Under One Roof

I sometimes wonder at the number of corporations that own real property.

It is often the case that the property is the corporation’s principal asset, which it leases to one or more commercial tenants, for example. That’s bad enough.[i]

There are other instances, however, in which the corporation is engaged in an active trade or business that operates out of the corporation’s real property.[ii] In most cases, the operating business occupies the entire property – there are no other tenants. What’s more, the corporation is not engaged in the kind of activity that the active management of a property typically entails; in other words, the corporation is dealing with itself for the most part.[iii]

There is a kind of simplicity in this arrangement that often appeals to the owners of a closely held business. There is no need for two business entities – one that owns the operating business and one that owns the real property – no need to file two business tax returns, no need to keep separate books and records, no need to maintain separate bank accounts, no need for a lease between the two entities, etc.

Unfortunately, this minimalist approach may turn into a serious tax problem, one that may go unrecognized until it is too late to address it in any meaningful or economical way – on the “eve” of selling the business.

Asset Sale

As we’ve discussed on many occasions, a prospective buyer of a corporate-owned business would prefer to acquire from the corporate seller only those assets that will be necessary to the buyer’s operation of the business after the deal closes. This is best accomplished by identifying and purchasing only those assets.[iv]

A not insignificant benefit of such a “direct” purchase of assets is the stepped-up cost basis[v] for these assets in the hands of the buyer, which the buyer may then be able to expense, depreciate or amortize[vi] – depending upon the asset – and, thereby, reduce the buyer’s economic cost for the transaction.

Thus, where the buyer has no need for the real property owned by the corporate-seller – for example, where the buyer is consolidating the seller’s business into one of the buyer’s existing locations – the buyer may simply choose not to purchase the property.

Stock Sale

By contrast, the purchase of the stock of the corporation from its shareholders would necessarily include the indirect acquisition of every asset owned by the corporation, including those that the buyer neither needs nor wants.

There are instances, however, in which the buyer has no choice – as a legal or as a practical matter – but to acquire the stock of the target corporation, along with everything that goes with it, including the real property. This may occur, for example, where the corporation’s business includes certain difficult-to-transfer assets,[vii] and the target corporation must be kept in existence.

In recognition of this reality, the Code permits the buyer and the selling shareholders to elect to treat the actual purchase-and-sale of the target corporation’s stock as a deemed purchase-and-sale of its assets for tax purposes – provided certain conditions are satisfied – thereby generating a basis step-up in the underlying assets for the benefit of the buyer.[viii]

Removing/Keeping the “Unwanted” Property

Query, in a situation where the purchase-and-sale transaction must be effected as a sale of stock, how the corporate target may dispose of the unwanted real property before the stock sale is completed?[ix]

Conversely, what if the shareholders of the target corporation want to keep the real property for themselves, in order to lease it to the buyer, or to another party, after the stock sale?[x] How may they remove the property in a tax-efficient manner?

The issue is easily surmounted where the corporate target is selling its assets. In that case, the buyer may simply choose not to purchase, and the target corporation may simply choose not to sell, the real property. Instead, the buyer will often agree to lease the property from the corporate-seller for an arm’s-length rate over some period of time (perhaps with extensions) beginning immediately after the closing; the delivery of an executed lease will often be identified as a condition to closing the deal.

But what if the transaction is structured as a purchase-and-sale by the shareholders of the target corporation’s stock?[xi]

Sell the Property?

One of the more obvious “solutions” is for the target corporation to sell the real property to some unrelated person before the shareholders sell the corporation’s stock to the buyer. The corporation would likely realize a gain from the sale[xii] that would be taxable to the corporation,[xiii] and for which its shareholders will likely be held responsible by the buyer even after the buyer’s acquisition of their shares in the corporation.[xiv]

If the corporation is an S corporation, the gain from the sale of the property (including its character as ordinary or capital) will pass through, and be taxed, to its shareholders.[xv]

Where the corporation is a C corporation, or an S corporation with earnings and profits from taxable years during which it was a C corporation,[xvi] and the shareholders want the net proceeds from the sale of the real property to be distributed to them,[xvii] they may want to consider structuring the purchase-and-sale of their stock to include a partial redemption of their shares by the corporation.[xviii]

Sale or Distribution to Shareholders?

Another option would be for the corporation to sell the real property to those of its shareholders who want it.

In the case of an S corporation, the gain from this sale will pass through, and be taxed, to all of the shareholders based upon their relative stock ownership. However, the gain from this sale may be treated as ordinary income, rather than capital gain, under certain related party sale rules.[xix] Although this result may not matter in the case of a C corporation[xx] (except to the extent it has capital losses, which may only offset capital gains), the effect on the shareholders of an S corporation cannot be underestimated: a federal capital gain tax rate of 20-percent versus an ordinary income tax rate of 37-percent.[xxi]

The corporation may also distribute the real property to its shareholders in respect of their shares in the corporation: as a dividend, or in a partial redemption of their stock that is part of their plan to sell their shares to the buyer. Such a distribution would likewise be treated as a sale of the property by the corporation,[xxii] with the same basic consequences as above, including treatment of the gain as ordinary income.

Although the foregoing options are certainly effective in removing the real property – unwanted by the buyer and/or wanted by the target’s shareholders – from the target corporation prior to the sale by the shareholders of the corporation’s stock, they also probably generate a not-insignificant tax cost.

What other alternatives might be considered?


Some readers may ask whether a “tax-free” spin-off of the real property would be possible.[xxiii] Specifically, why couldn’t the target corporation form a new subsidiary corporation, contribute the real property to the subsidiary in exchange for all of its stock, then distribute this subsidiary stock to the target’s shareholders?

Under the facts as stated, above, where the property is basically owner-occupied, probably not. The corporation would be hard-pressed to demonstrate that its activities with respect to the real property satisfy the five year “active trade or business” requirement.[xxiv]

Even if the active trade or business test were met, the relative proximity (in terms of time) of the spin-off distribution and the sale of the corporation’s stock – for all intents and purposes, on the eve of sale[xxv] – would likely cause the distribution to be taxable.[xxvi]

Disregarded Entities

Where does that leave the buyer, not to mention the target corporation and its shareholders? In the context of a stock sale where the shareholders of the target corporation want to retain ownership of the property, will they have to remove the property by way of a taxable transaction, the price tag for which includes a hefty tax liability?

Or might it be possible to remove the property by restructuring the target corporation in advance of the transaction so as to enable it to take advantage of the rules that govern transactions between a taxpayer and an entity owned by the taxpayer and that is disregarded as separate from the taxpayer for tax purposes.[xxvii]

In general, transactions between a taxpayer and an entity that is disregarded as separate from the taxpayer for tax purposes – including a sale or exchange of property – have no tax consequences for the simple reason that a taxpayer cannot sell property to themselves. That is not to say that, as a matter of contract or of state law, the transaction did not occur – indeed, a sale has occurred and ownership of the subject property has changed; it’s just that the transaction is ignored for tax purposes.[xxviii]

For example, assume corporation “Corp” owns 100-percent of limited liability company “LLC.” LLC is treated as a “disregarded entity” for tax purposes.[xxix] If LLC sells property to Corp pursuant to a contract, in exchange for full and adequate consideration paid in cash, there has been a bona fide sale between the two business entities. If LLC distributes property to Corp in respect of its membership interest, there has, in fact, been a distribution. However, because LLC is disregarded for tax purposes, Corp is treated as owning all of LLCs assets. Thus, as a tax matter, Corp cannot acquire from LLC – whether by way of a purchase-and-sale or by way of a distribution – property that Corp is already deemed to own.

Might this basic rule provide a means by which a target corporation can divest itself of unwanted real property on a tax-efficient basis, while it remains intact as a matter of state law?

Perhaps. The question, of course, is how does a corporation create an entity that is disregarded from it for tax purposes, and to which it may transfer a property (i.e., remove the property from the corporation) without adverse tax consequences, in preparation for the sale of the corporation’s stock?

Enter the F reorganization.

F Reorganization

The Code describes several types of corporate transactions that constitute “tax-free” reorganizations. The purpose of the reorganization provisions of the Code is to except from gain recognition certain specifically described exchanges that are incident to readjustments of corporate structures made in one of the particular ways specified in the Code, and which effect only a readjustment of continuing interest in property under a modified corporate form.[xxx]

One of these transactions is described as “a mere change in identity, form, or place of organization of one corporation, however effected” – a so-called “F” reorganization.[xxxi]

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations, one (a “transferor corporation”) that transfers (or is deemed to transfer) assets to the other (a “resulting corporation”). However, the statute describes an F reorganization as being undertaken with respect to “one corporation.”

An F reorganization is treated for most purposes of the Code as if the resulting corporation were the same entity as the transferor corporation that was in existence before the reorganization; indeed, the resulting corporation retains the transferor’s tax attributes.

Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation; for example, the taxable year of the transferor corporation does not close, its tax return includes the operations of the resulting corporation for the post-reorganization portion of the taxable year, and the resulting corporation inherits the tax elections of the transferor corporation.

A transaction that involves an actual or deemed transfer of property by a transferor corporation to a resulting corporation may qualify as an F reorganization – as may a series of related transactions, that together result in a mere change of one corporation – if certain regulatory requirements are satisfied.[xxxii]

According to one of these regulatory requirements, the transferor corporation must completely liquidate for federal income tax purposes as part of the potential F reorganization; however, the corporation is not required to dissolve under applicable state law.

Deemed transfers also include those resulting from the application of step transaction principles. For example, step transaction principles may treat a contribution of all the stock of the transferor corporation to the resulting corporation, followed by a liquidation (or deemed liquidation) of the transferor corporation – which are formally separate steps – as a deemed transfer of the transferor corporation’s property to the resulting corporation, followed by a distribution of stock of the resulting corporation in complete liquidation of the transferor corporation.

In keeping with the basic premise that the F reorganization involves a mere change in form of a single corporation, a qualifying transaction may occur before or within other transactions that effect more than a mere change, even if the resulting corporation has only a transitory existence. Related events that precede or follow the potential F reorganization generally will not cause that potential reorganization to fail to qualify as an F reorganization. Conversely, an F reorganization will not alter the character of other transactions for federal income tax purposes.

As we will see, it is the “deemed liquidation” requirement, the application of step transaction principles, and the fact that the F reorganization may be undertaken as part of a larger transaction without affecting the tax treatment of such transaction that, brought together, may provide a target corporation the means to divest itself of an unwanted asset just prior to the sale of its stock.

Practical Example

The following is but one example of how the foregoing rules and principles may be brought together to achieve the desired result: the removal of an asset from the target corporation on a tax efficient basis and the subsequent sale of the target’s stock.[xxxiii]

Assume Taxpayer owns all of the stock of Y, an S corporation. Y owns Prop plus other assets.

In Year 1, Taxpayer forms New-Corp and contributes all of the Y stock to New-Corp in exchange for all of the New-Corp stock.

New-Corp meets the requirements for qualification as an S corporation, and timely elects to treat Y as a qualified subchapter S subsidiary (QSub), effective immediately following the transaction.

As a result of the QSub election, Y is deemed to have liquidated into New-Corp on a tax-free basis, and its separate existence is then ignored, tax purposes, though it continues to exist as a matter of state law. Because Y is not treated as a separate corporation for tax purposes (but more like a division of New-Corp), and all its assets (including Prop), liabilities, and items of income, deduction, and credit are treated as assets, liabilities, etc. of the S corporation, New-Corp.

This transaction – the transfer of the Y stock to New-Corp, coupled with the QSub election – qualifies as an F reorganization, with New-Corp being treated as the “new form” of Y. Consequently, Y’s (now New-Corp’s) original S election does not terminate, but attaches to New-Corp.

In Year 2, Y distributes Prop to New-Corp. The distribution of Prop from Y to New-Corp is disregarded for tax purposes because New-Corp is already treated as owning it.

In Year 3, New-Corp sells the stock of Y to Buyer.[xxxiv] However, because New-Corp is deemed to own all of Y’s assets (for tax purposes), the sale – a stock sale as a matter of state law – is treated as a sale of an undivided interest in Y’s assets for tax purposes. Buyer acquires these assets with a basis step-up (and the opportunity for cost recovery deductions). Buyer is then treated as having contributed the newly acquired assets to a “new Y” corporation that comes into existence after the stock sale and the termination of its QSub status.


The fact pattern set forth above is but one illustration of how F reorganizations and disregarded entities may be utilized by a selling corporation and its shareholders to achieve some pre-sale “corporate tailoring” – the removal of an asset from a target corporation prior to the sale of its stock – on a tax efficient basis; there are others.

The interplay of these rules, however, can be complicated, and it will be imperative that the parties’ respective tax advisers be fully engaged in the analysis. Moreover, there will be times when the seller, the buyer, and their respective owners will not be able to reconcile their various goals through such corporate tailoring, though they will often need the input of their tax advisers to come to that realization.

At that point, choices will have to be made. Much will depend, as it usually does, upon relative leverage – including the ability to extract a gross-up for the tax liability arising from such tailoring – and upon how badly the parties want to consummate the sale.


[i] https://www.taxlawforchb.com/2017/10/thou-shalt-not-hold-real-property-in-a-corporation/

[ii] Every now and then, you encounter a situation where the real property owned by the corporation has no connection to the business being conducted by the corporation.

[iii] For example, it is not listing the property for rent, it is not interviewing tenants or dealing with brokers, it is not negotiating leases, it is not attending to tenant complaints, etc.

[iv] A forward merger of corporations under state law that does not qualify as a tax-deferred reorganization under IRC Sec. 368 is treated as a taxable purchase and sale of assets.

[v] IRC Sec. 1012.

[vi] IRC Sec. 168(k), Sec. 167, Sec. 197.

[vii] This would include an asset that, by its terms, is generally not transferable; for example, a contract or a license.

[viii] IRC Sec. 338(h)(10) and Sec. 336(e).

[ix] Of course, the buyer may cause the newly acquired target corporation to sell the real property post-closing.

[x] Not an uncommon situation.

[xi] Including a reverse subsidiary merger, which may be necessary when dealing with a relatively large number of shareholders, or where some minority shareholders are reluctant to go along. In those circumstances, the merger will likely trigger appraisal rights for any dissenting shareholder. That’s when folks wish they had a shareholders’ agreement that included a drag-along provision.

[xii] IRC Sec. 1001.

[xiii] This would include an S corporation that is subject to the built-in gains tax. IRC Sec. 1374.

[xiv] The allocation of economic “risk” as between the seller and the buyer (including for taxes) is a significant part of any purchase-and-sale agreement.

[xv] IRC Sec. 1366. The gain will result in an upward adjustment to the shareholders’ stock basis pursuant to IRC Sec. 1367.

[xvi] Or if it acquired the assets of a C corporation in a tax-deferred exchange (for example, under IRC Sec. 368), so that the C corporation’s earnings and profits became tax attributes of the S corporation pursuant to IRC Sec. 381.

[xvii] After all, they will likely be responsible for any liabilities arising from the sale that are arise post-closing.

[xviii] Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954).

[xix] IRC Sec. 1239. https://www.law.cornell.edu/uscode/text/26/1239

[xx] The ordinary income and capital gain of a C corporation are taxed at the same flat rate of 21-percent; there is no reduced rate as in the case of individuals.

[xxi] One must also consider the application of the 3.8-percent surtax on net investment income under IRC Sec. 1411.

[xxii] IRC Sec. 311(b).

[xxiii] IRC Sec. 368(a)(1)(D) and Sec. 355.

[xxiv] IRC Sec. 355(b), Sec. 368(a)(1)(D). https://www.law.cornell.edu/uscode/text/26/355; Reg. Sec. 1.355-3(b)(2). https://www.law.cornell.edu/uscode/text/26/355

[xxv] I’ve really stacked the deck here.

[xxvi] IRC Sec. 355(e). Reg. Sec. 1.355-7.

[xxvii] For example, a single member LLC that has not elected to be treated as an “association” (basically, a corporation) for tax purposes.

[xxviii] The same concept has been applied in the case of transactions between a grantor trust and the grantor. Rev. Rul. 85-13. See also Reg. Sec. 1.368-2(b)(1)(iii), Ex. 2 (Good “A” reorganization where target corp. merges pursuant to state law with and into a disregarded subsidiary entity (maybe an LLC) of the acquiring corp., and the target shareholders receive stock of the acquiring corp. – the target is treated as having merged into the acquiring corp.).

[xxix] Reg. Sec. 301.7701-3.

[xxx] IRC Sec. 368(a). There are a number of statutory and regulatory requirements, not to mention a number of administrative and judicial interpretations, of which the taxpayer contemplating a reorganization must be aware.

[xxxi] IRC Sec. 368(a)(1)(F).

[xxxii] Reg. Sec. 1.368-2(m). https://www.taxlawforchb.com/2015/10/sometimes-an-f-is-a-good-result/. Note that the continuity of interest and continuity of business enterprise requirements do not apply to an F reorganization. Reg. Sec. 1.368-1(d) and (e).

In general, other requirements include no change in ownership of the corporation, and the resulting corporation must not have had any assets or conducted any business prior to the reorganization.

[xxxiii] See, e.g., Rev. Rul. 2008-18, and PLR 201115016.

[xxxiv] The sale does not affect the F reorganization. Rev. Rul. 96-29.