Business owners often use C corporations as a means of limiting personal liability. Typically, the owners attempt to shield their personal assets from business related liabilities. While this can be a useful protection in some circumstances, like preventing a business creditor from placing liens on personal assets, it is often the case that the owner is protecting himself from an unlikely lawsuit while simultaneously subjecting himself to a guaranteed tax.
This is due in part to the fact that most lawsuits against corporations target the business’s insurance, rather than the owner individually. There is another way to organize your business and its assets that will offer greater legal protection, flexibility, and reduce tax liability.
For many C corporations, the most valuable asset is the real estate that is used to conduct business. One of the biggest mistakes an owner can make is to place the property in the C corp. There are two reasons why this is a mistake: 1) you have made the C corp a more attractive target for a potential lawsuits or creditor liens (there is a valuable assets that can be taken) and 2) any appreciation on the property will be subject to double taxation upon disposition of the property or liquidation of the business. To avoid this situation, many tax planners recommend that business owners have 2 entities, a C corp for your business and a partnership or LLC to own the real estate.
The increased protection of your assets is pretty straight-forward in this situation. Because you do not own the property, it will never be at risk in the event of a lawsuit or creditor action against the C corp. The corporation is merely a tenet paying rent and has no claim to the property. Since the partnership or LLC is controlled by the same owner that controls the C corp, there is virtually zero risk that the partnership/LLC would be sued by the tenet (the owner would not sue himself).
The tax benefits of placing the real estate in a partnership instead of the C corp can be realized anytime the real estate appreciates in value. Let’s use an example to illustrate. Mr. Jones decides to start a business and purchases a building for $100,000. Mr. Jones then forms ABC Inc. and transfers the property to the C corp, which takes the land with a $100,000 carry over basis. Over the next 5 years, the land appreciates to a FMV of $200,000. At this point, ABC Inc. decides to sell the real estate to capture some of the appreciation. If the land is sold for the FMV of $200,000, ABC Inc. will recognize $100,000 of gain. This gain is subject to corporate income tax of 35% (C corps do not get the more favorable capital gains rates). After completing the transaction, ABC Inc. will receive $165,000.00 net of corporate tax. The second tax bite occurs with the distribution of the proceeds to Mr. Jones. Of the $65,000 of gain remaining, Mr. Jones will owe a personal income tax of 23.8%, or $15,470.00. The after tax proceeds to Mr. Jones on a $200,000 transaction with a $100,000 gain is $149,530, meaning over 50% of the gain was lost to taxes. It should be noted that due to Section 311 (b), whether the property is sold by the corporation, given as a current distribution, or sold as part of a corporate liquidation, the transaction is treated as if the corporation sold the property for cash and distributed the cash as a dividend.
Now let us take the above example and modify it. In this scenario, Mr. Jones places the property in a partnership instead of transferring it to the C corporation. After 5 years, when Mr. Jones decides to sale the property, he will not have to recognize the property’s appreciation as income at the corporate level. When transferring the property from the partnership to back to himself, Mr. Jones simply takes as basis in the property the lesser of the partnership basis in the building or Mr. Jones’s basis in the partnership. Gain would then be recognized upon the subsequent sale of the property, but subject to the more favorable personal capital gains rates of 15%, 20% or 23.8% and without the secondary tax on the dividend. If we use the same figures from the prior example, Mr. Jones’s after tax proceeds from the sale of his property would be $176,200, a net increase of $26,670, which is at the top marginal capital gains rate.
If you are looking for ways to limit your liability, call 214-696-1922 and ask for Mark Patten.
McKinnon Patten is Dallas CPA that provides a full range of services to high net worth individuals. Our client base includes many corporate executives, as well as entrepreneurs and owners of closely held businesses.