“When will they ever learn?”
No, I am not channeling Seeger. I am referring to those individuals[i] who continue to acquire real property (“RP”) in, or who contribute RP to, corporations. In just the last couple of months, I have encountered taxpayers who want to remove RP from the closely held corporations in which they are shareholders. Of course, they want to do so on a “tax efficient” basis. Their reasons for removing the property are varied.
In one case, for example, the shareholders want to dispose of the business that also resides in the corporation; they want to do so by selling their shares of stock in the corporation, so as to avoid the two levels of tax that would result from a sale of the corporation’s assets; however, they also want to retain ownership of the RP.
In another, the shareholders want to withdraw some of their equity from the RP in the form of a distribution from the corporation.
In yet another, the two shareholders want to go their separate ways, each of them taking one of the RPs owned by the corporation.
There are others. In each case, the shareholders have come to realize – for the reasons set forth below – that they should not have used a corporation to hold their RP.
In the Beginning
A taxpayer who contributes RP to a corporation in exchange for shares of stock in the corporation will be taxable on the gain realized in such exchange unless the taxpayer – alone, or in conjunction with others are also contributing a not insignificant amount of money or other property to the corporation in exchange for shares – owns at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of other all other classes of stock of the corporation immediately after the exchange. It may not be possible for a taxpayer to attain this level of control – and the desired tax deferral –when he is seeking to become a shareholder of an established corporation.
This should be contrasted with a contribution of property to a partnership (or to an LLC that is treated as a partnership for tax purposes). In that case, the contributor is not required to attain a specific level of ownership in order to avoid gain recognition on the contribution of the RP to the partnership in exchange for a partnership interest.
However, the contributor must be attuned to the partnership “disguised sale” rules, which may treat the contributor as having sold all or some of the RP to the partnership; for example, where he mortgages the RP to withdraw equity therefrom just prior to contributing the RP (subject to the indebtedness) to the partnership.
The contributor must also be careful of “shifting” liabilities, as where he contributes mortgaged property to a partnership; if the contributor is not personally liable for the indebtedness, it will be “re-allocated” among all the partners, and he will be treated as receiving a distribution of money that may be taxable to him. .
“Day by Day” Operations
Where the RP is held in a C corporation, the corporation, of course, enjoys the benefits and burdens of ownership. If the property is leased to another, the corporation includes the rent in its gross income; it also claims the associated depreciation and other expenses in determining its taxable income. After satisfying its tax liability, the corporation may pay a dividend to its shareholders, which will be taxable to them.
If the shareholders elect to treat the corporation as an S corporation, the corporate-level tax may be avoided, the corporation’s taxable income will be passed through and taxed to its shareholders, the basis for their shares will be adjusted upward to reflect this income, and the distribution of the corporation’s net income should not generate additional tax to the shareholders.
In order to qualify as an S corporation, however, the corporation will be limited as to who may have hold its stock; for example, another corporation, a partnership, and a nonresident alien cannot own shares of stock in an S corporation.
In addition, an S corporation may have only one class of stock, meaning that each outstanding share must have the same rights to current and liquidating distributions as every other share; no preferred interests are permitted.
Thus, an S corporation is severely limited in its capitalization choices.
Finally, if an S corporation was formerly a C corporation, and has accumulated earnings and profits from its C corporation tax years, the S corporation will be subject to a 35% corporate-level excise tax on a portion of its rental income if the gross receipts from such rental activity constitute “passive investment income” and they exceed 25% of the S corporation’s total gross receipts. The corporation will even lose its “S” election if this situation continues for three consecutive tax years, in which case the corporation will generally not be eligible to re-elect “S” status for a period of five years.
In contrast, a partnership is not subject to an entity-level income tax, its profits are taxed directly to its owners and may be withdrawn by them without additional tax (to the extent the money withdrawn does exceeds a partner’s adjusted basis for his partnership interest), the partnership is not limited as to the nature or the number of its owners, and it can provide for any manner of profit allocation among its partners, including preferred and carried (“promote”) interests, provided such allocation has substantial economic effect.
Once a RP has reached a certain level of equity (fair market value over mortgage balance), it is not uncommon for the owner of the RP to access the increased equity – without having to sell the RP – by refinancing the existing indebtedness; the owner borrows more than the amount of the existing indebtedness, replaces that indebtedness, and withdraws the balance. Because the money that the owner has “cashed out” must eventually be repaid, the owner do not have a taxable event.
As we saw a few weeks ago, this approach to withdrawing equity from RP on a tax efficient basis works well when the property is held by a partnership. Unfortunately, the same cannot be said when a corporation owns the property.
Of course, the corporation, itself, can withdraw the increased equity from its RP through a refinancing without tax consequences. However, what happens when the corporation then distributes this cash to its shareholders? In the case of a C corporation, the amount distributed is treated as a dividend to the extent of the corporation’s current and accumulated earnings and profits; the balance is then treated as a tax-free return of capital to the extent of each shareholder’s basis for his shares of stock; any remaining portion of the distribution is taxable to the shareholders as gain from the sale of their stock.
In the case of an S corporation with no C corporation earnings and profits, the amount distributed is first applied against a shareholder’s adjusted basis for his shares, and any excess is treated as gain from the sale of such shares. Unlike the partners of a partnership, the S corporation shareholders do not receive an increased basis in their shares of corporate stock as a result of the refinancing, even if they personally guarantee the corporation’s indebtedness.
Disposition of the Property
There may come a time when the RP is sold. In the case of a C corporation, that means a corporate-level tax followed by a taxable liquidating distribution to its shareholders.
There is also a corporate-level tax where an S corporation that is subject to the built-in gain rules sells its RP within the recognition period (the 5-year period beginning with the first day of the first taxable year for which the corporation was an S corporation).
Where the S corporation was always an S corporation, and did not acquire the RP from a C corporation in a tax-free exchange, there is no corporate-level tax, and the gain from the sale is taxed to its shareholders. The subsequent distribution of the net proceeds from the sale may be taxable to a shareholder to the extent it exceeds his stock basis (as adjusted for his pro rata share of the gain from the sale of the property).
Again, in the case of a partnership, there is no entity-level tax, its partners are taxed on their pro rata share of the gain recognized on the sale (though the partner who contributed the disposed-of RP may receive a special allocation of taxable gain based upon the gain inherent in the RP at the time it was contributed to the partnership), and a partner may recognize additional taxable gain to the extent the amount of cash distributed to the partner exceeds his basis for his partnership interest (as adjusted for his pro rata share of the gain from the sale of the property).
What if the disposition is to take the form of a like kind exchange? In that case, the taxpayer that sells the “relinquished property” must also acquire the “replacement property;” thus, a corporation-seller must acquire the replacement property – there is no opportunity for a single shareholder to participate in such an exchange if most of the shareholders have no interest in doing so.
In the case a partnership, however, the partnership and one or more partners may be able to engage in a so-called “drop and swap” – by making a non-taxable in-kind distribution of a tenancy-in-common interest in the RP to one or more partners – thus enabling either the partnership or the distributee partners to participate in a like kind exchange.
Distribution of the Property
What if the RP is not to be sold? What if it is to be distributed by the entity to one or more of its owners?
In general, a corporation’s distribution of appreciated RP to its shareholders is treated as a sale of the property by the corporation, with the usual corporate tax consequences. In addition, the shareholders will be taxed upon their receipt of the property, either as a dividend or as an exchange, depending on the circumstances.
Where the corporation is an S corporation, and the RP will be depreciable in the hands of the shareholders, the gain realized on the deemed sale of the RP may be treated as ordinary income and taxed to the shareholders as such.
There is an exception where the corporation’s activity with respect to the RP rises to the level of an “active trade or business.” In that case, the actively-conducted RP business, or another active business being conducted by the corporation, may be contributed to a subsidiary corporation, the stock of which may then be distributed to one or more shareholders on a tax-deferred basis. Unfortunately, if the RP is owner-occupied, the corporation will generally not be able to establish the existence of such an active business. Moreover, the corporation will have to be engaged in a second active business.
In general, a distribution of property by a partnership to its partners will not be treated as a taxable disposition; thus, the partnership may be able to distribute a RP to a partner in liquidation of his interest, or it may split up into two or more partnerships with each taking a different property, without adverse tax consequences. There are some exceptions.
For example, if RP is distributed within seven years of its having been contributed to the partnership, its distribution to a partner other than the contributor will be treated as a taxable event as to the contributor-partner. If a contributor- partner receives a distribution of RP within seven years of his in-kind contribution of other property to the partnership, the distribution will be treated as a taxable event as to the contributor-partner.
In addition, the so-called “disguised sale” rules may cause a distribution of RP to be treated as a sale of the property; for example, where the partnership encumbers the RP with a mortgage (a “non-qualified liability”) just before distributing the RP to the partner who assumes or takes subject to the mortgage.
Even where the disguised sale rules do not apply, a distribution of RP may be treated, for tax purposes, as including a cash component where the distributee partner is “relieved” of an amount of partnership debt that is greater than the amount of debt encumbering the RP.
“Choose Wisely You Must” – Yoda
The foregoing represents a simple outline of the tax consequences that must be considered before a taxpayer decides to acquire or place RP in a corporation or in a partnership.
There may be other, non-tax, considerations that also have to be factored into the taxpayer’s thinking, and that may even outweigh the tax benefits.
All-in-all, however, a closely held partnership is a much more tax efficient vehicle than a corporation for holding, operating, and disposing of real property.
Yes, some of the tax rules applicable to partnerships are complicated, but that should not be the decisive factor. Indeed, with proper planning, these rules can negotiated without adverse effects, and may even be turned to one’s advantage.