Purchased real estate separately when ownership of S corp was transferred

[PPJCPA]

I am currently working on a new client's tax return. In 2015 his parents transferred the business to my client (son and his wife) as of 12/31/2015. They sold the building and land to my client on an installment sale. The property was transferred by quitclaim deed. The loan and property is in my client's name.

I have done considerable amount of research on self-rental income and understand a loss would be considered passive and income is non-passive.

I also understand it's in my client's best interest to have the building and property outside of the business and the real estate should be held in an LLC and NOT in my client's name.

The following are my questions:

- Is it possible to add the real estate and the loan to the business books? Basically this would be done just to avoid self-rental. Depreciation and loan interest would all be recorded by the business. I think this could possibly lose the asset protection from separation of real estate and business. I realize this may not even be possible at all and/or just all around bad thought.

- My client is paying the loan through the business bank account. I thought I could use this amount as the rent expense if I set it up as "self rental". The loan payment amount is very close to FMV of the rent. However by reporting this way, after interest, depreciation and property taxes - there would be a rental loss.

Also my client's parents had basis in the S corporation as of 12/31/2015. My client did not pay his parent's for the stock. I understand that this transfer is subject to gift tax reporting based on the FMV of the stock. Can anyone provide me with a way to value the stock? I realize I could go through a certified valuation analyst but was wondering if there was another way. Originally I was just going to transfer my client's parents' basis to my client but then thought I needed to use FMV. Right?

I am posting this because I looking for feedback on how to best deal with the above situations and/or any feedback on something I may be not considering.

[Roland Slugg]

Hello PPJ. I read your post and wanted to respond but became uncertain about some of the basics. I therefore made the following assumptions:

1. The Corp owned (and still owns) the business but did not own the real estate.
2. The parents gave the shares of the Corp to their son (and his wife).
3. The parents sold the real estate to their son, taking a note for some or all of the selling price.

I'll offer answers to your questions, based on my understanding of the facts as stated above.

I have done [...] research on self-rental income and understand a loss would be considered passive and income is non-passive.

That is correct, assuming that your client "materially participates" in the business operated by the Corp.

I also understand it's in my client's best interest to have the building and property outside of the business and the real estate should be held in an LLC and NOT in my client's name.

By "business" I assume you are referring to the Corporation. It is almost always inadvisable for real estate to be owned by a corporation, including one that has elected S Corp tax status. If the S Corp election is terminated, either voluntarily or inadvertently, the real estate can become locked-in, resulting in very undesirable tax consequences.

Whether or not the real estate needs to be held in an LLC is a matter for your client to decide. Lawyers seem to love LLCs, but in many cases I believe they are completely unnecessary. LLC's offer little financial liability protection, and lawsuit liability protection can and should be obtained by carrying adequate insurance.

Is it possible to add the real estate and the loan to the business books?

Absolutely not! If the Corp doesn't own the real estate and isn't liable for the debt, how can the property and related loan be treated as an asset and liability of the Corp?

My client is paying the loan through the business bank account.

The loan isn't the Corp's debt, so why is it making the payments? You should advise your client to stop that practice immediately ... and retroactively to day one.

The Corp should instead be paying fair market rent to your client (also retroactively), and your client, in turn should be making the note payments.

I also suggest a "triple net lease" in which the tenent, i.e. the Corp, pays: (1) the real estate taxes, (2) the hazard and liability insurance and (3) all minor, ordinary repairs and maintenance (but not major repairs or improvements, such as a new roof). This would help avoid a loss from the rental activity, or at least it will serve to minimize it.

Also my client's parents had basis in the S corporation as of 12/31/2015. My client did not pay his parent's for the stock. I understand that this transfer is subject to gift tax reporting based on the FMV of the stock. Can anyone provide me with a way to value the stock?

You are correct. Get an appraisal, as you suggested. The shares' overall FMV might be subject to a "valuation adjustment" due to their closely-held nature. You didn't indicate an approximate value of the business and, therefore, of the Corp's shares, but there is an easy way to transfer $112,000 based closely on the facts you gave, without any of that amount eating into the parents' lifetime gift and estate tax exemption. Each parent can give each donee ... i.e. the son and his wife ... $14,000 per year. So they gift half the Corp's shares on 12/31/2015 and the other half on 1/01/2016. That's two donors and two donees and two tax years, or $14,000 x2 x2 x2 ... $112,000.

You understand, I trust, that for income tax purposes the parents' basis in their shares of the Corp become the son's (and his wife's) basis. The new owners also need to make the S Corp election.

[PPJCPA]

Hello PPJ. I read your post and wanted to respond but became uncertain about some of the basics. I therefore made the following assumptions:

1. The Corp owned (and still owns) the business but did not own the real estate.
2. The parents gave the shares of the Corp to their son (and his wife).
3. The parents sold the real estate to their son, taking a note for some or all of the selling price.

I'll offer answers to your questions, based on my understanding of the facts as stated above.

The above assumptions are correct.

By "business" I assume you are referring to the Corporation. It is almost always inadvisable for real estate to be owned by a corporation, including one that has elected S Corp tax status. If the S Corp election is terminated, either voluntarily or inadvertently, the real estate can become locked-in, resulting in very undesirable tax consequences.

Whether or not the real estate needs to be held in an LLC is a matter for your client to decide. Lawyers seem to love LLCs, but in many cases I believe they are completely unnecessary. LLC's offer little financial liability protection, and lawsuit liability protection can and should be obtained by carrying adequate insurance.

Thank you, Roland Slugg. Per my research in this matter, your opinion above seems to be the consensus.

Absolutely not! If the Corp doesn't own the real estate and isn't liable for the debt, how can the property and related loan be treated as an asset and liability of the Corp?


The loan isn't the Corp's debt, so why is it making the payments? You should advise your client to stop that practice immediately ... and retroactively to day one.

The Corp should instead be paying fair market rent to your client (also retroactively), and your client, in turn should be making the note payments.

I also suggest a "triple net lease" in which the tenent, i.e. the Corp, pays: (1) the real estate taxes, (2) the hazard and liability insurance and (3) all minor, ordinary repairs and maintenance (but not major repairs or improvements, such as a new roof). This would help avoid a loss from the rental activity, or at least it will serve to minimize it.

This is what I expected the answer to be. I appreciate the time you took to explain further.

You are correct. Get an appraisal, as you suggested. The shares' overall FMV might be subject to a "valuation adjustment" due to their closely-held nature. You didn't indicate an approximate value of the business and, therefore, of the Corp's shares, but there is an easy way to transfer $112,000 based closely on the facts you gave, without any of that amount eating into the parents' lifetime gift and estate tax exemption. Each parent can give each donee ... i.e. the son and his wife ... $14,000 per year. So they gift half the Corp's shares on 12/31/2015 and the other half on 1/01/2016. That's two donors and two donees and two tax years, or $14,000 x2 x2 x2 ... $112,000.

Thank you, Roland. I did not think of the gift splitting on 12/31/15 and then doing it again on 01/01/2016.

You understand, I trust, that for income tax purposes the parents' basis in their shares of the Corp become the son's (and his wife's) basis. The new owners also need to make the S Corp election.

I did not know the son and his wife need to make the S Corp election as well. I am past the late election filing due date. Any advice on how I proceed with this?