If you have clients who own real estate in a C-corporation, you probably already know some of the difficulties that stand in the way of clients getting their hands on “their” money (i.e. the assets inside the C-corporation).

Consider a case we’re currently working on. (The names are changed to protect client and advisor confidentiality.) The advisor has been handling the investment of the client’s non-corporate assets for over ten years.

The client’s primary business is real estate brokerage. In connection with that business, the client’s company, a C-corporation, has acquired a significant portfolio of property. That property has appreciated a great deal. The company’s total basis is about $5 million, and the estimated market value of the property is $40 million.

The client doesn’t want to keep working, neither in the business nor managing the real estate. However, the gain from the appreciated property is trapped inside the C-corporation.

Bad “Solutions”

C-corporations involve double-taxation. The corporation is taxed, and the individual shareholder receiving dividends from the corporation is taxed. There is no simple, straightforward way to get the real estate out of the corporation without generating double tax.

Alternatives that create double tax include having the corporation sell and then pay out a dividend, or directly deeding the real estate out as a dividend. The latter transaction is treated for tax purposes as a “deemed sale” and will generate both corporate level tax and a dividend income (taxable) to the shareholder.

A Better Solution

If the shareholder has time (and control), a better solution than either of the above alternatives may be to convert the C-corporation to an S-corporation.

The actual mechanics of making the conversion are relatively simple. However, there are several important rules and limitations that must be considered. Consider a case in which a corporation owns appreciated real estate. Some of the most important rules are:

1. There is a five year window after the conversion during which the corporation will still be taxed as a C-corporation on the “built-in gains.”
2. If the corporation has “earnings and profits” from the time it was a C-corporation, the new S-corporation may be subject to tax on its net passive income if gross passive income exceeds 25% of gross income.
3. If an S-corporation has “earnings and profits”, and excess passive income (see (2) above), for three years in a row, that can defeat the conversion to an S-corporation, causing the corporation to revert to C-corporation status.

There are solutions to the above issues, and those solutions may be as simple as paying out certain amounts or items to shareholders as dividends.  The preferred course of action will depend on the exact amounts and involved and the desires or preferences of the shareholders.

A successful conversion from C-corporation to S-corporation, after 5 years, will allow the corporation to sell the real estate without tax at the corporate level. However, the sale will still result in tax at the shareholder level, because S-corporations are pass-through entities.

In addition, it is necessary to wait five years, during which the real estate must be managed, and the market may change.

The Best Solution?

There may be a better way to avoid the double tax. That way is to combine the conversion from C-corporation to S-Corporation with the use of a tax-exempt Real Estate Shelter Trust inside the corporation.

If the corporation contributes less than “all or substantially all” of its assets to the Real Estate Shelter Trust, the trust can sell the real estate tax-free. The trust, properly structured, will then not distribute any income to the S-Corporation during the 5 year period.

After the 5 years have run, the “built-in gains” issue goes away, and there will no longer be double tax.

To Learn More

Cases involving assets owned inside closely held corporations often present significant complexities. The solutions will typically involve more than one facet. To learn more about tax-exempt Real Estate Shelter Trusts, request an advisor guide here, email [email protected], or call 703 437 9720 and ask for Connor or Katherine