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Way back near the end of May, which feels like a very long time ago, we published a couple of pages of overview on how to classify ownership interests in activities as passive vs. non-passive.  Somewhere in that article I promised to mention how real estate interests can qualify as non-passive activities.

This determination is key in the proper treatment of income and losses both for the purposes of the limitations under the passive activity loss rules and also for the inclusion in the calculation of the new Net Investment Income tax.

For an activity to be considered non-passive, the owner must materially participate in that activity and generally meet one of seven tests enumerated in Reg. Section 1.469-5T, explained previously.  Despite those requirements, rental activities are per se passive, that is, automatically treated as passive regardless of the level of the owner’s participation.  There are a couple of exceptions to that default which we mentioned in the earlier article for self-rental activities, holding a working interest in an oil and gas property, and where a grouping election would be allowed with a non-rental activity in only specific circumstances. However, the most frequently used (and risky) exception to the default treatment of real estate income or loss as passive is when an election is made for a real estate professionals.

Special rules are provided under IRC §469(c)(7) for rental activities commonly referred to as the real estate professional rules.  If the test is met, the rental activity of a real estate professional is treated as non-passive.  Treatment as non-passive is advantageous when a real estate rental activity is generating losses that can be used to offset other income such as interest, dividends and wages.  Conversely, the passive losses would not reduce other passive real estate income for purposes of the net investment income tax.  Planning to make this election should be well thought out in that it may not always be desirable to treat net rental real estate income or loss as non-passive and the election itself may invite increased IRS scrutiny.

Am I a real estate professional?

The real estate professional must satisfy two tests:

  • more than one half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
  • such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

At first glance, the test seems relatively easy to satisfy until you realize that for an activity to be counted towards the first and second test, the owner must materially participate in each activity to treat the income or losses as non-passive.  If there are interests in several real estate activities, this may be difficult to satisfy.  To help satisfy the material participation for each activity, a special grouping election can be made under Reg. Section 1.469-9 to treat all interests in rental estate as one activity. Once made, the election is binding for all future years the taxpayer is a qualifying real estate professional and is revocable only if there is a material change in facts and circumstances.  In case you missed the election, one can be filed with an amended return under Rev. Proc. 2011-34.

The rental estate activity is owned by a trust.  Can the trust be a real estate professional?

The Code nor the regulations address how material participation rules can be satisfied for taxpayers who are trust, estate or personal service corporations.  Under IRC §469(c)(7)(B) the requisite amount of service hours must be performed in real property trades or businesses, the performance of which the IRS has previously stated must be by a taxpayer who is a natural person and has the capability for physically performing such services.  In looking to case law for guidance, the U.S, Tax court in a recent decision, held that a trust taxpayer could meet the material participation standards through the performance of its trustees and thus qualify for the real estate professional exception under §469(c)(7). [Frank Aragona Trust, (2014) 142 TC No. 9.] In the case, the taxpayer was a trust that owned rental real estate properties and engaged in other real-estate activities.  The court ultimately rejected the IRS’ argument that a trust is incapable of performing personal services.  Rather, the Tax Court held that the trust is an arrangement whereby trustees have a fiduciary responsibility to manage assets for the benefit of the trust’s beneficiaries and therefore worked performed by an individual as part of their trustee duties are personal services for purposes of satisfying the section 469(c)(7) exception.

The trust was formed by a grantor who, after his death, was succeeded as trustee by his five children and one independent trustee.  All six trustees acted as a management board for the trust and made all major decisions regarding the trust’s property. In addition, a disregarded LLC, wholly owned by the trust, managed the trust’s rental real-estate properties.  The LLC employed several people, some of whom were the trustees.  The court ruled that not only were the activities performed by the individuals in their duties as trustee included as personal services performed in a real-estate trade or business, but also their time spent as employees of the LLC managing the rental real estate properties.

Because the requisite hours in real-property trades were met and the trust materially participated in the real property businesses, the trust met the exception to the per se passive treatment of rental real estate activities and was able to treat the income and losses from the activities as non-passive.

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The Philadelphia 76ers will construct an $82 million dollar state-of-the-art practice facility and team headquarters in Camden, NJ, aimed to be completed by 2016.  Pursuant to New Jersey’s New Jobs Investment Tax Credit,” the State has awarded tax credits to the 76ers over a 10-year period (not to exceed $82 million,) which should allow the team to recoup the FULL cost of building the complex.

The deal guarantees an $8.2 million tax credit annually that the Sixers can use or sell, so long as the team (1) employs 250 people in Camden, and (2) stays in the city for 15 years.  If the team employee total at the facility drops below 250 in any year, the tax credits would be reduced to $5 million per year.

This specific New Jersey tax credit entitles corporate entities to a credit against the portion of their corporation business tax liability that is attributable to certain qualified investments in buildings, building components, equipment and capitalized start-up costs, in any new or expanded business facility in New Jersey, which results in the creation of a specified number of new jobs in the state.

The credit is determined by multiplying the amount of a corporation’s “qualified investment” by its “new jobs factor.” “Qualified investment” is determined based on the expected depreciation life of the property for federal income tax purposes, as depicted below:

  • property with a 3-year life—35% of cost;
  • property with a 5-year life—70% of cost; and
  • property with a life of seven or more years—100% of cost.

The “new jobs factor” is based on the number of jobs created in New Jersey which are directly attributable to the entity’s investment in the new or expanded business facility.

While the Sixers are required to provide 250 jobs to maintain the tax breaks, 200 of these positions are already filled by team administrators, players, and staff. Thus, only 50 new jobs will actually be created.

The 76ers are the only NBA franchise without its own practice facility, and the team has been using the Philadelphia College of Osteopathic Medicine for such purposes since 1999. The team will continue to play its home games at the Wells Fargo Center in Philadelphia.

The team’s individual players currently pay Philadelphia wage taxes on days they have home games, and pay other city wage taxes when the team is on the road. The players will eventually have to pay a New Jersey wage tax for the time they spend practicing in New Jersey.

Authored by CJ Stroh

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One of the most common questions I get from clients relates to the structure of their potential real estate deals.  While almost everyone has heard the age old adage “Never put real estate in a C corporation,” many people seem to see LLCs and S corporations as equally acceptable pass-through alternatives for holding real estate.   In reality, this couldn’t be farther from the truth.  The following will outline five reasons why an LLC is preferable to an S corporation for holding real estate in the current environment.

  1. Number of shareholders – An S corporation is limited to only 100 shareholders.  Under Sec. 1361, members of a family (as defined within the Code) are considered one shareholder for purposes of this 100 shareholder test.   Conversely, there is no limit on the number of allowable members of an LLC.  While this wouldn’t seem like a major limitation for a majority of property owners, if a taxpayer were interested in syndicating interests in the pass through entity in an effort to raise capital this 100 shareholder cap could significantly limit their ability to do so.
  2. Type of shareholders – In addition to limiting the number of shareholders to 100, the Internal Revenue Code also limits the types of entities that can be shareholders of an S corporation.  For starters, nonresident aliens are not permitted to own stock in an S corporation and certain types of trusts are excluded as shareholders as well.  Neither C corporations nor partnerships and other entities taxed as partnerships under the default entity classification rules (multi-member LLCs) may not own shares in an S corporation.  With an LLC, any type of entity, domestic or foreign, is a permitted member.
  3. Only one class of stock – Many investors demand priority returns on their invested capital, as well as a priority return of their invested capital. In an S corporation, it is not possible to offer these benefits to investors.  S corporations are only permitted to issue one class of stock. While the rules will permit an S corporation to issue voting and nonvoting stock, it is not possible to provide distribution or liquidation preference to certain shareholders at the expense of others.  In an LLC, the allocations of cash are much more flexible and allow for these priority returns so long as the allocations meet the overall requirement of substantial economic effect.
  4. Basis concerns – Many real estate investments offer losses in early years as a result of the benefits of accelerated depreciation deductions.  These noncash deductions shield cash flow from taxation during the early years of the investment and generate losses that are allocable to the shareholders or members.  The investors are only permitted to deduct those losses to the extent that they have basis in the pass through entity.  I will avoid for now a long detour into the rules of both partnership and S corporation basis, but there is one major difference that is worth highlighting. Shareholders in an S corporation are only deemed to have basis in the pass through entity to the extent of any money invested into the entity and any loans made directly from the shareholder to the pass through entity. In an LLC, members are deemed to have basis for both their contributions into the entity and their ratable share of all liabilities of the entity. This allows members in an LLC to deduct losses in excess of their individual investment to the extent that they are allocable a portion of the liabilities of the entity.
  5. Basis adjustments – The last way in which the two past through types differ is in the allowable adjustment to basis under IRC Sec. 754.  This section of the Internal Revenue Code allows a partnership to adjust the basis of partnership property when there are taxable sales or exchanges of interests or redemptions of a partnership interest.  There is no similar adjustment available to shareholders of an S corporation.  This adjustment helps to keep a members’ outside basis in his or her partnership interest in line with the partnerships’ basis in the underlying partnership property. Since this opportunity does not exist for an S corporation, an S corporation shareholder can end up with a substantial variance in his or her basis in the S corporation stock, which could generate undesirable income tax consequences.

These five issues should be considered heavily when making a choice of entity.  In most cases, one or more of these factors will make the choice of entity obvious. In more cases than not, an LLC will be preferred entity type for real estate investment. With an LLC, there is no cap on the number of shareholder and no limitation on the types of shareholders.  In addition, a referred return on capital and a priority return of capital can be provided to investors without the fear of running afoul of the IRC rules.  If none of the other issues outlined makes the decision, the optional basis adjustment under Sec. 754 alone can be substantial enough to point to an LLC as the preferred entity type.  The Sec. 754 adjustment can provide significant tax advantages to an investor and should be given a good amount of weight in the choice of entity decision.

Authored by Brian Lovett

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As I recover from the latest busy season, I took time to reflect on what was the most common question I was asked.  Not surprisingly, it dealt with the material participation standards under Section 469 and the interplay with the net investment income tax under Section 1411

Although material participation rules are hardly new, they were given added importance with the introduction of the new net investment tax this filing season.  This new tax forced many of us to reexamine with our clients, their participation throughout the year in business entities in which they own an interest.  To complete the new Form 8960 we needed to go through the exercise of putting various ownership interests into separate buckets of nonpassive activities and passive activities, that is, activities in which the taxpayer materially participates or does not materially participate. This lead to further discussion on issues that we have always had to deal with such as passive loss limitations, grouping elections, self-rental rules and the real estate professional exception. Various common questions arose and are discussed in general below:

Is this activity passive or nonpassive?  Usually this question arose in the context of whether or not the activity was subject to the new net investment tax.  But, the answer tends to be more important for the reason for which the rule was first enacted: to limit the allowance of passive losses to the amount of passive income for the year.  A passive activity is defined in IRC 469(c) as the conduct of a trade or business in which the taxpayer does not materially participate.  A nonpassive activity is one that is not passive, and, therefore, one in which the taxpayer materially participates.  So, meeting the requirements for material participation is key to this determination.  Material participation is briefly defined in IRC Section 469(h) as involvement in the operations of an activity on a basis which is regular, continuous and substantial.  The Temporary Regulations under Reg. 1.469-5T enumerate seven tests, any one of which can be met to satisfy material participation in an activity:

1) The individual participates in the activity for more than 500 hours during such year.

(2)The individual’s participation in the activity for the taxable year constitutes substantially all of the participation in such activity of all individuals (including individuals who are not owners of interests in the activity) for such year;

(3)The individual participates in the activity for more than 100 hours during the taxable year, and such individual’s participation in the activity for the taxable year is not less than the participation in the activity of any other individual (including individuals who are not owners of interests in the activity) for such year;

(4)The activity is a significant participation activity (within the meaning of paragraph (c) of this section) for the taxable year, and the individual’s aggregate participation in all significant participation activities during such year exceeds 500 hours;

(5)The individual materially participated in the activity (determined without regard to this paragraph (a)(5)) for any five taxable years (whether or not consecutive) during the ten taxable years that immediately precede the taxable year;

(6)The activity is a personal service activity (within the meaning of paragraph (d) of this section), and the individual materially participated in the activity for any three taxable years (whether or not consecutive) preceding the taxable year; or

(7)Based on all of the facts and circumstances (taking into account the rules in paragraph (b) of this section), the individual participates in the activity on a regular, continuous, and substantial basis during such year.

Stay tuned for more in part 2 next week…

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Withum Smith + Brown’s (“WS+B”) client base is very diverse.  During my 10+ year career I have worked with clients from multi-national consolidated groups to start-up entities. No matter how big or small the company, I often am asked: “Is my current entity choice optimal from a tax perspective?”

To help our clients better understand their choices, WS+B created a chart that highlights the differences amongst the three most common entities (C-Corporation, S-Corporation and LLC).

Aside from the tax considerations, when choosing an entity, thought should be given to the current goals, long term goals and legal issues of the company.

(Click to enlarge)

Capture

Authored by Steve Talkowsky

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When the calendar turns to mid-March and tax season makes the leap from annoying to soul-crushing, I spend more time than I should daydreaming about goin’ all Walter White and breaking bad, only instead of cooking meth, I’d use my well-honed number-crunching skills to become an underground bookie.

Oh, what a life it would be. Instead of spending March Madness in a tiny office cranking out tax returns, I’d spend it in a giant war room complete with wall-to-wall flat screens, building my riches on the failed dreams of student athletes. I’d work the phone better than Gordon Gecko, avoiding detection by using subversive colloquialisms like “unit” and “juice.” I’d threaten to break thumbs with impunity. And I’d make money. Lots and lots of money. Because the house never loses.

The house doesn’t lose because it is (generally) indifferent to who the bettors favor. Not to get into Gambling 101, but if you bet $100 on the Seahawks + 2 ½ in the Super Bowl, you won $100, But if you bet $100 on the Broncos to cover the 2 ½ points (sucker), you lost $110. The $10 the loser pays over and above the wagered amount is the “vig.”

Thanks to the vig, bookies generally don’t care who people are betting on, as long as the bets are fairly even on both sides. And of course, bookies have the advantage of being able to move the line to make sure this happens.

When it comes to horse racing — which in my bookie fantasy world, I will  occasionally dabble in but not invest heavily – the house has an added level of protection in the form of “parimutuel wagering.” It works like so:

The entire amount wagered on a particular race is referred to as the betting pool or “handle.” The pool can then be managed to ensure that the track receives a share of the betting pool regardless of the winning horse. This share of the betting pool that the track keeps for itself is often referred to as the “takeout,” and the percentage is driven by state law, but generally ranges from 15% to 25%.

The takeout is then used to defray the track’s expenses, including purse money for the winning horses, taxes, licenses, and fees. The takeout can also be used, if needed, to cover any shortfall in the amount necessary to pay off winning bettors. To the extent any excess takeout remains after covering these two classes of obligations, the track has profit.

Once the betting pool has been reduced by the takeout, the balance is generally used to pay off any winning wagers, with the excess, once again, representing profits. Great business model, isn’t it?

Yesterday, an enterprising CPA with a raging gambling habit threatened to strike a blow for bettors everywhere when he took on the IRS in the Tax Court and argued that the portion of his wagers attributable to the “takeout” were deductible without limitation. But before we can understand the significance of the case, we need to understand some basics about the taxation of gambling.

Treatment of Gambling Expenses, In General

Section 165(d) provides that “losses from wagering transactions shall be allowed only to the extent of the gains from such transactions.” Generally, any winnings are reported on page 1 of the Form 1040, while the losses (but only to the extent of winnings) must be claimed as itemized deductions. Thus, if a bettor is one of the 66% of Americans who don’t itemize their deductions, they would effectively be whipsawed – they would be forced to recognize the gambling income, but would receive no benefit from the losses.

Section 162, however, generally allows a deduction for “all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.”

Putting these two provisions together, many bettors have taken the position that if their gambling activities are so frequent, continuous and substantial as to rise to the level of an unhealthy addiction a Section 162 trade or business, then gambling losses are deductible as Section 162 business expenses, and are not subject to the loss limitations imposed by Section 165(d). In their view, if the gambling activity constitutes a business, because the losses (along with the gains) should be reported on Schedule C, rather than itemized deductions, the losses should be permitted in full.

The courts have repeatedly shot this theory down, holding that even a professional gambler who properly reports his activity on Schedule C may only deduct losses to the extent of gains.

In a very important 2011 decision out of the Tax Court, however, the court held that while gambling losses are limited to the extent of gambling winnings, any non-loss expenses of a professional gambler engaged in a trade or business – items like automobile expenses, travel, subscriptions and handicapping data – are not subject to the Section 165(d) limitation. Thus, a professional gambler could reduce his winnings to zero by his losses, and then further deduct any non-loss business expenses, generating a net loss from the activity. (See Mayo v. Commissioner, 136 T.C. 81 (2011).)

And that brings us back to our gambling CPA.  In Lakhani v. Commissioner, 142 T.C. 8 (2014), settled yesterday, an accountant/prolific track bettor made the compelling argument that his portion of the track’s “takeout expenses” represented non-loss business expenses rather than gambling losses, and were thus deductible without limitation. The taxpayer posited that by extracting takeout from the taxpayer’s wagers and using those funds to pay the track’s operating expenses, the track was acting in the capacity of a fiduciary. The taxpayer further likened the process to that of an employer who collects payroll taxes from his employees and remits them to the IRS and state agencies. Stated in another manner, the taxpayer argued that he was paying the operating expenses of the track, with the track acting as a conduit by collecting the takeout and using the funds.

Based on this position, the taxpayer argued that he was entitled to non-loss gambling business deductions in excess of $250,000 between 2005 and 2009.

The IRS disagreed with the taxpayer’s argument, countering that because the takeout is paid from the pool remaining from losing bets, “it is inseparable from the wagering transactions,” and thus constitutes wagering losses that are subject to the limits of Section 165(d). Furthermore, the Service argued that the taxpayer could not deduct business expenses for amounts paid from the takeout by the track for taxes, fees, and licenses, etc… because these were expenses owed by the track, not the individual bettor.

The Tax Court sided with the IRS, holding that the taxpayer’s share of the takeout expenses represented wagering losses that could only be deducted to the extent of winnings under Section 165(d). In reaching this conclusion, the court differentiated between an employer remitting payroll taxes on the behalf of an employee and a track using takeout funds to pay its operating expenses.

The employee, the court stated, is ultimately responsible for his share of the payroll taxes on his wages, and it is the remittance of these taxes by the employer that discharges the employee of this obligation. To the contrary, at no point are the expenses of the track imposed on the individual bettor; they are always obligations of the track. The tracks use of the takeout to pay its expenses, the court stated, does not discharge any obligation of the bettor.

As a result, the court concluded that because the track’s expenses were never an obligation or expense of the bettor, the takeout could not qualify as the bettor’s business expense. Instead, the takeout represented an additional gambling loss by the taxpayer, and could only be deducted – when added to his other losses – to the extent of his winnings.

follow along on twitter @nittigrittytax

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Earlier today, House Ways and Means Committee Chairman Dave Camp released his long-awaited and highly anticipated proposal for tax reform. The proposal promised to present the most thorough, sweeping changes to the law since the 1986 Act, and it didn’t disappoint.

Before we begin our analysis of the plan let me start by saying that while I clearly admire Chairman Camp for his tireless push to simplify the industry in which I ply my trade, I’d be remiss if I didn’t point out the irony that in the tax world, even a proposal for “simplification” stretches to nearly 1,000 pages.

Because there’s so much to take in, we’ll be separating our analysis into two parts

Part 1: Proposal for individual tax reform

Part II: Proposal for business tax reform

Let’s get to it with Part 1, Chairman Camp’s proposal for individual tax reform.

Streamlining of Individual Income Tax Rates

Current Law

Effective January 1, 2013, we now have seven income tax rates that are applied against so-called “ordinary income,” (i.e. income from wages, business income, interest, etc…): 10%, 15%, 25%, 28%, 33%, 35%, and a top rate of 39.6%. If you’ve ever wondered how efficient this type of structure is, consider that in 2013, the 35% rate was only applied on single taxpayers with incomes in excess of $398,351 but less than $400,000. Yes, we had a tax bracket that was $1,649 wide.

Because our tax system is a progressive one, taxpayers don’t pay a flat rate of tax on all earned income; rather, as income increases, so does the tax rate applied to the income. Thus, when someone proclaims that they are in the “39.6% bracket,” that does not mean they paid 39.6% on all of their income; rather, it means they paid 39.6% on their last dollar of income. It also means that they are likely insufferable.

No matter how you slice it, a system with seven brackets – and a high of nearly 40% — is far from ideal.

Camp Solution

Camp’s proposal would consolidate the current seven brackets into three, consisting of 10%, 25%, and 35% rates. Generally, the new 10% rate would replace the old 10% and 15% brackets, meaning it would cover all income earned up to approximately $73,800 if married, $36,900 if single (for simplicy’s sake, from this point on I will refer to married versus single thresholds or limitations like so: $73,800/$36,900).

The new 25% bracket would replace the former 25%, 28%, 33% and 35% brackets, meaning single taxpayers with taxable income between $36,900 and $400,000 would pay a 25% rate on that income, while married taxpayers with taxable income between $73,800 and $450,000 would pay a 25% rate on that income.

If you happen to earn taxable income in excess of $450,000/$400,000, then you will pay a rate of 35% on the excess, as opposed to 39.6% under current law.

Excluded from this top rate of 35% — meaning it would be taxed at a top rate of 25% — would be any income earned from “domestic manufacturing activities,” which is defined as “any lease, rental, license, sale, exchange, or other disposition of tangible personal property that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States, or (2) construction of real property in the United States as part of the active conduct of a construction trade or business.”

Click here to read the rest on Forbes

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While the debate format that has ruined sports entertainment [ESPN: All Yelling, All the Time!]  obsesses over the inane and inherently unanswerable question of, “Has Kevin Durant surpassed LeBron?” the Oklahoma City Thunder forward and aspiring first-time MVP has managed to keep his attention right where it belongs: on his tax returns.

News came out this week that Durant – who has been lighting up the NBA at a 31.5 points-per-game clip this season – is suing his accountant for perpetrating some untoward shenanigans on Durant’s tax returns.

The suit alleges that California-based accountant Joel Lynn Elliot deducted expenses for Durant’s personal travel and personal chef on the five-time All-Star’s tax returns. This, of course, is a big no-no, because Section 262 of the Internal Revenue Code provides that “no deduction shall be allowed for any personal, living or family expenses.” Unless, of course, the personal expenses are specifically allowable for policy reasons, such as the deduction for mortgage interest and real estate taxes.

The IRS soon came calling, and Durant will now have to amend his returns, pay the back taxes, and, very likely, interest and penalties. As a result, he is looking to recover $600,000 from Elliot. Interestingly enough, should Durant recover that amount from his CPA, the settlement payment would itself be taxable, because the tax law was written by a crazy person.

Durant’s first mistake, of course, was hiring a tax preparer  who goes by three names, as people who do so are generally only fit to serve as famous assassins, serial killers, or country music singers. That’s just science.

Follow along on twitter @Nittigrittytax

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Super Bowl parties are the worst, and that’s largely because people are the worst. I’m no literary buff, but I’m pretty sure that cramming a couple dozen yahoos into a living room for three hours so they can scream incoherently at an inanimate object was one of Dante’s levels of hell.

Things are even worse for us tax professionals. When the party winds down late Sunday night, we’re greeted with the reality that we’re mere hours away from starting another hellacious “busy season” work week, this one with a bit of a hangover.

The only thing that makes a Super Bowl party palatable — aside from the nachos – is having a rooting interest in one of the teams. Of course, if you hail from Colorado or Washington, your allegiances are firmly entrenched. But if you call one of the other 48 states homes, who should you root for?

To help the decision making process, I’ve put together this handy comparison that summarizes the salient issues that you, the sports fan-tax geek — need to know before deciding who deserves your love on Sunday night.  Think of the table as one of the Tax Court’s “factor tests,” while the Broncos may win the preponderance of the factors, you may weigh the factors based on your personal ideology and reach a different overall conclusion.

Superbowl-Nitti2(Click to enlarge)

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Sometimes in life, when faced with a given situation, we say things simply as a matter of reflex. For example:

“What an adorable baby!”

“You have a lovely home here.”

“You’re a great gal, I’ll call you sometime. Now can you help me find my pants?”

Things are no different in the tax world. As advisors, we keep an army of axioms always at the ready to be used in response to client queries. Take, for example, the client who contemplates the type of entity that should be used to hold a piece of real estate. For most tax practitioners, this would elicit the following Pavolovian reaction:

“You should NEVER put real estate inside a corporation.”

And while there are very few NEVERS in the tax world, this one is pretty darn accurate. But do you really understand why you should never put real estate into a corporation? It’s because, as the ensuing discussion will reflect, while real estate can go into a corporation tax-free, it can never come out tax free. In today’s Tax Geek Tuesday, let’s peel back the layers of the statute and find out why.

Case study:  A, an individual, owns a building with a basis of $400,000 and a fair market value of $1,000,000. B, another individual, owns business assets worth $1,000,000. A and B would like to form a business that will use both the business assets owned by B and the building owned by A.  The entity will be owned 50/50 by A and B. Should the entity be a C corporation,  S corporation, or partnership?

Transfers to Controlled Corporations, In General

Under the general tax principles of Section 1001, the transfer of appreciated property triggers gain for the difference between the amount realized on the transfer less the adjusted tax basis of the property. Thus, barring a statutory exception, if A were to transfer the building to a corporation in exchange for the corporation’s stock, A would recognize $600,000 of gain ($1,000,000 fair market value less A’s $400,000 tax basis).

Section 351 is one such exception to the general rule of gain recognition, however, as it allows you to contribute appreciated property to a corporation in exchange for the corporation’s stock without recognizing gain provided you “control” the corporation immediately after the transfer.

For these purposes, “control” is defined as 80% of the vote and value of the corporation, with a couple of important distinctions. First, you don’t have to acquire 80% of the corporation; you simply must own 80% immediately after. A taxpayer who already owns say, 85% of a corporation may continue to transfer appreciated property to the corporation, and the gain will be deferred under Section 351.

In addition, Section 351 allows for a group of transferors. If you contribute appreciated property to a corporation in exchange for, say 20% of the corporation’s stock, but simultaneous to the transfer, another two individuals transfer cash or property to the corporation in exchange for an additional 65% of the stock, all three transfers are covered by Section 351 because on a combined basis, the transferor group controls the corporation immediately after the transfer.

Section 357(c)

Problems arise when the property contributed to a corporation is subject to a liability. Under Section 357(c), if you transfer property to a corporation that is subject to a liability and the corporation assumes that liability as part of the transfer, the transfer triggers gain to the extent the liability exceeds the tax basis of the property.

This provision is particularly problematic when the subject property is real estate, where mortgages are the norm. If, for example, A’s property were subject to a $700,000 mortgage, the transfer of the property to a corporation in exchange for corporate stock would generate $300,000 ($700,000 debt relief less $400,000 tax basis) of gain to A, even if the transfer were otherwise tax-free under Section 351.

Basis and Holding Period

When Section 351 applies to a transfer of property to a corporation, the gain is not excluded, it is merely deferred. This is accomplished through two statutory provisions that provide basis rules that ensure that any gain inherent in the building will be recognized if either you dispose of the corporation’s stock or the corporation disposes of the building.

Under Section 358, you must take a basis in the stock received equal to the basis in the property you transferred to the corporation. This is often referred to as a “substituted basis,” because the basis in the property received is determined in reference to the basis in the property relinquished.

In turn, Section 362 provides that the corporation must take a basis in the building equal to your basis in the building. This is often referred to as a “carryover basis,” because the corporation’s basis in the property remains unchanged from that which you held in the property.

Going back to our case study, if A and B simultaneously transfer property to a corporation in exchange for 50% of the corporation’s stock, Section 351 applies to the transfer. Despite the fact that A’s building has a fair market value of $1,000,000 and a tax basis of $400,000, no gain is recognized. 

Under Section 358, A takes a basis of $400,000 in the corporate stock received. Because the total value of the corporation’s assets is $2,000,000, A’s 50% stock ownership is presumably worth $1,000,000. If A sells the stock for its value of $1,000,000, A will recognize $600,000 of gain, the amount that was deferred when A transferred the building to the corporation.

Under Section 362, the corporation takes a basis in the building of $400,000. If the corporation sells the building for its value of $1,000,000, the corporation will recognize the $600,000 of gain deferred on the contribution.

Distributions and Liquidations of C Corporations, In General

The big problem with placing real estate in a corporation does not present itself until it’s time to get the property out, whether as a sale or distribution.

Sale

As mentioned above, if the corporation sells the building, courtesy of the basis mechanics of Section 362, the sale will generate $600,000 of gain. This gain will be taxed at the corporate level at a maximum federal rate of 35%, resulting in $210,000 of corporate-level tax.

The tax inefficiency is only exacerbated if A would like to get his hands on the remaining $790,000 ($1,000,000 less $210,000 tax liability) of purchase price.  If the corporation liquidates and distributes the net cash to A, A would be required by Section 331 to recognize capital gain for the difference between the amount distributed and A’s basis in the stock. A would recognize $390,000 of gain ($790,000 distribution less $400,000 stock basis) upon the liquidation, and assuming the stock were held longer than one year, would pay tax on the liquidation at a maximum rate of 23.8%, resulting in an individual tax bill of $93,000.

Thus, by selling the property in a C corporation and withdrawing the after-tax cash, A will incur a total tax liability in excess of $300,000.

Current Distribution

Alternatively, A may simply have second thoughts about dropping the building into a corporation, and wish to unwind the transaction. If the corporation transfers the building to A in a non-liquidating distribution, Section 311(b) governs the taxability of the transfer. Under this provision, when a corporation distributes appreciated property to a shareholder, the corporation recognizes gain as if it had sold the property for its fair market value. Thus, the distribution would trigger $600,000 of gain to the corporation — just as it did with a sale — which would be taxed at a maximum federal rate of 35%.

And just as seen with a sale, A isn’t through paying tax yet. Under Section 301, A must treat the fair market value of the distributed property as dividend income (to the extent of any corporate E&P, which will include the $600,000 of gain) where it will be taxed at a maximum rate of 23.8%.

Liquidating Distribution

Things are equally painful if the corporation distributes the property to A in a liquidating distribution. Under Section 336, when a corporation transfers appreciated property in a liquidating distribution, the corporation recognizes gain as if the property were sold for its fair market value. Thus, the corporation would once again recognize gain of $600,000, just as it did in the sale and current distribution examples, and once again pay corporate level tax of $210,000.

Under Section 331, A is treated as having received payment for his corporate stock equal to the fair market value of the distributed property ($1,000,000) less the corporate tax liability assumed by A in the liquidation ($210,000). A receives $790,000 of payment in exchange for his stock with a $400,000 basis, resulting in long-term capital gain of $390,000 that is taxed at a maximum of 23.8%. As you may have noticed, these are the exact same tax consequences that would arise if the corporation had simply sold the building for cash and distributed the after-tax proceeds.

Summary

In summary, while A can get his building into the corporation without triggering the $600,000 of appreciation, he cannot get it out of the corporation — by sale or distribution — without incurring a tax liability of approximately $300,000. For this reason, a C corporation is not the ideal entity choice for A and his building.

Application to S Corporations

Section 351 applies equally to C and S corporations. Unfortunately, Sections 311(b) and 336 also apply equally to an S corporation. This means that if the S corporation distributes the property to A in either a non-liquidating or liquidating distribution, the S corporation will be treated as if it sold the property for its fair market value of $1,000,000, triggering $600,000 of corporate level gain.

Of course, S corporations – at least S corporations that are not subject to the built-in-gains tax (future Tax Geek Tuesday idea!) – do not generally pay tax at the corporate level. Instead, the $600,000 of gain will flow through to A who will pay tax on the income at the individual level, and the gain will increase his basis from $400,000 to $1,000,000 under Section 1367(a)(1). As a result, the distribution will not be taxed a second time at the shareholder level. If the distribution were of the non-liquidating variety, A would simply reduce his $1,000,000 stock basis by the $1,000,000 value of the building. If the property were distributed in a liquidating distribution, under Section 331 A would be treated as having received property worth $1,000,000 in exchange for stock with a basis of $1,000,000, resulting in no further gain or loss. .

Even with the favorable single-level taxation afforded S corporations, however, because of Section 331 A cannot take the property out of the corporation without incurring a tax bill of nearly $150,000 ($600,000 flow-through gain * 23.8% rate on LTCG or 25% rate on unrecaptured Section 1250 gain).

Application to Partnerships

So, what is it that makes partnerships such an attractive entity choice for holding real estate? For starters, just like corporations, appreciated property can be contributed to a partnership in exchange for a partnership interest without the recognition of gain. This is accomplished by virtue of Section 721, which works just like Section 351, only without as many restrictive rules.

For example, while Section 351 requires the transferor or a group of transferors to own more than 80% of the corporation immediately after the transfer in order to obtain tax-free treatment, Section 721 carries no such ownership requirement. Instead, an individual can transfer appreciated property to a partnership in exchange for as little as a 1% interest without triggering any gain.

Like Section 351, Section 721 is a deferral provision rather than an exclusion provision. Moreover, there are basis rules in Section 722 and 723 that mirror those previously discussed in Sections 358 and 362. Under these rules, when a partner transfers property to a partnership in exchange for an interest in the partnership, the partner takes a substituted basis in the partnership interest equal to his basis in the property contributed, and the partnership takes a carryover basis in the contributed property equal to the partner’s basis in the property.

Applying Section 721, 722 and 723 to our case study, A recognizes no gain on the transfer of property with a basis of $400,000 and a fair market value of $1,000,000 in exchange for a 50% interest in the partnership. A takes a basis of $400,000 in the partnership interest received, and the partnership takes a $400,000 basis in the real estate.

Liability Relief

It is much less likely that transferring mortgaged property to a partnership will create gain, because there is no parallel to Section 357(c) in subchapter K. Instead, a transferor of mortgaged property to a partnership must apply the principles of Sections 731 and 752 to determine if gain is recognized on the transfer, and as shown below, gain can be avoided in the partnership context where it would be required in subchapter C.

Section 752 provides that a partner increases his basis in the partnership interest for his share of the partnership liabilities. Conversely, if a partner’s share of the partnership’s liability decreases, the reduction is treated as a distribution of cash to the partner. Why do we care?

Because Section 731 provides that a partner will only recognize gain on a distribution if the cash (or liability relief) distributed exceeds the partner’s basis in the partnership interest.

Combiningg these rules with the partner basis rules of Section 722, it becomes much less likely that a partner contributing leveraged property to a partnership will recognize gain.

To illustrate, assume the property A contributes to the partnership has a basis of $400,000, a fair market value of $1,700,000, and is subject to a $700,000 mortgage. If the property were transferred to a corporation, Section 357(c) would apply and A would be required to recognize $300,000 of gain on the transfer for the excess of the liability over the tax basis of the property.

The partnership rules yield a different result. Under Section 722, A takes an initial basis in the partnership interest of $400,000. Then, under Section 752, A increases his basis to reflect his 50% share of the $700,000 liability that now belongs to the partnership, or $350,000, raising A’s basis to $750,000. Finally, because A has been personally relieved of 100% of the liability upon transferring it to the partnership, this debt relief is treated as a distribution of cash to A by Section 752. Under Section 731, A must reduce his outside basis by the deemed distribution of $700,000. As a result, A’s final outside basis is $50,000 ($750,000 – $700,000).

Because the deemed distribution of $700,000 did not exceed A’s basis immediately before the distribution, no gain is recognized by A on the transfer.

Distributions and Liquidations of Partnerships, In General

While appreciated property can go into a corporation free from tax, as shown above, it can’t come out without the corporation being required to recognize gain as if the property were sold for its fair market value. Partnership law, however, provides deferral rules governing both the contribution of property to a partnership as well as the distribution of appreciated property from a partnership.

Sections 731 and 732 combine to provide that when a partnership distributes property to a partner in a current distribution, generally no gain or loss is recognized by either the partnership or the partner. Instead, the partner simply takes a basis in the distributed property equal to the lesser of:

  • The partnership’s basis in the distributed property, or
  • The partner’s outside basis in his partnership interest.

This nonrecognition treatment is extended to liquidating distributions as well. If a partnership transfers property to a partner in liquidation of the partnership, no gain is recognized by either the partnership or the partner; rather, the partner simply takes a basis in the property equal to the partner’s remaining basis in the partnership interest, after reduction for any cash received or debt relief.

And this is why partnerships are the vehicle of choice for holding real estate. Put a building in a C corporation, and it’s not getting out – either by sale or distribution – without triggering two levels of tax. Contribute the property to an S corporation instead, and the property can’t come out without triggering corporate-level gain. But place appreciated real estate into a partnership, and you receive the gift of flexibility; you can always undo your previous decision and distribute the building without recognizing gain at either the partnership or individual level.

Assume A and B transfer their respective properties to a partnership, and the value of the building increases from $1,000,000 to $2,000,000 while the tax basis of the building decreases from $400,000 to $300,000. Assume further that A’s basis in his partnership interest has also decreased from $400,000 to $250,000.

If the partnership distributes the building to A, neither A nor the partnership will recognize any gain on the distribution, despite the fact that the building’s fair market value of $2,000,000 greatly exceeds its tax basis of $300,000. Upon the distribution, A will take a basis in the building equal to the lesser of:

  • The partnership’s basis in the building of $300,000, or
  • A’s basis in his partnership interest of $250,000.

Thus, A reduces his basis in the partnership from $250,000 to zero and takes a $250,000 basis in the building.

If instead, the partnership liquidates and distributes the building to A in liquidation of his 50% interest, neither the partnership nor A will recognize gain. Instead, A will simply take a basis in the distributed building equal to A’s basis in the partnership interest, or $250,000.

Of course, these favorable distribution rules also operate on deferral principles; should A turn around and sell the property, the pre-distribution appreciation inherent in the building will be triggered by virtue or A’s modified carryover basis in the building. This still represents a tremendous advantage over the corporate regime, which forces the hand of the shareholder upon distribution by requiring the corporation to recognize all appreciation at the time of distribution. And that, above all other reasons, is why partnerships have become the entity of choice for holding real estate.

Got an idea for a future Tax Geek Tuesday? Send it along to anitti@withum.com or on twitter @nittigrittytax

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