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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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While the Supreme Court’s decision to uphold Obamacare has left half of the nation readying plans to renounce their citizenship and flee to Canada, the rest of us who stick around have to deal with the aftermath. And while to date, the individual insurance mandate has been the target of much of the ire, my guess is that sooner rather than later the nation’s attention will turn where it likely belongs: on the 3.8% surtax set to be imposed on investment income beginning in 2013.

The surtax will apply only to those with AGI in excess of $250,000 ($200,000 for single taxpayers), but when coupled with the slated increase in the preferential tax rates currently afforded long-term capital gains and qualified dividend income should the Bush tax cuts expire, those taxpayers affected by the increase are staring at a doubling — or in some cases tripling — of the tax rates they currently pay.  

To illustrate, should the Bush tax cuts expire, the tax rate imposed on long-term capital gains is set to rise from 15% to 20%. Tack on the 3.8% surtax for appropriate taxpayers, and you’re looking at a 8.8% rise from 2012 to 2013, an increase that will — and should — have taxpayers considering accelerating the sales of investments and businesses into 2012.

Similarly, courtesy of the Bush tax cuts, taxpayers have enjoyed a 15% tax rate on qualified dividend income for over a decade. Should those cuts expire, all dividends will again be taxed at a top rate of 39.6% plus the 3.8% surtax, meaning the dividend rate will increase from 15% to 43.4% with the turn of the calendar.

Of course, few experts expect the Bush cuts to expire at year-end; rather, a short-term patch is the more likely answer. In that case, the top tax on both long-term capital gains rates and qualified dividends will increase only by the 3.8% surtax — from 15% to 18.8%, while the top rate applied to interest income will increase from 35% to 38.8%.

While the leading question facing questions in light of the increasing tax rates may well be, “Should I sell my business in 2012?” there are other concerns that need to be addressed as well.

For example, assume a client owns many rental properties that, in total, generate significant income. An election treat the taxpayer as a “real estate professional” under I.R.C. § 469(c)(7) has never been necessary, because the taxpayer is not generating losses. In fact, you’ve preferred to treat the client’s interests in the rental activities as passive, because the client has other non-rental passive investments that generate losses and can partially offset the passive rental income.

But starting in 2013, the 3.8% surtax is slated to be applied not only to long-term capital gain, dividend and interest income, but also to rental income. While the Patient Protection Act is largely bereft of guidance on how the surtax will apply to rental income, certain questions are raised:

If I don’t make the election to treat the client as a real estate professional, does all the rental income become subject to the 3.8% tax, or would material participation suffice?

If material participation will suffice, will I need to make the election to aggregate all the activities in order to meet the tests under Section 469?

If I make the election, the rental activities are no longer treated as passive. Thus, the non-rental passive losses the client generates will no longer have passive income available to offset, and will be suspended under I.R.C. § 469. Is trading the 3.8% surtax for the inability to use the passive losses worth it?

I don’t know the answer yet, and in all likelihood, neither does the IRS, since they have not issued formal guidance, likely waiting like the rest of us to see what the Supreme Court decided to do with Obamacare.

Of course, even with the Supreme Court’s blessing, the fate of the surtax is still shrouded in a bit of uncertainty, as there is the matter of the election to come this November. Should Mitt Romney prevail, the first thing on his to-do list would be to repeal the Patient Protection Act, and send the 3.8% surtax with it. Should that happen, it would make the decisions to accelerate investment income into 2012 — whether on the sale of publicly traded stock or closely held business look rather rash and ill-conceived.

In the meantime, however, I’ve scoured the interwebs, and as she always does, Laura Sanders over at the WSJ did a great job dissecting the the looming surtax. I highly recommend you give it a read.

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