REAL ESTATE OPERATIONS IN THE CORPORATE
FORM -- WHEN DOES IT MAKE SENSE?
I.
INTRODUCTION
A.
Historically real estate owned by partnership or
limited partnership.
B.
Many circumstances favor the use of a corporation taxed
under Subchapter C of the I.R.C. of 1986 or Subchapter S of the
I.R.C. of 1986.
C.
Advantages of C corporation
Limitations of C
corporation -- circumstances in which S corporation’s overcome C
corporation disadvantages -- and partnership freezes.
--
II. C CORPORATION ADVANTAGES
A.
Limited liability - historically the reason C
corporations used in various settings:
(i) limited liability not assured for active owner
except through the corporate form.
(ii) money investors in a corporation need not restrict
their participation in management to preserve
limited liability.
B.
Centralized management.
C.
Continuity of existence.
D.
Free transferability of shares.
E.
Anonymity of shareholders.
IICLE/DOC/KHB/BE
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(1) limited partnerships under RULPA in Illinois are
now able to obtain anonymity but general partners
are still disclosed - even if not active.
F. Assured tax status.
(1) more certainty than partnership tests pursuant to
the regulations under I.R.C. §7701.
G. Tax free reorganizations in the future
(1) not available to partnerships.
H.
Income splitting between shareholder and corporation.
(i) shareholder and corporation still considered
independent and separate taxpayers.
both shareholder and corporation benefit from
graduated rates, provided incomes not high enough
to phase out.
(a) Example: See three year tax tables, attached
as Exhibit 1.
Suppose individual already paying 28% flat tax on other
income owns business that produces $50,000 of taxable
income. If he operates a sole proprietorship for tax year
1988 he pays 28% tax on $50,000 or $14,000. If operates as C
corporation initially pays only 15% on $50,000 or $7,500.
Tax Savings of $6,500 (Note: second tax on distribution).
Caveat: Disadvantages of C corporation - the inversion
of tax rates at higher income levels: Corporation @ 34% v.
Individual @ 28%.
(iii) Undistributed C corporation taxable income is not
taxed to shareholders.
Funds can be used for
direct corporation investment, reduction of
mortgage indebtedness, fringe benefits - avoiding
2% shareholder floor on some itemized deductions.
I.
Income Splitting between family members.
(i) less available than in the past because unearned
income of children under 14 taxed at parent’s
highest rate.
(ii) lesser spread between highest and lowest rates.
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(iii) effective for older kids working summers and
vacations - lower tax cost for college or other
expenses.
J. Medical reimbursement plans more flexible for
corporation.
(1) deductible for C corporation, not income to
shareholder.
K.
Profit Sharing Plans.
L.
Timing of deductions and income.
(1) generally C corporation can still choose a fiscal
year.
(ii) limitations on fiscal year for a personal service
corporation.
M.
Separate taxpayer for dealer taint on the sale of
property.
(i) particularly appropriate for complex and diverse
real estate operations - i.e., ownership of an
apartment complex and condominium sales in a
second complex.
(ii) this will be discussed more fully at IV.B. (viii).
N.
Passive Loss rules, I.R.C. §469.
(i) general rule:
passive losses cannot be offset
against portfolio income or active income.
(ii) Bozo Game - 3 baskets of income/losses and
deduction equivalent credits.
(a) active income/losses - income from a trade or
business and not portfolio income or passive
activity income.
(b) portfolio income/losses - income from
interest, dividends and royalties, e.g., from
investment portfolio.
(c) passive income/losses - any activity which
involves the conduct of any trade or business
in which the taxpayer does not "materially
participate."
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(1) material participation is a
subjective test.
(2) activity must be "regular,"
"continuous," and "substantial" terms not defined in I.R.C.
Also
consider if:
(a) activity is taxpayer’s principal
business?
(b) amount of taxpayer’s physical
presence in the business?
(c) extent of taxpayer’s personal
services?
(iii) Impact of passive loss rules depends on type of
entity. Types of regular C corporation entities:
(a) closely held C corporation - corporation with
5 or fewer shareholders owning directly or
indirectly 50% or more in value of the
outstanding
stock.
§469(j)(1),
§465 (a) (1) (B), §542(a) (2).
(b) personal service corporation.
§469 uses a
modified definition of personal service
corporation.
Generally corporations
providing services
- professional
corporations, financial service firms, etc.
(c) corporation that is not a closely held C
corporation or personal service corporation.
regular corj Dorat ion.
(d) Advantages of corporate ownership.
See
handout 3, "Passive Activity v. Nonpassive
Activity."
(a) Regular C corporation may offset passive
losses against active income and portfolio income.
Not
subject to disallowance rules of §469.
(b) Closely held C corporation may offset
passive losses against active income. Cannot offset passive
losses against portfolio income.
(c) Personal service corporation may not
offset passive losses against active income or portfolio
income.
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(d) Note special rule for defining "active"
income for closely held C corporation. Generally
shareholders owning 50% or more of the stock must materially
participate in the activity.
(e) Two caveats before transferring passive
activity to C corporation:
(1) if activity turns profitable, income will be
taxed at higher C corporation rates.
(2) deductions and credits that produce the tax
loss for passive activity, e.g. accelerated
depreciation, are likely to be tax preference
items that result in the new corporate
alternative minimum tax.
(f) Special Rental Activity Rule for Real
Estate. See footnote 3 on handout 3.
(1) taxpayer participates in real
estate activity.
(2) taxpayer’s adjusted gross income is
less than $100,000.
(3) real estate activity loss is
$25,000 or less, loss is treated as
nonpassive activity
- even for
individuals, personal service
corporations and shareholders of S
corporation.
0.
III.
Summarize C corporation advantages.
C corporation disadvantages.
A.
Because corporations are separate and distinct entities
there are various unfavorable tax consequences in a C
corporation.
B.
Double Taxation
(1) tax at corporate level and at shareholder level.
(ii) Note: Approximately $1.00 in corporate earnings
necessary to put $.48 in shareholder pocket.
Corporate level tax at 34% and shareholder level
tax at 28%.
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Caveat: Tax at corporate level can be reduced by
salary payments to shareholder/employee except if
they are unreasonable and deemed a dividend.
C. CORPORATE TAX RATE HIGHER THAN INDIVIDUAL TAX RATE.
Tax Reform Act of 1986 inverted corporate and individual tax
rates for first time making corporate "effective tax rates"
higher than shareholder "effective tax rates."
(1) See handout 2 - tax rate phase-in: corporation
compared to married filing jointly.
(a) highest marginal rate
(1) corporation 34% with 5% surtax
(2) married filing jointly 28% with 5%
surtax.
(b) Difference of marginal rate v. effective
rate.
(ii) Surtax is a clawback of lower marginal rates on
first dollars earned. At corporate income of
$335,000 corporation’s effective rate or flat rate
of 34% is established. For married filing jointly
effective rate or flat rate is 28% at 171,900.
D.
Repeal of the General Utilities Doctrine
(i) generally this doctrine allowed a corporation to
distribute appreciated property to its
shareholders without recognizing a gain on the
distribution. Thus circumventing the general
regime of double taxation.
Tax Reform Act of 1986 eliminated general
utilities with certain transitional exceptions.
These should be reviewed.
(iii) Partnership or S corporation freeze - discussed at
Hybrid Use of C corporations, at V.
E. CORPORATE ALTERNATIVE MINIMUM TAX
(i) TRA of 1986 replaced the 15% corporate add-on
minimum tax with a 20% alternative minimum tax.
(ii) Corporations tax base for the ANT is expanded:
Regular taxable income increased by its tax
preferences for the year and adjusted by
recomputing designated deductions and items of
income.
Adjustments generally counteract accelerated
deductions or methods of reporting income that
defer recognition of taxable income, e.g.
accelerated depreciation and completed contract
methods of accounting.
(iv) Preferences include items like amortization of
pollution control facilities, percentage
depletion, excess intangible drilling costs, etc.
(v) Corporation pays higher of corporate income tax
and Alternative Minimum Tax.
(vi) Corporation is given a $40,000 exemption against
ANTI but that phases out at the rate of 25 cents
per dollar for ANTI in excess of $150,000. Phase
out of exemption is completed at ANTI of $310,000.
(vii) Corporation must keep two sets of books to
maintain ANTI for tax purposes - administrative
difficulties.
(viii) ANT may counteract benefit of Passive loss rules
for corporation.
F.
No pass through of Losses
(i) C corporation is separate entity - no loss pass
throughs
G.
Limitations on Related Party Loss Rules
(1) losses on transactions between corporation and
shareholder are not allowed if shareholder owns
directly or indirectly more than 50% of the
outstanding stock.
Capital gain treatment, to the extent applicable
in the future, also disallowed in this
circumstance.
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H. Accumulated Earnings Tax
(i) Additional tax imposed to penalize corporations
for improperly accumulating income - i.e.
circumvent double taxation.
(ii) Additional tax of 27.5% of accumulated taxable
income up to $100,000 and 38.5% of taxable income
in excess of $100,000.
(iii) First $250,000 of accumulated earnings is exempt.
Some service corporations like law firms and
accounting firms limited to a $150,000 exemption.
(iv) Service allows accumulation for "active" purposes
- e.g. expand business but not for "passive"
purposes - buying minority shareholder’s interest.
(v) Real estate corporations can use excess earnings
to reduce mortgage indebtedness.
Real estate
vulnerable to attack for investing earnings in
other real estate because may be determined to be
passive.
I.
Personal holding company
(i) Discourage individuals from using corporation to
avoid personal income taxes. Less likely today
with individual tax rates lower than corporate
rates.
Tax for years beginning after July 1, 1987 is 28%
of undistributed personal holding company income.
(iii) Two tests for personal holding company:
(a) 60% of corporation’s adjusted gross ordinary
income must be from passive sources; and
(b) 5 or fewer persons must own at least 50% of
the stock during the last half of
corporation’s taxable year.
(iv) Personal Holding Company income includes
dividends, interest, rents, royalties, personal
service contracts, etc.
(a) Rents excluded if they constitute 50% or more
of the adjusted ordinary income of the
corporation and if other personal holding
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company income does not exceed 10% of the
ordinary gross income of the corporation.
J.
Summarize Corporate Disadvantages.
IV. THE CORPORATE ALTERNATIVE: THE S CORPORATION.
A.
Eligibility (6 requirements)
(1) 35 or fewer shareholders
(ii) no shareholders other than individuals, certain
trusts and estates.
(iii) no non-resident alien shareholders
(iv) one class of stock
(v) domestic corporation
(vi) must not be an ineligible corporation as defined
in §1361(b)(2).
Ineligible corporations are
members of an affiliated group, financial
institutions to which §585 or §593 apply and
various other non-eligible entities.
B. ADVANTAGES SHARED WITH C CORPORATION.
(i) Limited liability.
(ii) Centralized management.
(iii) Continuity of existence.
(iv) Free transferability of shares subject to
eligibility requirements.
(v) Anonymity of shareholders.
(vi) Income splitting between family members.
(vii) Generally, profit sharing and other benefit plans
can be in parity with C corporations.
(viii) Separate taxpayer for dealer taint issues - but
more likely to be attacked than a C corporation.
C. ADVANTAGES NOT SHARED WITH C CORPORATION.
(1) Timing of income and deductions:
(a) generally must be on a calendar year.
(b) exception: Natural business year test: 25%
or more of corporation’s receipts are
recognized in last two months.
(c) unlikely this will apply to Real Estate
entities.
(ii) Passive Loss Rules See Handout 3.
(a) S corporation not subject to passive loss
limitations but shareholders of S corporation
subject to rules on pass through.
D. DISADVANTAGES OF C CORPORATION OVERCOME BY S
CORPORATION.
(i) Double Taxation.
(a) generally, income taxed at shareholder level,
no corporate level tax.
(b) exceptions if previously a C corporation.
Not applicable to virgin S corporations:
(1) Sting Tax on excess net passive income
(only if C corporation prior to S
corporation election).
(2) Tax on built in gains during the ten
year recognition period provided in TRA
1986.
(3) Corporate alternative minimum tax on any
preference items on built in gains.
(4) Recapture of investment tax credit taken
during a C corporation period.
(ii) Inversion of Tax Rates
(a) Shareholders taxed at lower rate, 28% v. 34%.
Repeal of General Utilities not applicable to
"virgin" S corporations.
(a) Transitional rules for C corporations
converted to S corporations - 10 year built
in gain rule.
(iv) Corporate Alternative Minimum Tax
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(a) Generally not applicable at the corporate
level.
(v)
Losses generally pass through subject to basis
requirements.
(a) basis is capital contribution plus loans
directly to corporation from shareholders.
(b) Loans to corporation from third parties do
not increase shareholders basis, even if
Note
shareholders personally guarantee.
difference from partnership.
(C)
Note example of real estate, borrowing and
limitation on shareholder basis.
(vi) Related party loss rules not applicable.
(vii) Accumulated Earnings tax not applicable.
(viii) Personal Holding Company Tax not applicable.
E.
S corporation Problems.
(i) Not favorable in many instances because of basis
problems. Particularly difficult for real estate
syndications.
(ii) Special allocations more difficult in S
corporation because one class of stock.
(a) Some special allocations possible through
salary guarantees.
(iii) 35 shareholder limitation and other qualification
limitations, i.e. - no corporate shareholders.
(iv) Must have buy/sell or shareholder agreement to
protect S corporation status.
(v) Difficult to use S corporation with equity
investors.
(a) dry income problems.
(b) voting control problems.
(vi) Inadvertent termination.
(vii) 5 year delay for reelection.
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V. HYBRID USE OF C CORPORATIONS
A.
Partnership Freeze
(i) C corporation transfers some of its assets
("growth assets") to a partnership in return
for a preferred partnership interest.
(1) Partners can hold interests in
partnership through one or more S
corporations.
(ii) Value of transferred assets must be exchanged
for FMV of partnership interest.
(1)
capital contribution by
Significant
partners important to give economic
substance on fixed return to C corporate
partner.
(2) Return to corporate partner should be
cumulative.
(iii) Freeze partnership, not C corporation, must
control and manage growth assets.
(iv) Freeze partnership must conduct business as a
separate entity.
(v) Probably must be general partnership Spreads
liability and risk and gives
significant
business purpose.
(vi) Partnership must be structured to have
substantial economic effect.
B.
S Corporation Freeze
(i) Corporation forms subsidiary ("Newco")
transfers assets to Newco for all of Newco’s
stock. Corporation transfers all of Newco’s
stock to shareholders who then elect S
corporation status.
(a) Need for a Ruling.
(1) Must satisfy tax free spin off
rules.
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S
(2) Newco’s stock ownership may violate
§1361(b) (2) (A) against membership
in affiliated groups and
§1361(b) (1) (B) concerning eligible
S corporation shareholders.
(3) Must have valid business purpose or
service will not allow avoidance of
general utilities repeal.
(ii) Built in gain on appreciated assets for 10
years after Newco established.
(a) No worse than if C corporation elected
to be a S corporation or used a
partnership roll-out.
C. For more details and greater discussion of Tax
Risks see the August, 1988 publication of The
Journal of Taxation", Using a Partnership Freeze
to Shift Future Appreciation in Corporate Assets",
by Bruce N. Lemons and Daniel R. Child.
VI. CONCLUSION
A.
Type of entity used in real estate will depend on:
(i) Type of real estate:
(a) purchase and sale.
(b) development.
residential sales
(C)
etc.
B.
after development,
Presumption: start with S corporation.
(i) Consider corporate benefits
(a) limited liability
(b) centralized management
continuity of existence
(C)
(d) free transferability of shares
(e) anonymity of shareholders
(f) assured tax status
(g) tax free reorganizations
(h) income splitting (between entities and
family members)
(1) separate taxpayer for dealer taint rules
(j) no double tax
(k) lower tax rates
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(1) loss pass throughs
(m) no general utilities problems
(ii) Problems or disadvantages with S corporation.
(a) shareholder limitations
(1) 35 shareholders
(2) no corporate shareholders
(3) no trust etc. shareholders
(b) basis limitations
(c) passive loss rules
(d) special allocations
C. Based on problems with S corporation consider
partnership (i.e., shareholder limitations or basis problems), or
C corporation (passive loss rules or shareholder limitations).
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