1120S to be converted to 1065

[sami]

I have a new client who started LLC for a rental property but selected it to be taxed as an 1120S in 2019. I informed him that it was a bad choice as he should have file is 1065. I am not aware of a way that it can be changed now. The loan that he took out to purchase this property is also under an LLC name. The LLC is owned by a husband and a wife in a Community property state. I was hoping if anyone has any idea that they can recommend me what to do in this situation. Client actually want it be taxed as a disregarded entity.

[spanel]

What would be the point, both 1120S & 1065 require separate returns and both will be taxed the same as its rental income.

Chris

[terryats]

When you choose to be taxed as an Scorp it will be 5 years to change to another entity. You can ask IRS for permission to change sooner. Here are the instructions to revoke Scorp status:
https://www.irs.gov/forms-pubs/revok...ter-s-election. You should also see this article on the subject: https://www.thetaxadviser.com/issues...evocation.html

[TaxGuyBill]

If the LLC made the S-election starting when it was formed, the 5 year rule does not apply.

As the link that Terry posted shows, if you revoke the S-election, it will then be taxed as a C-corporation, so that does not seem to be what you want to do.

You first said you want it converted to a 1065, but then you said you want it to be a disregarded entity (presumably you mean page 1 of Schedule E). So you will need to figure out which treatment you actually want.

[sami]

Either a 1065 or disregarded entity ( Sch E) but client preference is disregarded entity as he does not file to file two tax returns if it could be prevented. The reason for switch is the asset has been appreciated a lot. So how the switch will impact the appreciation in the rental property?
Yes, the S-Corp election was made from the beginning.

[TaxGuyBill]

If it is taken out of the corporation, it is treated as 'sold' at Fair Market Value. So effectively the taxpayer will be taxed on any appreciation/gain from the property. You said it was done in 2019, so it is possible that the FMV has not increased much, so the the taxable gain might be small (obviously that can vary).

But take a step back. What is are their long-term plans for the rental? Besides the need (and expense) of filing a corporate return every year, having it in a S-corporation isn't a big deal as long as the rental is never taken out of the corporation (other than selling it). But if there is a chance it will ever be taken out of the corporation (other than selling it), then in most cases, the sooner it comes out, the better.

[sami]

Client plans to keep the rental for at least 10 to 15 years. It has already appreciated by million dollar as of now. Should he just continue and worry about taxes upon sale ?

[TaxGuyBill]

If it stays in the corporation until sold, I don't see any problem with it being in a S-corporation.

The warning of "never put real estate in a corporation" applies to a C-corporation or any corporation (including an "S") if it is taken out before it is sold. But I don't see a problem with it being in an S-corporation if it remains there until sold.

[terryats]

What if the clients pass away. Food for thought. S corporation assets do not receive a step-up in tax basis upon the death of a shareholder. When shareholders in S corporations pass away or sell their interest to third parties, the beneficiaries (or buyers, in the case of a sale) receive a step-up in the basis of their inherited (or purchased) stock to the fair market value at the time of death (or time of sale). This readjustment in the value of appreciated assets is higher than the amount paid by the original owners, which, in turn, can minimize or even eliminate the heirs’ and/or buyers’ exposure to capital gains tax in the future. The problem is that the step-up does not apply to the S corporations’ underlying assets. This can result in heirs and/or buyers being subject to income tax on an S corporation’s earnings from before they took ownership of the stock, and it may reduce the availability of valuable depreciation and amortization deductions that would otherwise apply to real property.

[TaxGuyBill]

The stock itself receives a step-up in Basis, so from my point of view, the step-up would be about the same in both situations for the heirs.

You have a good point about the depreciation. I'll have to think about that aspect a bit more. :-) However, assuming the property is increasing in value, the decreased depreciation for the heirs is largely a timing issue. Less depreciation would equal lower gain when it is sold. But you have a good point that the ordinary income versus long-term capital gain versus Unrecaptured Section 1250 Gain could differ between those situations. Thanks for pointing that out.