For most small businesses, ownership of real estate by a C corporation is a bad idea. Unlike S corporations, partnerships, and LLCs taxed as partnerships, C corporations are taxed twice on all income: once when it is earned and once when it is distributed to shareholders.
Double taxation is a common problem when real estate is owned by a C corporation. 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). Under the rules governing distributions from C corporations, the same income is taxed again at the shareholder level when it is distributed to the shareholders.
S corporations and limited liability companies can provide the liability protection of a corporation without the double taxation. If the business will own real estate, these “passthrough entities” are usually a better choice than a C corporation. But a few decades ago, limited liability companies were not widely accepted and S corporations were subject to more restrictions than they are now. Corporations were often used to hold real estate, creating a legacy of tax inefficiency.
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 usually ten years ago; the second best time is now.
Fortunately, now may be the best time in years to move real estate out of a C corporation. After several years of declining property values, we may be at the bottom of the real estate market. 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.
There are three ways to deal with appreciated real estate owned by a C corporation:
- Distribute the property in kind to the shareholders;
- Sell the real estate to the shareholder or an unrelated party; or
- Convert the C corporation into a subchapter S corporation.
This article will look at the tax consequences of the first two choices. Later articles will deal with converting a C corporation to another form of business entity.
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 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.
Whether a sale of real estate will is 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 entirely 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.
As mentioned above, there is a third method of dealing with appreciated real estate owned by a C corporation: The shareholders can convert the C corporation into a subchapter S corporation. Unlike these first two alternatives, conversion to subchapter S status can completely avoid double taxation. This technique will be discussed in a later article.