REAL ESTATE OPERATIONS IN THE CORPORATE FORM -- WHEN DOES IT MAKE SENSE?

Transcription

1 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 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

2 (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 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. 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: 34% v. 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. 2

3 (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 (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. (b) (c) active income/losses - income from a trade or business and not portfolio income or passive activity income. portfolio income/losses - income from interest, dividends and royalties, e.g., from investment portfolio. passive income/losses - any activity which involves the conduct of any trade or business in which the taxpayer does not "materially participate." 3

4 (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: (b) (c) activity is taxpayer s principal business? amount of taxpayer s physical presence in the business? extent of taxpayer s personal services? (iii) Impact of passive loss rules depends on type of entity. Types of regular C corporation entities: 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 (1) (B), 542 (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." 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. 4

5 III. (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 Summarize C corporation advantages. C corporation disadvantages. (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. 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%. 5

6 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. 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.

7 (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. 7

8 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: (b) 60% of corporation s adjusted gross ordinary income must be from passive sources; and 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. Rents excluded if they constitute 50% or more of the adjusted ordinary income of the corporation and if other personal holding 8

9 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: generally must be on a calendar year.

10 (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. 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. (b) generally, income taxed at shareholder level, no corporate level tax. 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 (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 Shareholders taxed at lower rate, 28% v. 34%. Repeal of General Utilities not applicable to "virgin" S corporations. Transitional rules for C corporations converted to S corporations - 10 year built in gain rule. (iv) Corporate Alternative Minimum Tax 10

11 (v) Generally not applicable at the corporate level. Losses generally pass through subject to basis requirements. (b) (C) basis is capital contribution plus loans directly to corporation from shareholders. Loans to corporation from third parties do not increase shareholders basis, even if shareholders personally guarantee. Note difference from partnership. 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. 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. (b) dry income problems. voting control problems. (vi) Inadvertent termination. (vii) 5 year delay for reelection. 11

12 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) Significant capital contribution by 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. Need for a Ruling. (1) Must satisfy tax free spin off rules. 12

13 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. 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: (b) (C) purchase and sale. development. residential sales etc. B. Presumption: start with S corporation. (i) Consider corporate benefits after development, limited liability (b) centralized management (C) continuity of existence (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 13

14 (1) loss pass throughs (m) no general utilities problems (ii) Problems or disadvantages with S corporation. 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). 14