Corp Owns Real Estate

[JohnH]

Don't ask me how this came about - I came on the scene after all the major decisions had been made.

In 1996, clients formed a corporation which bought a commercial property, which has now been depreciated down to $100K.
Client and his wife equally owned the stock in the corp.
Wife has since died, so the stock in the corp is now owned by the client and his wife's trust.

Someone has tentatively offered $1.5 million for the property.
Buyer is not a related party.
Buyer has no interest in buying the corp of course - they only want the property.

I told the client the corp will pay tax on 1.4 million at ordinary corp tax rates, then it will need to be liquidated and the remaining money paid to him and the trust.
He and the trust will be taxed on this distribution as well.

This is all back-of-the-envelope planning, as nobody has put anything in writing.
Anyone disagree with me or have any ideas on how to mitigate some of the taxes?

[Gary2]

Doesn't the trust get a stepped up basis in the wife's stock? Calculating the value of the stock would be tricky, as being a closely-held corporation with real estate as (I assume) the main asset, the stock will be worth less than the corresponding share of the building. Still, it should help at that end.

And this, by the way, is one reason not to hold real estate in a corporation.

[ATSMAN]

Assuming Goodwill is not involved, I have seen stock valuation formula that uses the value of the company assets and earnings. I think CFS has a tool for that.

Hiring a professional valuation company is going to be in the $2000 range from my prior experience in an estate case.

[JohnH]

I agree that this is an extreme example of why you should not hold real estate in a corporation. This was all done before I became involved, but limiting their liability was a very important consideration at the outset, and in 1996 LLC's were not that common in NC. So the corp was probably a good decision at the time, in spite of the tax ramifications. We also discussed selling the property to an LLC several times over the intervening years, but the tax hit would have been significant and the owners just couldn't bring themselves to pull the trigger. Having the benefit of hindsight, this should probably have been done about 10 years ago.

I've been wondering about the wife's stock. If the buyer purchased the corp, then the wife's stock would get a step up in basis. But a buyer isn't going to want to buy the corp - a buyer would only want the asset. If the buyer simply bought the stock in the corp, he would not be able to deduct depreciation going forward.

When the corp liquidates, I was thinking that virtually the entire amount distributed would be taxable as a dividend. But if the step up in basis of the wife's stock can somehow factor into the liquidation, that would reduce the tax on the personal return significantly.

[TXEA]

Try IRC Sec 331

Unless I am missing something here, I think the provisions under IRC Sec 331 will apply

IRC Sec 331
Internal Revenue Code Section 331
Gain or loss to shareholders in corporate liquidations.
(a) Distributions in complete liquidation treated as exchanges. Amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock.
(b) Nonapplication of section 301. Section 301 (relating to effects on shareholder of distributions of property) shall not apply to any distribution of property (other than a distribution referred to in paragraph (2)(B) of section 316(b)) in complete liquidation.
(c) Cross reference. For general rule for determination of the amount of gain or loss recognized, see section 1001.

If you completely liquidate the corporation in a timely manner immediately following the sale, then this Code Section would allow treatment as a capital gain. There must be a plan of liquidation filed with the IRS (Form 966) along with some boilerplate language prepared by the attorney that just states the corporation is liquidating, paying final bills, and winding up the affairs of the entity. The Form has a prescribed filing deadline, so take care to follow the steps.

Also, take care to make no distributions in the general time-frame of the final terminating distributions as they may be determined to be dividends.

With the terminating distributions, the basis in the stock will offset the proceeds for capital gain purposes. Hopefully the trust's basis in the stock is substantially higher due to a step up in basis.

Not sure if this will help you, but it might be worth reviewing.

[Burke]

Was this an S-Corp and were there losses which passed through to the shareholders during the time the property was held? Was this the only asset and only purpose of the corp -- i.e, to own the real estate in such an entity? I had a client with this same situation but it was an S-Corp and everything passed thru to the shareholders, including the gain at time of sale. If the spouse's stock was passed to a trust through her will, then I agree it got a stepped up basis.

[JohnH]

Burke.
No, it is a C-corp.
It had operated briefly as a C-corp when first organized, then made an S-corp election for several years while the owners ran the business. Then they retired, began renting the property to a third party, and reverted to a C-corp. I think that was due to all the income becoming passive from that time forward.

TXEA: Thanks very much for that info.
I'm going to study it, and if the conversation actually materializes into an offer, I'll have that on hand.
I'm not familiar with this aspect of tax law, and plan to counsel the client that I'll work with him to find someone who is.

[Roland Slugg]

Hello John H. Yes, you have it pretty much right, but I will comment on a couple of points you or others have said.

The wife's shares will not "get" a step-up in basis; they "got" a step-up in basis the day she died. If the real estate is the corp's only asset, her trust's basis in the corp's shares is 50% of the FMV of the building as of her DOD. If the corp owns other assets, the value of those other assets, less any liabilities, will affect the shares' value. The husband's basis in his half of the shares was not affected by his wife's death.

Yes, there will be a gain of about $1.4M on the sale of the building, and this will be taxable to the corp at the normal corporation tax rates. There is no special, lower rate for LTCGs realized by a corporation. It's a pity is was structured this way. In fact it more than a pity ... it's downright shocking! I can not imagine any competent business or tax attorney recommending this without a clearly-written letter to the clients advising against it. The surviving spouse might wish to consult a tax lawyer, as he may have a legitimate malpractice case against the lawyer who advised putting the building in the corp back in 1996.

... then it will need to be liquidated and the remaining money paid to him and the trust.

Well, eventually, perhaps, but that doesn't necessarily have to be done right away. The surviving spouse (and the trust) can liquidate the corp slowly over several years. They don't have to do it immediately.

Observation: The real estate was bought in 1996 and now has a basis of $100K, having been depreciated for about 18 years. One can surmise, then, that the real estate must have originally cost about $200K, more or less, depending on the amount allocated to land. It's now worth $1.5M, which means that the pure gain is about $1.3M. If the real estate had NOT been owned by the corp, half of that gain (the wife's) would now escape federal income tax altogether, and the other half would get LTCG treatment ... 20% (or less). (There would also be some gain ... roughly $75K I'm guessing ... that would be treated as Unrecaptured §1250 Gain and taxed at a rate of up to 25%.) Instead, the corp will pay tax on the full $1.4M of recognized gain at the rate of 34% ... a whopping $476K give or take ... and then the after-tax proceeds will be taxed, again, to the shareholders, when it's distributed to them. Only the husband will incur that second tax, and, depending on his basis in the corp's shares, that tax will amount to roughly $90K or so. If the real estate was held by the H&W directly, his federal tax would be roughly $135K. So the tax cost of having the corp own that real estate is roughly $430K. $430K!!! I would definitely see a lawyer.

Finally, the wife's trust may yield a further problem: Its stepped-up basis in the corp shares is around $750K, but the after-tax funds that will be distributed by the corp to that trust will be just slightly more than $500K. (One-half of the $1.5M proceeds from the sale of the real estate, less the federal income taxes paid of $476K.) In fact it will be even less that that if the corp also incurs a state income tax. Thus, the wife's trust appears to be headed for a LTCL in the vicinity of $250K. How does THAT grab you? If the trust's shares can be distributed to the husband before the sale of the real estate, that would probably be a very wise thing to do.

[JohnH]

Thanks Roland.
I appreciate your comments, as well as the others.

I have discussed this many times with the client and his wife (prior to her death) over the years after I began handling their tax work. They went into the original transaction knowing that it could have some severe tax consequences in the future. But at the time and during the intervening years, their primary concern was insulating themselves from any potential liabilities (this is a convenience store). They were very risk-averse from day one and never felt they could buy enough insurance to protect them from all eventualities.