Whether or not to hold business real estate in a regular C corporation is one of the most common questions asked of accountants. And, while every situation is different, there are significant federal tax reasons not to have the corporation hold the property.
For those business owners who already hold real estate in their corporations, getting the real estate out can lead to a big tax bill. However, through careful tax planning, adverse tax consequences may be minimized.
Reasons To Hold Property Outside the Corporation
There are several reasons to hold real estate outside of a C corporation.
· When a C corporation sells appreciated real estate, the potential for double taxation exists. The gain is taxed to the corporation on transfer/sale, and again to the stockholders when the proceeds are distributed to them as dividends. Holding the property individually or in a partnership avoids the double-taxation problem.
· C corporations pay tax on capital gains at their regular corporate tax rate. Individuals currently pay a maximum 15% tax on long-term capital gains.
· If the property generates rental income, the tax law's personal holding company (PHC) rules could apply. Undistributed PHC income is subject to an additional 15% tax rate at the corporate level. While the additional tax can be avoided by distributing the income as dividends to the stockholders, double taxation of that income (at the corporate and personal levels) still applies.
· When it comes time to sell the company, real estate held together with operating assets in the corporation can cause complications, especially if the seller desires a stock sale. The buyer may not want to hold the property in the corporation or may not want the real estate in any case.
· Property held by individuals or a partnership can receive a step-up in tax basis to fair market value should certain events (such as death of the owner or partner) occur. This can result in income-tax savings for the surviving family or partners. There is no step-up in basis if a corporation holds the property.
Of course, there may be countervailing reasons for holding realty in a business corporation (example: increasing the corporation's ability to borrow money). However, approaches other than having the corporation own the property can often accomplish the same objectives.
Dealing with Corporate-held Realty
What if a corporation already owns real estate? Is it worthwhile to have the corporation divest itself of the property? In other words, are the tax consequences of having the corporation surrender ownership of the property less burdensome than facing the potential results of keeping the realty in the corporation?
As stated earlier, on sale or distribution of the property, any gain will be taxed to the corporation at its regular C corporation rate. Distributions of the net proceeds to the stockholders are taxed as dividends, to the extent of the corporation's accumulated earnings and profits. Before deciding whether to have the corporation sell the realty or distribute it to stockholders, the owners need to examine the amount of potential gain on the property and how it would be taxed.
In some cases, if the gain is not large, selling or distributing the realty may have a relatively small overall tax impact. Under current law, any distributions of the net proceeds that are treated as dividends would be taxed to the stockholders at a maximum 15% rate (assuming the dividends were "qualified" for tax law purposes).
Another strategy for addressing appreciated corporate-held real estate is for the corporation to sell the property to one or more stockholders. In that case, while a corporate level tax would likely apply, there would be no stockholder-level tax on the realty's appreciation.
Example: Corporation purchased real estate used in its business in 2003. Now, Owner, the sole stockholder, wants to remove the property from Corporation and own it individually. If Corporation sells the property to Owner for its market value, Corporation will be taxed on the gain. However, Owner will not be taxed on the transaction. Rather, the purchase price becomes Owner's tax basis in the property, and only subsequent capital gain will be taxed to Owner.
Other planning approaches are available. For instance, the corporation could place the appreciated real estate in a limited liability company (LLC) and gradually distribute membership units in the LLC to its stockholders. It may be possible to utilize discounts (minority interest discounts, for example) in determining the value of the units for dividend purposes. Using this strategy requires care and professional expertise since the IRS has been known to challenge valuation discounts in this situation.
We Can Help
If you are faced with the decision of whether to hold real estate in your corporation or are looking to divest your corporation of its real estate assets, our professionals can help you determine the best course to take from a tax perspective. If we can be of service to you, let us know.