Real estate values have returned to pre-recession levels in many cases. And suddenly, I’m getting people asking me a similar question.
What do you do if you have real estate inside a C Corporation?
Maybe you inherited it. Maybe you had a business that grew and you just never paid any attention that you were putting an appreciating asset inside the wrong structure.
The bottom line right now is that you’re about to find out WHY we say you should never put an appreciating asset inside a C Corp.
Most of the time real estate should be held inside an LLC that is just held as a disregarded entity. That means you do not elect how you want it to be taxed. Instead it is the default taxation. If you have just one member (owner), you have a single member LLC and the default would be a Schedule E on your Form 1040 if you have real estate in the entity. If you have more than one member (owner), you have a multi-member LLC and the default is a partnership return.
That’s the ideal.
Some people use a S Corporation. I’m not a fan because if you need to change any part of it, you’re stuck. You can not make a distribution from any type of corporation – a flow-through S Corporation or a C Corporation – without having a taxable situation. Distributions of property from corporations (either S or C) are done at the fair market value. So, if down the line, you need to distribute appreciated property out of an S Corporation to the shareholders, there is tax due. The distribution is done at the current value, even though there may be no sale or cash. Doesn’t matter. You still owe tax.
On the other hand, if you sell an asset inside an S Corporation you won’t get penalized. The income from the sale will flow through to the shareholder’s individual tax returns. That means it is taxable at the individual rate.
In the case of a C Corporation, you can’t make a distribution without paying tax based on fair market value. If you sell the asset within the C Corporation structure, you will pay tax based on the C Corporation rate. Effective for 2018, the flat rate for C Corps is 21%, which isn’t much more than the maximum capital gains rate now (20%).
However, that’s not the main problem. Once you have the sale within the C Corporation and paid the 21% tax, now what?
How do you take the money out of the corporation? If it’s paid in the form of salary, you’ll pay tax at your ordinary tax rate and plus need to prove why you should be receiving a salary. It will be a deduction for the corporation. That would work as long as there is other income inside the corporation. For example, if you pay the salary in the same year as the capital gains is earned due to the sale, it could offset the capital gains income. It would be a deduction at 21% for the C Corp and then taxed at your ordinary income tax rate, plus payroll tax.
If you paid the salary early and it created it loss in the C Corporation, that net operating loss could carry forward to offset income in a subsequent year. In other words, pay the salary in Y1 and sell the property in Y2. It could do the offset, but again you are trading a 21% deduction for possibly a higher ordinary tax rate.
If you pay the salary late (in a later year), you’re stuck. You can no longer carryback NOLs.
You could pay yourself a dividend. In fact, if all the C Corporation does is hold the property, then the IRS will argue the payment you receive is a liquidating dividend. A dividend is taxable to recipient and it is not a deduction for the corporation. That’s how the term “double taxation” came about. You pay tax twice. Once as the C Corporation and then once as an individual. That’s the worst possible answer.
Other than just biting the bullet and paying the tax, the only other real alternative is for the C Corp to elect to be treated as an S Corporation. The S Corporation will allow you to pay tax on your own personal return, at the capital gains rate. And you don’t have an issue with double taxation. While the LLC taxed as a disregarded tax entity is the best way to hold it, if you have an appreciated property, you may have a lot of tax due when you make the change.
If you change the C Corporation to an S Corporation, you won’t have a problem when you sell the property inside the corporation. And unless you do a distribution and try to start another entity (like a partnership or LLC), you won’t have a tax based on fair market value. Sounds perfect, right?
However, there is one more issue if you make that election. It’s called a built-in gain (BIG) tax. If you sell any asset within the new S Corp that had been held by the previous C Corp within the next 5 years, it will be treated as if the C Corporation said it.
The only strategies left are basically waiting 5 years to sell, selling the shares in the corporation instead (and passing on the tax problem) or looking for offsetting bad debt, NOL carryforwards or other under-utilized offsets to the gain.