business
A corporation is treated as engaged in the active conduct of a trade or business if the assets and activities of the corporation satisfy certain requirements.
Specifically, a corporation shall be treated as engaged in a trade or business if the corporation carries on a specific group of activities for the purpose of earning income or profit, and the activities include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.
The determination of whether a trade or business is actively conducted will be made from all of the facts and circumstances. The corporation is required itself to perform active and substantial management and operational functions through its employees. Generally, activities performed by the corporation itself do not include activities performed by persons outside the corporation, including independent contractors. However, a corporation may satisfy the requirement through the activities that it performs itself (through its employees), even though some of its activities are performed by others (for example, skilled contractors).
A trade or business that is relied upon to meet these requirements must have been actively conducted throughout the five-year period ending on the date of the distribution.
Expansion or New Business?
The fact that a trade or business underwent change during the five-year period preceding the distribution is disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business. In particular, if a corporation that is engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period. (Query how a like kind exchange of real properties would be treated for this purpose.)
However, if that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business, and that trade or business is to be relied upon to meet the above requirements, then the acquisition must not have occurred during the five-year period ending on the date of the distribution unless the new business was acquired in a transaction in which no gain or loss was recognized.
Stay tuned for Part II, tomorrow.