The other day, I had a consultation with a new client. He and his partners had broken one of the C Corp rules and now they needed to figure out how to get out of the mess they’re in.
Left as it was, it would cost them over $20,000 in extra taxes. Was there a way to fix it?
First, let’s look at what happened. What was the rule they broke about C Corporations?
Never hold appreciating assets such as real estate within a C Corporation. To demonstrate why, let’s go through an example of holding property inside an LLC (limited liability company) versus a C Corporation.
Let’s say you and your partner buy a property for $600,000. Over time the property appreciates to $2,000,000 and you sell the property.
In an LLC: You have gain of $1,400,000 that is split between you and your partner. The $700,000 each is taxed as long-term capital gains. Assuming you are paying at the top long-term capital gains rate of 20%, the tax per partner would be: $140,000. (I’m keeping it simple in this demonstration and not including the Medicaresurtax nor state taxes.)
In a C Corporation: You have a gain of $1,400,000 that is taxed at the top C Corporate tax rate of 35%. The tax per partner would be: $245,000, but this is actually a tax that is paid by the corporation. So, the corporation pays $490,000.
Let’s stop there a moment. In the first case, the total tax is $280,000. In the case of the C corporation it’s $490,000.
But it doesn’t stop there. All the money is still held within the C Corporation. How are you going to get it out? If you take it out as dividends, it’ll be taxed again and there is no deduction.
If you take it out as salary, you’ll pay tax on the income as ordinary income (not capital gains) plus have to pay some payroll taxes. You get the deduction on the C Corp return, but you’ve gained nothing and actually could have a timing issue. Is it possible to take a HUGE salary in the year in which you sell the property? If that’s not reasonably and you need to space out your salary, what income will you have in the C corp to offset the deduction. You can no longer take losses retroactively.
The moral of the story is: Do NOT put appreciating assets inside a C Corporation.
But what about the guys who DID put property inside a C Corp. They weren’t ready to sell yet, so they made an election to change the C Corporation to an S Corporation. The S Corp is a flow through entity, which meant that the gain would be reported on the individual owner’s tax returns.
The S Corp election works in the right circumstances. There are others, but let’s look at the possible issue with making this C Corp to S Corp change.
There is a “gotcha” however. The C Corporation has a period of 5 years from the election when the “built in gains” tax applies. This means that any sale that occurs during that window will be subject to the same tax as if it still was a C Corporation. You don’t get the benefit of changing to an S Corporation.
If you’re in this situation, make sure you talk to an experienced tax strategist first. You need to crunch some numbers to come up with the best strategy.