Tuesday November 28, 2023
Case of the Week
Exit Strategies for Real Estate Investors, Part 26 Buildings Inside Subchapter S Corporation
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.
Karl Hendricks is age 85, and owns a Subchapter S corporation named KarHend. Ten years ago, KarHend bought two commercial properties. One is valued at $7 million with an adjusted basis of $2 million. The second property is valued at $8 million with an adjusted basis of $2.5 million. Both properties are commercial buildings with a long-term tenant on a fixed payment lease. Karl's CPA has taken straight line depreciation on the properties.
KarHend has received multiple offers for the two commercial buildings, but has not entered into a sale contract. Karl believes it is a good time to sell, but knows there would be a large state and federal tax with his potential gain of $10.5 million.
Question:Is there a way that Karl can sell the two properties and reduce his capital gains tax?
Solution:Karl initially thought he might transfer his KarHend stock into a charitable remainder unitrust (CRT). However, his CPA informed Karl that while a charity is a permissible S corporation shareholder, a split-interest trust like a charitable remainder trust ("CRT") is not. Sec. 1361(e). If a CRT receives S corporation stock from a donor, the S corporation will be disqualified and reclassified as a C corporation. Such reclassification will likely be upsetting to the corporation's shareholders and will cause the corporation's income to be taxed twice (as is the case with all C corporations), once at the corporate level and once at the shareholder level. In addition, a charity might be hesitant to accept S corporation stock because the ownership of the stock may produce unrelated business taxable income.
An asset sale within the S corporation is often a better strategy. This strategy avoids the outcome of the rules that require nonprofits to pay tax on S corporation income or sale proceeds. Rather than having a shareholder transfer S corporation stock to charity or a term of years CRT, the S corporation itself contributes assets to a term of 20 years CRT. Income from the CRT flows to KarHend and through to shareholder Karl for 20 years. KarHend receives a charitable deduction for the gift and this deduction "flows through" to S corporation shareholder Karl.
If an S corporation chooses to contribute assets to a charity or a CRT, it is important that the S corporation contribute less than substantially all of its assets. This is because a corporation that transfers all or substantially all of its assets to a charity or a CRT must recognize gain or loss as if it had sold the assets for their fair market value. Reg. 1.337(d)-4. In this instance, the benefits of transferring appreciated property to charity -- including the bypass of capital gain -- are lost and the contribution is treated as though it were one of cash.
Whether a transfer involves "substantially all" of a corporation's assets is determined based upon the facts and circumstances. However, the IRS has generally held that the substantially all threshold is met if (1) when assets representing at least 90% of the value of the corporation's net assets are transferred or (2) the assets transferred represent at least 70% of the value of gross assets prior to transfer. Sec. 368(a)(1). To avoid the application of the "substantially all" rule, conservative counsel limit asset transfers from S corporations to charity or a CRT to between 50% to 60% of total S corporation asset value.
After discussions with his CPA and attorney, Karl transferred the $8 million KarHend property into a 20-year term CRT with income distributed to KarHend. Because the $8 million building is less than 60% of the total KarHend value, his attorney is confident this will not trigger a Reg. 1.337(d)-4 gain. Karl plans to sell both the CRT property and the $7 million building to a new buyer. The gain on the CRT property is bypassed and tax savings from the CRT deduction will reduce the tax payable on the remaining $5 million gain.
Next week: Part 27. Subchapter S Corporation CRT and Sale.