HOLDING PROPERTY IN A CORPORATION POTENTIAL ISSUES
Holding property in an entity provides asset protection from creditors, but the type of entity holding the property will have a big tax impact; for example, partnerships have an edge over C or S corporations when it comes to getting the property back out of the entity. Weighing the pros and cons of different entities, whether real estate will be held in the entity should be a major consideration.
Debt Basis Rules
Under Internal Revenue Code Subchapter K (which contains the partnership rules), a partner gets basis for his or her share of all of the partnership’s debts, including those owed to third parties such as banks. But, under the S corporation rules, the shareholder gets basis only for those loans made directly from the shareholder to the corporation. A loan made to an S corporation by a nonshareholder, even if it’s guaranteed by the S corporation shareholder, does not provide debt basis to the shareholder.
This is why it’s generally not a good idea to hold in an S corporation any debt-financed rental real estate (which is most rental real estate).
Also, losses from a C corporation don’t flow to the shareholders. This means that debt incurred by a C corporation has no beneficial effect to the C corporation shareholder the way it does for a partner in a partnership.
Distributions of property from an S corporation can result in a taxable event, whereas this is not the case for partnerships. So when trying to get the property back out of the entity, if it’s held in a partnership or an LLC taxed asba partnership, that transaction is generally tax-free, and the partner takes the property from the partnership with transferred basis.
For partnerships, it’s possible to recognize gain if there’s a cash distribution in
excess of basis, and in other situations, for example:
- Certain payments to retiring partners;
- Disproportionate distributions involving unrealized receivables; and
- Distributions to a partner that contributed built-in gain property.
But if the property is held by an S corporation, a distribution of property is treated as a deemed sale and the gain is taxable to the S corporation, which then flows to the S corporation shareholder on their K-1. The S corporation shareholder will then have a higher basis in the property going forward, but
they’ll have to grapple with a large taxable gain in the year of the distribution.
In the case of a C corporation, if a shareholder receives a distribution of property, then the C corporation is deemed to have sold the property for its fair market value at the date of distribution, and the shareholder also receives
a taxable dividend equal to the fair market value of the property on the date of distribution.
So it’s important for taxpayers to consider these differences before deciding
what type of entity to hold their property in. Please contact us if you have any questions.