Don’t Do It
There are certain generally accepted “dos and don’ts” of which almost every investor is certainly aware. For example, do not put all your eggs in one basket; if an investment seems too good to be true, stay away from it; take a long-term approach; etc. These guidelines are so obvious, they have become cliché.
However, based upon my recent experience, it seems too many investors in real property have yet to understand that, in the overwhelming majority of cases, they should not acquire real property in a corporation, even one that has elected to be treated as an S corporation. These investors and their successors will often pay the consequences of this misstep for many years.
Take the situation described below, which is one that most tax advisers have probably encountered with some frequency.
Mom organized a corporation (“Corp”) for the purpose of acquiring and managing rental real property.[i] Corp elected to be treated as an S corporation for tax purposes, effective as of the date of its formation.[ii]
Over a few years, Corp purchased several commercial and residential real properties, all of which it held directly.[iii] As president of Corp, Mom supervised all its activities.
Because the value of the properties appreciated over time, and because Corp’s initial cost basis[iv] in each of the properties was reduced by depreciation deductions claimed by Corp for purposes of determining its “taxable income,”[v] Corp would have realized a significant gain if it had disposed of any of its properties in an arm’s-length sale.
Passing the Torch – Not Quite
At the time of her death, Mom still owned all the issued and outstanding shares of Corp’s stock.[vi] These shares were included in Mom’s gross estate[vii] for purposes of the estate tax. Her estate (or trust)[viii] took the shares with a basis equal to their fair market value as of the date of Mom’s death.[ix] Of course, Corp’s adjusted basis for its real properties was not affected by the passing of its shareholder.[x]
Mom’s children, who were the beneficiaries of her estate, did not always get along with one another, and had little-to-no interest in continuing the ownership and operation of the real properties; instead, they sought to monetize Corp’s value and go their separate ways. YOLO.[xi]
In order to achieve this goal, they either had to sell the shares of Corp stock – for which they had a stepped-up basis following Mom’s death – or cause Corp to sell its low basis properties[xii] and then make current and liquidating distributions to its shareholders of the net proceeds from the sales.
Monetize Corp’s Value
Because the shareholders would recognize little taxable gain from the sale of Corp’s stock, a stock sale seemed the logical choice.
Unfortunately, what was the likelihood that a buyer would want to acquire, directly or indirectly, every property owned by Corp?[xiii] Slim.
Alternatively, would a buyer purchase Corp’s stock, convince Corp’s shareholders to elect to treat the transaction as a sale of assets,[xiv] then assume the risk of being able to dispose of the unwanted properties? Unlikely.
Having resigned themselves to the fact that Corp would probably have to sell its real properties to different buyers, the beneficiaries of Mom’s estate also realized that the sale of each property would generate a large capital gain,[xv] as well as an income tax liability[xvi] that had to be satisfied, thereby reducing the net proceeds from the sale, and putting a dent in their plans to use Mom’s wealth to fund their already profligate lifestyles.[xvii] Life is too short.
Glimmer of Hope
Just when things looked darkest, the estate’s tax adviser suggested there may be a way to mitigate this adverse economic consequence, provided Corp was able to recognize in a single tax year the gain from the sale of its properties,[xviii] following which the corporation would make a liquidating distribution of the net sale proceeds to its shareholders in the same year.
For example, assume Corp’s real properties had an aggregate gross fair market value of $10 million, were encumbered by $1 million of debt, and were fully depreciated for all intents and purposes (zero basis).[xix] Assume also that the fair market value of Mom’s Corp stock was reported on her estate tax return[xx] as $7.5 million;[xxi] this figure would also be the starting basis for the shares of Corp stock that passed from Mom at her death.
On a sale of all the properties to one or more third parties, Corp would recognize $10 million of long-term capital gain. Because Corp was an S corporation, this gain would flow through to its shareholders, who would include the $10 million of gain in their gross income for the year of the sales; consequently, they would increase their adjusted basis for their Corp stock by the amount of such gain.[xxii] Thus, the basis for the Corp stock would increase from the $7.5 million reported on Mom’s estate tax return to $17.5 million.
Following the sale of its properties, Corp would pay off its $1 million debt, leaving it with $9 million of cash to distribute in liquidation to its shareholders.[xxiii] This distribution would generate a capital loss to the shareholders of $8.5 million.[xxiv]
When the shareholders filed their income tax returns for the year of the sales and liquidation, they would report the capital gain of $10 million that flowed through to them from Corp’s sale of its properties and a capital loss of $8.5 million from the liquidation/sale of their shares of Corp stock; in short, a net capital gain of $1.5 million.[xxv]
Thankfully, just as the beneficiaries of Mom’s estate began planning how they were going to spend their money, the tax adviser alerted them to the distinct possibility they may not be able to dispose of all of Corp’s properties, and recognize all the gain therefrom, in the same tax year.[xxvi]
In that case, the sought-after benefit illustrated in the example above may not be attainable.
At that point, one beneficiary asked whether this issue could be addressed by having Corp sell or distribute any of its more-difficult-to-sell properties to its shareholders.
Sale to Shareholder(s)
A sale of such a property would be completed in exchange for an installment obligation[xxvii] from a purchasing shareholder, and Corp would elect out of installment reporting to recognize the gain in the year of the sale.[xxviii] The purchasing shareholder would take the property with a cost basis and later sell the property to a third party at a fair price (and with little-to-no gain); the proceeds would be used to satisfy the obligation.
Corp’s basis for the installment obligation would be adjusted to reflect Corp’s recognition of all the gain inherent in the installment obligation. Corp could then make a liquidating distribution of the obligation, together with the proceeds from the sale of its other properties, without triggering additional gain recognition.[xxix]
Distribution to Shareholders
Alternatively, Corp could distribute the “difficult” property to its shareholders pursuant to its plan of liquidation.
The liquidating distribution of appreciated property by a corporation to its shareholders is treated as the sale of such property by the corporation in exchange for an amount equal to the fair market value of the property.[xxx]
The basis of the property in the hands of the distributee-shareholders would be equal to the fair market value of the property at the time of the distribution.[xxxi] The distributees would later be able to sell the property at a fair price and presumably without much additional gain.
Related Party Sale
The sale and distribution transactions described above with respect to Corp’s difficult-to-sell properties appear reasonable. However, they overlook one significant problem: the related party sale rules.
According to the Code, the gain from the sale or exchange of property between related persons is treated as ordinary income if the property is subject to depreciation[xxxii] in the hands of the acquiring party.[xxxiii]
If the gain from the disposition of the property is treated as ordinary income, it cannot be offset with the capital loss recognized on the liquidation of Corp’s stock.[xxxiv]
Avoid the Mismatch?
Because of this mismatching of income and loss, the parties to such a transaction must consider whether they can plan around the capital-gain-to-ordinary-income conversion rule; specifically, can they break the relationship that is covered by the rule without forfeiting the desired economic benefits, or can the property to be disposed be converted into non-depreciable property the sale or exchange of which still qualifies for capital gain treatment?[xxxv]
For purposes of the foregoing rule, the term “related persons” includes:
- a person and all entities (for example, a corporation) which are controlled entities with respect to such person;
- a taxpayer and any trust in which such taxpayer (or his spouse) is a beneficiary; and
- except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate.[xxxvi]
The term “controlled entity” includes, with respect to any person, a corporation more than 50 percent of the value of the outstanding stock of which is owned (directly or indirectly) by or for such person.[xxxvii]
For purposes of determining the relationships identified above, stock ownership is ascertained in accordance with certain attribution rules.[xxxviii] Thus:
(1) stock owned, directly or indirectly, by or for a corporation, partnership, estate, or trust is considered as being owned proportionately by or for its shareholders, partners, or beneficiaries;
(2) an individual is considered as owning the stock owned, directly or indirectly, by or for their family (which includes only brothers and sisters, a spouse, ancestors, and lineal descendants); and
(3) stock constructively owned by a person by reason of the application of (1) above is, for the purpose of applying (1) or (2) above, treated as actually owned by such person, but stock constructively owned by an individual by reason of the application of (2) is not treated as owned by them for the purpose of making another family member the constructive owner of such stock.
On the basis of the foregoing, and because siblings cannot shed that relationship,[xxxix] notwithstanding how much they may want to do so, Corp was a controlled entity with respect to Mom’s estate or trust, or with respect to any of the Children.[xl]
By what alchemy can depreciable real property be converted into something else in the hands of the distributee-shareholders?
For years, at least in other contexts, taxpayers have been “converting” tangible property into intangible property by contributing the property to a newly formed corporation in exchange for shares of stock in the corporation.[xli] Provided the taxpayer respected the separate status of the corporation and treated with it on an arm’s-length basis, the taxing authorities would likewise respect the corporation.
Check the Box
Starting from this premise, what if Corp organized a new LLC for each of its unsold properties. Corp would contribute one property to each LLC and be its sole member, following which the LLC would elect to be treated as a corporation.[xlii] For tax purposes, Corp would be treated as having contributed the one property held by the LLC to a new subsidiary corporation in exchange for all the stock of the subsidiary. This exchange would be tax-deferred because Corp would be “in control” of the subsidiary “immediately after the exchange.”[xliii]
The new subsidiary would take the contributed property with the same low basis and long-term holding period that Corp had for the property.[xliv] Corp would take the new subsidiary’s stock with the same low basis and long-term holding period that Corp had for the property.[xlv]
Liquidation of Corp
Later, but in the same year in which its other properties were sold, Corp would make a liquidating distribution of the subsidiary “stock” to Corp’s shareholder(s).
Although the distribution of the subsidiary’s stock would not violate the “control immediately after the exchange” requirement, which would cause the otherwise tax-deferred exchange (deemed to have occurred upon the LLC’s having checked the box) to become taxable,[xlvi] Corp would recognize capital gain on the liquidating distribution of the new subsidiary’s stock.
The gain from this distribution would flow through to Corp’s shareholders, who would include the gain in their gross income and increase the basis for their shares of Corp stock.
The aggregate value of the sale proceeds and subsidiary stock (i.e., LLC membership interests) comprising Corp’s liquidating distribution should be less than the shareholders’ bases for their shares of Corp stock, thus generating a capital loss to offset at least some of the capital gain recognized by Corp’s shareholders from the properties sold by Corp earlier in the year plus the subsidiary stock deemed sold by Corp as part of its liquidation.
In addition, the now-former shareholders of Corp would take the subsidiary stock distributed to them with a cost basis equal to the fair market value of such stock; they would also begin a new holding period for such stock.
Each distributed subsidiary, however, would continue to hold its property with the same low basis and long-term holding period it acquired from Corp in the tax-deferred exchange.
The last step described immediately above is not the final step in the Children’s quest for minimizing their tax liability while maximizing their liquidity. After all, there is still gain inherent in the properties held by the LLCs-qua-corporations distributed to the Children in the liquidation of Corp. These properties still need to be sold to unrelated persons before the Children can accomplish what they set out to do. Now or never.
Quick Comparison to Partnerships
Think about all the steps outlined above that must be undertaken by the S corporation and its shareholder(s) to overcome the income tax liability attendant on the sale of the properties that were indirectly held by the deceased shareholder at their date of death.
Compare the foregoing to the death of a partner that owned 99 percent of a partnership, the other 1 percent being held by an S corporation owned by the decedent. The partnership owned real properties identical to those owned by Corp, described above. Upon the death of the decedent, the basis for their partnership interest was adjusted to the fair market value of such interest at the decedent’s date of death,[xlvii] increased by their estate’s share of partnership liabilities on that date and reduced to the extent that such value was attributable to items constituting income in respect of a decedent.[xlviii]
If the partnership were to make a liquidating distribution of all its properties to its partners, each partner would take the property distributed to them with a starting basis equal to the partner’s basis in their partnership interest, less any money distributed to the partner.[xlix] In other words, the stepped-up basis of the partnership interest at the decedent’s date of death would become the basis for the distributed property in the hands of the successor partner.
For example, Partner B, with a partnership interest having a stepped-up basis of $14,000, receives a liquidating distribution from the partnership of $2,000 cash, and real property with an adjusted basis to the partnership of $2,000 and a fair market value of $12,000. The basis of the real property to B is $12,000 (B’s basis for his partnership interest, $14,000, reduced by $2,000, the cash distributed).[l]
Alternatively, the partnership may decide to continue (not liquidate) until it has disposed of its real properties. If the partnership already had an election in effect under Section 754 of the Code, or if it made such an election on its tax return for the year of the decedent’s death,[li] the estate would enjoy a special basis adjustment[lii] with respect to the properties held by the partnership such that the estate would not recognize gain on the partnership’s subsequent sale of such properties.[liii]
Clearly, it would behoove the taxpayer-investor to understand the foregoing before they decide upon the form of business entity in which to acquire their investment.
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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.
[i] Assume the corporation had a TYE December 31 and used the cash method of accounting.
[ii] IRC Sec. 1361, Sec. 1362; Reg. Sec. 1.1362-6(a).
[iii] Inexplicably, the properties remained exposed to one another’s liabilities; for example, the corporation failed to establish separate subsidiary LLCs to hold the properties (one per LLC).
[iv] IRC Sec. 1012. What it paid for the properties plus other acquisition costs that had to be capitalized.
[v] IRC Sec. 167, Sec. 168, Sec. 1016.
[vi] She was probably reluctant to cede any control or benefit to her children.
[vii] IRC Sec. 2031, Sec. 2033.
[viii] Perhaps Mom held her shares of stock in a revocable trust in order to facilitate the administration and disposition of her property after her death.
[ix] IRC Sec. 1014. Prior to her death, Mom’s stock basis reflected her original capital contribution, some additional paid-in capital, plus the net effect of the income and deductions that flowed through to her from the S corporation, as well as the distributions made by the corporation in respect of her shares. IRC Sec. 1366, Sec. 1367, Sec. 1368. Her death and the adjustment to fair market value wipe away this basis history.
[x] A corporation’s built-in gain warrants a discount for estate tax valuation purposes if the sale of the corporation’s properties would result in a corporate-level income tax, and especially where such a sale was likely. See, e.g., Eisenberg v Comm’r, 155 F.3d 50 (2d Cir. 1998).
[xi] More hedonistic than epicurean, in the philosophical sense.
[xii] Based upon our facts, the corporation was not subject to the corporate-level built-in gain tax. IRC Sec. 1374. It was never a C corporation and it acquired all its properties with a cost basis.
[xiii] Of course, there are many factors in play, including the locations of the properties: are they contiguous to one another or to other properties already owned by the buyer?
Even then, would this buyer take subject to every liability, both known and unknown, within Corp?
[xiv] IRC Sec. 338(h)(10), Sec. 336(e).
In that case, the sale of Corp stock would be disregarded for tax purposes. Instead, Corp would be treated as having sold all its assets and then as having liquidated. See the discussion below for the potential tax benefit of a sale/liquidation.
[xv] We’re ignoring any depreciation recapture. IRC Sec. 1245.
[xvi] Because we’re dealing with an S corporation that is not subject to the built-in gain tax, the gain from the sale would not be taxed to the corporation; instead, the gain and the nature of such gain would flow through to its shareholders. IRC Sec. 1366(a) and (b). Thus, the shareholders would report the gain on their tax returns and they would recognize long-term capital gain, subject to federal income tax at the rate of 20%. Depending upon whether the shareholder was a real estate professional under IRC Sec. 469(c)(7) – in this case, we assume they are not – the 3.8% federal surtax on net investment income may also apply to the gain. IRC Sec. 1411.
Don’t forget state and local taxes; for example, NYC does not recognize the S election.
[xvii] Whom do you blame?
[xviii] Not the same as selling all the properties in the same year.
[xix] Ignore the land for this illustration.
[xx] IRS Form 706. We’re assuming Mom had other substantial assets, the value of which required the filing of the return.
[xxi] Assume this figure reflects discounts for lack of marketability and for built-in gain, plus a slight premium for representing control of Corp. See Reg. Sec. 20.2031-2(f).
Note that a greater valuation discount may help with the estate tax liability, but the lower basis resulting therefrom would make it more difficult to eliminate the income tax exposure.
[xxii] IRC Sec. 1366 and Sec. 1367.
[xxiii] We’re ignoring transfer taxes and other closing costs.
[xxiv] $9 million cash distribution less stock basis of $17.5 million.
[xxv] As compared to the $10 million of gain recognized on the sales of the properties.
Of course, this strategy becomes more expensive where the decedent owns less than all the outstanding stock of the corporation.
[xxvi] At least not without selling them at below-market prices.
[xxvii] I’m assuming the obligation would be respected as real debt.
[xxviii] IRC Sec. 453(d).
[xxix] IRC Sec. 336. See below.
[xxx] IRC Sec. 336(a).
[xxxi] IRC Sec. 334(a).
[xxxii] The sale or exchange of land is not covered by this rule because land is not depreciable for tax purposes.
[xxxiii] IRC Sec. 1239. The idea is that a selling party should not be able to get out of an investment at capital gain rates while enabling the related purchaser to recover their investment through depreciation deductions that offset ordinary income.
[xxxiv] Specifically, if an individual’s capital losses for the year exceed their capital gains, the amount of the excess loss that can be claimed to lower the individual’s income for the year is capped at $3,000. If the net capital loss is more than this limit, the excess loss can be carried forward to later years.
[xxxv] For example, property described in IRC Sec. 1221(a)(1), IRC Sec. 1231(b)(1)(A), or Sec. 1231(b)(1)(B) is not depreciable, but its disposition generates ordinary income.
[xxxvi] IRC Sec. 1239(b).
[xxxvii] IRC Sec. 1239(c)(1). A similar rule is provided for partners and partnerships. In addition, certain relationships described in IRC Sec. 267(b) are treated as controlled entity relationships. IRC Sec. 1239(c)(1)(C).
[xxxviii] IRC Sec. 1239(c)(2). This provision refers to the rules of IRC Sec. 267(c), other than paragraph 3 thereof (which attributes ownership among partners).
[xxxix] “Atticus says you can choose your friends but you sho’ can’t choose your family, an’ they’re still kin to you no matter whether you acknowledge ’em or not, and it makes you look right silly when you don’t.” – Jem in To Kill A Mockingbird, by Harper Lee.
[xl] In the case of any sibling, they would be attributed the stock held by each of the other siblings.
[xli] For example, the contribution by a nonresident alien of U.S. real property to a corporation – one of the few exceptions to the general rule with which we started this post – for the purpose of facilitating nontaxable gifts of such stock.
[xlii] IRS Form 8832. An “association” within the meaning of Reg. Sec. 301.7701-3(c)(1)(i) and 301.7701-3(g)(1)(iv).
I’m suggesting an LLC rather than a state law corporation in case it makes sense later to check the box back into disregarded entity status.
Query whether the LLC should elect to be treated as a QSUB under IRC Sec. 1361(b)(3).
[xliii] IRC Sec. 351(a).
[xliv] IRC 362(a), Sec. 1223(2).
[xlv] IRC 358(a), Sec. 1223(2).
[xlvi] IRC Sec. 351(c) ignores the distribution for purposes of the “control” requirement.
[xlvii] Which should have reflected a discount for lack of marketability, as in the case of the deceased controlling shareholder of Corp.
[xlviii] Reg. Sec. 1.742-1.
[xlix] IRC Sec. 732(b).
Of course, if the properties were distributed such that the partners became TIC owners of each property, one would have to wonder whether, as a tax matter, the partnership had been liquidated at all.
[l] Reg. Sec. 1.732-1(b).
[li] Reg. Sec. 1.754-1(b).
[lii] IRC Sec. 743(b); Reg. Sec. 1.743-1(b). The amount of the adjustment would be equal to the excess of the estate’s basis for the partnership interest at the date of death over the estate’s share of the partnership’s basis for its properties.
[liii] IRC Sec. 743 and Sec. 754.
If the partnership, having made such an election, instead distributed one of its properties to a partner in partial liquidation of such partner’s interest, the distribution would not be taxable to either the partnership or the distributee-partner, and the partner’s Section 754 adjustment for such property would attach to their basis for the property, thereby preserving their ability to reduce or even eliminate the gain on their subsequent sale of the property.