Back in the days when the C corporation (“C corp”) was really the only entity in town, many individuals formed closely-held C corps to hold their real estate or business assets. Now, many years later, the C corp’s assets have often substantially appreciated in value. In more recent years, individuals may have formed closely-held C corps to hold appreciated assets as a result of faulty advice or for other reasons.
In any event, if the C corp sells its appreciated assets or continues to operate without taking further action, the corporate-level income or gain (after all applicable deductions, including a deduction for salary paid to the Shareholder) would be taxed at the C corp income tax rate (up to 35% in 2009). In addition, the Shareholder would be taxed on any salary paid by the C corp at ordinary income tax rates (up to 35% in 2009 and the salary would also be subject to employment taxes) and on any ordinary distributions at the dividend tax rate (generally 15% in 2009).
The C corp’s built-in gain and double-tax issues could also worsen with time if no action is taken because real estate and business assets often continue to appreciate in value. For depreciable assets, the built-in gain could also increase over time by the depreciation that is taken, which further reduces the basis of the assets. Furthermore, the tax rate for dividends (and salary) may also increase in subsequent years as Congress or the President look for additional revenue sources and tax increases for higher income individuals.
Therefore, in the spirit of celebrating our Declaration of Independence in July, this article will set forth five common options for a Shareholder of a closely-held C corp to consider to help liberate its C corp from the chains of double taxation. For simplicity of discussion, the options herein assume that the C corp is owned by one Shareholder (without charitable intentions), has accumulated earnings and profits, and owns appreciated assets. This article also only addresses federal income taxes.
If any of these options are of interest to you or your clients, please contact a member of the McGrath North Tax Group and we can discuss the best option for your particular circumstances.
Option 1: Distribute Accumulated C Corp Earnings And Profits To Shareholder, Convert To S Corporation (Need Not Be An Active Business), Wait 10 Years Before Selling Appreciated Assets
The C corp could distribute its accumulated earnings and profits to its Shareholder and the Shareholder would pay income tax on the distribution at its dividend tax rate (i.e., 15% in 2009). After the distribution, the C corp could convert to an S corporation (“S corp”), wait ten years, and then sell its appreciated assets with one level of tax at the Shareholder capital gain or ordinary income tax rate (depending on the holding period for the asset and any applicable depreciation recapture).
With this option, only one level of income tax should apply to the built-in gain at the time of the S election (i.e., the built-in gain attributed to the C corp period), and to the subsequent appreciation in the assets and the S corp’s earnings and profits after the S election. In addition, in such event, the S corp should not be subject to the passive income tax (summarized below) on any passive income (e.g., rents, interest, dividends, royalties, etc.) because such tax only comes into play if there are accumulated C corp earnings and profits at the time of the S election. Furthermore, with the low dividend rates in 2009 and the President’s intention to raise federal tax rates on high income taxpayers, now may be a good time to distribute the C corp’s earnings and profits to the Shareholder.
Option 2: Convert To S Corp, Operate An Active Business, Wait 10 Years Before Selling Appreciated Assets
The C corp could convert to an S corp, operate an active business, wait ten years, and then sell the appreciated assets with one level of tax. With this option, only one level of income tax should apply to the built-in gain at the time of the S election, and with respect to the subsequent appreciation in the assets after the S election. However, if the C corp does not want to distribute its earnings and profits before making the S election, the S corp would need to operate an active business in order to avoid the passive income tax (if applicable). The passive income tax applies to a C corp that converts to an S corp if the corporation has accumulated C corp earnings and profits at the time of the S election and has excess net passive income. In addition, the corporation’s S status may be revoked if the corporation has passive income in excess of twenty five percent (25%) of its gross receipts (the “excess net passive income”) for three consecutive tax years after electing S status, if it had accumulated C corp earnings and profits at the end of those three years. The tax on excess net passive income is currently thirty-five percent (35%).
In any event, to the extent the C corp accumulated earnings and profits are distributed to the Shareholder after the S election, the Shareholder would pay income tax on such dividends (i.e., these dividends would not escape double taxation). As mentioned above, it may be prudent to make distributions in 2009 and 2010 while the dividend tax rates are favorable. With respect to the S corp’s earnings and profits after the S election, only one level of income tax should apply.
Real estate rental activity may be considered an active business if the S corp provides significant services (i.e., in excess of a lessor’s normal services and control in a standard lessor/lessee arrangement) or incurs substantial costs with respect to the S corp’s rental real estate activities. Generally, significant services are not rendered and substantial costs are not incurred in connection with “triple net” leases, but the test is a “facts and circumstances test”.
Option 3: Distribute Accumulated C Corp Earnings And Profits, Convert To S Corp (Need Not Be An Active Business), Liquidate S Corp At Death Of Shareholder
The C corp could distribute its accumulated earnings and profits to its Shareholder and the Shareholder would pay income tax on the distribution at the dividend tax rate at such time (i.e., 15% in 2009). The C corp could then convert to an S corp and conduct its business as normal. The S corp would not need to operate an active business. Upon the Shareholder’s death (presuming it is after the 10 year period), the S corp could liquidate and distribute the appreciated assets to the Shareholder’s estate, trust or heirs (any to be referred to as “successor” herein).
Upon the Shareholder’s death, the Shareholder’s stock would receive a step-up in its tax basis to fair market value. If the S corp then distributes its appreciated assets to the Shareholder’s successor, the gain on the distribution (a deemed sale), which is equal to the difference between the S corp’s tax basis in the appreciated assets and the fair market value of the assets because the S corp’s assets do not take a step up in basis at the Shareholder’s death, would be taxable to the Shareholder’s successor and would also increase the successor’s basis in its stock further (to the extent of the gain). If the S corp then liquidates in the same year as the distribution (deemed sale), the successor’s capital loss on the stock (arising from its unrecovered stock basis on the liquidation of its investment remaining after all of the distributions) is available to offset any capital gain arising from the distribution (deemed sale) of assets, but not any ordinary income resulting from the sale/distribution of the S corp’s assets. However, the deemed distribution (sale) and liquidation must occur in the same tax year to achieve the offset of capital gain and capital loss.
Once the property is in the hands of the Shareholder’s successor, the successor may depreciate any depreciable assets at the higher tax basis. If the successor would decide to immediately sell the assets to a third party buyer, the successor may incur little or no gain on the sale due to the step-up in basis of the assets.
Option 4: Stock Sale If Willing Buyer
If a buyer is interested in buying the C corp stock from the Shareholder, with either a C corp or an S corp, there is just one level of tax to the Shareholder on the stock sale. The Shareholder could offer the stock at a discounted price to help attract a buyer if the Shareholder could net more with that strategy versus paying the double-tax resulting from a sale of the appreciated assets and distribution of the proceeds (or liquidation during the Shareholder’s life).
If the C corp stock is held until the Shareholder’s death and the Shareholder’s successor finds an immediate buyer for the stock, there should be little or no capital gain upon a sale of the successor’s stock because the stock would take a step-up in basis to fair market value on the Shareholder’s death, which may be approximately equal to the subsequent sales price. However, most buyers prefer to buy assets instead of corporate stock to obtain the benefits of the step-up in basis of the purchased assets for depreciation and sale purposes, which is why Option 3 may work better as a solution on the Shareholder’s death.
Option 5: Relatively New C Corp
Although this is not the typical situation, if the C corp is a relatively new C corp with minimal earnings, profits and built-in gain, but holds rental real estate or assets that tend to appreciate substantially with time, it may make sense to convert the C corp to a limited liability company as soon as possible and pay any applicable taxes, which may be minimal at such time. The LLC is often the best entity for holding appreciated assets (like real estate) because, unlike with the C corp and the S corp, the LLC’s assets may often be liquidated or distributed to its owner without triggering income tax, and the LLC’s assets may receive a step-up in basis at death (along with the step-up in basis for the owner’s LLC interests) if a certain election is made, which is not available through the C corp or the S corp.
No single option works best in every situation to improve the tax consequences to a C corp and its Shareholder. In some cases, the best option may be to remain a C corp. Please contact a member of the McGrath North Tax Group and we will help you decide the best course of action for your C corp.
- If the C corp does not have an active business, the C corp may want to distribute its earnings and profits to its Shareholder to take advantage of the 15% dividend tax rate in 2009 and 2010, then elect S status and sell its appreciated assets after ten years. If the Shareholder dies after the ten year period, the S corp may often be liquidated in a favorable manner and the assets could then be sold to a third party buyer without double taxation.
- If the C corp has an active business, the C corp may want to elect S status, sell its appreciated assets after ten years and make dividends over time to its Shareholder; however, with the 15% dividend tax rate in 2009 and 2010, now may be a good time to pay dividends out of the corporation.
- If the C corp has a buyer that is interested in purchasing its stock during the Shareholder’s life or at death, a stock sale is often a great idea.
- If the C corp is relatively new and holds assets likely to substantially appreciate with time, the C corp should consider converting to an LLC and paying any applicable taxes, which may be minimal at such time.