Including the wrong kinds of assets in a corporation can be an expensive mistake. Things that are worth more over time, like investments, collectibles, and especially real estate, should be kept out of a closely-held corporation. This mistake costs more for C-corporations than for S-corporations, but even S-corps should be cautious about what assets they hold. Business real estate is generally best owned personally, in a single-member LLC, or in an LLC taxed as a partnership.
Real Estate in C-corporations
A family’s biggest asset is usually its home, and a business’s biggest asset is usually its real estate. This might be the corporate offices, a workshop, a garage, or retail space. It may seem normal that a business would own its own building, but that’s often a bad idea. Closely held corporations usually shouldn’t own any kind of real estate. If a small business needs real estate, the shareholder should buy it, not the corporation. Here’s why:
If the corporation is organized as a C-corporation, the profits get taxed twice. Any business profits are taxed at the corporate level, and then taxed again when they’re paid out to the shareholder as a dividend. If a company owns its real estate, it probably bought it because owning was be cheaper than renting. That means that owning the property drives up the amount of income that gets taxed twice.
The opposite happens when the shareholders own the real estate. When the shareholder owns the real estate, the rent expense is a deduction for the corporation and the shareholder’s rental profits are only taxed once. The business can’t pay more than market rent for the space, but paying rent near the high end of the market is a great way to get money out of a c-corp.
Owning land or buildings inside the corporation might be a minor mistake while the business is operating, but it can be a disaster when the owner retires. With a little bit of luck, retirement means usually means selling the business for lots of money. If a buyer can’t afford the property or wants to move the business, the shareholder can be stuck owning an empty building in the corporation or renting it out. This creates an ongoing tax and paperwork burden that would be much easier if the real estate was held personally.
The real pain comes when the shareholder sells the property. C-corps don’t get capital gains rates, so selling the corporate real estate can quickly drive the corporation’s income into the higher tax brackets. How big a of a a problem is that?
It’s a big one. With a top marginal rate of 39% kicking in for corporate incomes between $100,000 and $335,000, and a top Maine corporate tax rate of 8.93%, a C-corp shareholder who sells property inside of the corporations might lose 40% of their gains to taxes before they even get the money out of the company.
Withdrawing the after-tax profit from the corporation will trigger a federal tax on dividends as high as 20%. For Maine residents, the state taxes top out at 7.15%. For a high-income shareholder, the dividends could also be subject to new federal Net Investment Income Tax of 3.8%. Altogether, this means that a corporate shareholder might be left with as little as 42% of his or her gains. This is all just because the shareholder made the wrong decision about how to buy the property corporation decades earlier. These estimates simplify a few things, but are ballpark accurate.
If that same shareholder had held the building in his or her own name and leased it to the corporation, the profits from selling the building would only be subject to capital gains tax, ordinary income tax on depreciation recaptured, and state income tax. 2013 regulations clarify that gains from selling real estate that is rented to a shareholder’s active trade or business will not be subject to the net investment income tax. Therefore, the same shareholder who would lose 58% of his or her real estate gains to taxes if the building were held by the corporation might pay less than half of that in taxes if the building were held personally.
Real Estate in S-Corporations
S-corporations don’t pay tax at the shareholder level. Owning property in an S-corp isn’t as bad, but even S-corporations should still keep real estate in the shareholder’s name.
Holding real estate inside of an S-corporation can create problems when a shareholder joins or leaves the business. Imagine that one shareholder is running a business and someone else wants to buy-in and run it with them. If the business owns the real estate, the new shareholder needs to come up with enough money to by their share of the business and their share of the property at the same time. If the shareholder owned the land or buildings, the new shareholder could buy stock in the business now, and wait years before buying the property it occupies. This makes it easier for new owners to buy-in to the operating business because they don’t have to come up with payment for their share of the real estate value at the same time as their share of the business value.
Even sole-shareholder can run into problem with real estate in his or her S-corporation when they go to sell their business or when it makes sens for the business to move on to a new location. The shareholder can’t re-purpose the real estate for personal use without triggering a taxable event, and if he or she sells the business, the new owner may not want the real estate to go with it.
Avoid tax headaches by keeping real estate out of your closely-held corporation. Any corporation thinking of buying real estate in its own name should talk to its tax professional, and any tax pro worth his or her salt will probably have one piece of advice. “Don’t do it”.