Disadvantages to hold rental real estates by a California S corporation Not LLC

[jmc]

If an S corporation was never been a C corporation, what are the disadvantages to hold rental real estates by a California S corporation compared to an LLC, other than special allocation & basis from entity-level debt? Are there stronger legal protections for an LLC than an S corporation even in California, such as Charging Order rule?

If possible, could I receive answers also with pertinent source of document? Thank you very much.

[Bees Knees]

Real Estate Held Inside a Corporation

I don’t know California liability laws in regards to corporations vs. LLC. But from a federal income tax standpoint, the LLC taxed as a partnership or sole proprietor has a huge advantage over an S corporation when it comes to liquidating the entity.

For example, say you put the real estate in at $200,000, and then in five years, you decide to liquidate the business, but you want to keep the real estate. Let’s say the real estate appreciated in value to $300,000. If the business held the real estate as an S corporation, the liquidation of that asset would cause the shareholder to realize a $100,000 capital gain. That is because under section 336, the corporation has to recognize the gain as if it had sold the asset at its fair market value. The gain is then passed through to the shareholder to pay the tax, and the shareholder now owns the real estate with a $300,000 basis.

However, if the business were an LLC taxed as a partnership or sole proprietorship, section 731(a)(1) says there is no gain upon liquidation provided no cash was distributed. The partner (or sole prop) now owns the real estate with a $200,000 basis. Tax on the gain is deferred until the property is eventually sold.

I have been to Gear Up Tax Seminars where the speakers claim it would be malpractice to not warn a client if he wants to put real estate inside a corporation. Of course if the owner decides to sell the real estate at the same time the business is dissolved, then there would be no disadvantage to having the real estate inside an S corp, because gain would have to be taxed on the sale regardless of whether it was in an S corp or an LLC taxed as a partnership or sole prop.

[jmc]

Thank you for response

I really appreciate your response with valuable information and idea.

[S T]

Calif and S Corp vs LLC for Real Estate

Operating as an LLC in Calif is a little different than other States.

I have done a little research on S Corp vs LLC in Calif for real estate investments , so will make just a comment or two in relationship to these entities for real estate investments only (investor not a real estate professional) and not for other types of businesses looking at forming a LLC entity in Calif.

A disadvantage as a Calif LLC is that the Calif taxpayer must pay an additional California fee based on the amount of gross revenues(before cost of goods or expenses) exceeding $250,000. So the LLC must not only pay the $800 per year franchise fee but also a gross revenue tax to Calif, Example is $250,000 to $500,000 of revenues is a $900 revenue fee. $500,000 to $1 million is a $2,500 fee, $1 million up to $5 million is a $6,000 fee and $5 million and more is $11,790.

If the S corp will receive more than 25% of its income from passive investments (rent payments) , the IRS could terminate the "S" status if it's passive income is more than 25% of the S Corp's total income for more than 3 years in row. Doesn't seem like a S Corp would work for real estate investments with rents if taxpayer is showing a loss.

There are some that say for Real Estate Investors maybe a taxpayer should set up two entities. An S Corp for the "flip transactions" buying, fixing and selling real estate in a relative short period of time, and an LLC for long term real estate investments, such as investment property that the tax payer will hold for longer term and producing rents.

On real estate losses (income) I think with a S Corp you can only deduct losses up to the amount of your investment, but with an LLC you can deduct all of the losses even if they are in excess of the taxpayer's investment.

It appears on the LLC while most other activities are subject to SE tax, the real estate investor would not be.

Seems like in Calif we continually come back to this Gross Receipts Tax and trying to figure out if the taxpayer will pay more or less tax overall with an LLC or an S Corp.

I have found several links to some good information. If you would like them email me and I will forward.

Sandy

[jmc]

Thank you for your response.
For passive income tax rules for 25% passive investment, it applies to an S corp. with previous C corp. E & P.

Still, I would like to research more on this topic. So, please forward me the links to good information as you stated. Thanks.

[KBM]

Just scanned thru LLC books in bookstore. Couple books compared California S vs LLC with respect to Rev, Profit, Taxes:

For low revenue, high profit entity : incorporate as LLC
e.g. $250K rev, 100% profit of $250K, = 0.3% tax rate

For high revenue, low profit entity: incorporate as S
e.g. $50M rev, $250K profit = 1.5% tax rate ( I seem to recall from book )

At different revenue/profit RATIOs the LLC tax rate will exceed the S tax rate. The revenue/profit ratio of a company may be quite dynamic over the life time of the company. The selection of S vs LLC will not only affect the current year's tax rate but the overall tax rate for a period of years 5, 10, company lifetime. If the lifetime of a company can be accurately estimated, then the revenue/profit ratio for the lifetime period should be used to determine the proper entity: S or LLC. Also, LLC lifetime is limited but S is not ( I recall).

Borders.com/Amazon.com link:

http://www.amazon.com/exec/obidos/tg/browse/-/577394/102-6582434-5102556

( one question : LLC's can use cash basis, accrual or hybrid accounting method ? )

KBM

[jmc]

LLC's Accounting Basis

To your question, LLC's Accounting Basis follows the same rule as Partnership. That is, cash and other alternative methods are generally available unlesss inventory is involved.

I tried to connect to the link at Amazon.com you provided, but it directs me to a different kind of book. Could you provide me the exact name of book?