Excluding Assets from a Tax-Free Incorporation to Avoid Double Taxation Later

Editor:Albert B. Ellentuck, Esq.

When incorporating an ongoing business, the organizer must transfer enough assets to the corporation to allow it to operate the business for which it was organized. However, it may be wise to avoid the transfer of all the assets to the newly formed corporation. For example, vital business real estate may be best left in the hands of the organizer and leased to the corporation. This avoids double taxation from a future distribution or sale of the real estate and allows the organizer to withdraw funds from the corporation as deductible rent instead of nondeductible dividends. There are several commonly cited reasons for retaining assets outside a corporation.

Avoiding double taxation: When an incorporator transfers an asset to a corporation under Sec. 351, the adjusted tax basis of the asset generally carries over from the incorporator to the corporation. For a C corporation, there is a double tax cost if the corporation sells the asset or distributes it out of the corporation to the shareholders. Sec. 336 triggers gain (as if an asset were sold at its fair market value, or FMV) if property is distributed in a corporate liquidation, and Sec. 311(b) triggers gain to a distributing corporation if property is distributed to a shareholder in a nonliquidating situation. While this may be less of an issue in today’s economy, in general assets such as land and buildings, which tend to appreciate in value and may not be disposed of if the operating business is sold or fails, may be better owned outside the corporation.

Distributing cash in a form other than compensation: When assets are retained outside a corporation, the corporation must pay rents or royalties for the use of the assets. These rental or royalty payments can serve as a method of withdrawing corporate cash in a way that is tax deductible to the corporation but also without incurring the FICA tax costs or reasonable compensation issues associated with drawing compensation from the corporation. Furthermore, rents and royalties can be paid into the shareholder/lessor’s retirement years with the reasonableness of the payment measured by the market value of the asset, not by the shareholder’s ability to legitimately render services to the corporation. Finally, rents and royalties, as unearned income, do not reduce the Social Security benefits received by the shareholder/lessor.

Easing business transferability: When substantial assets are retained outside the corporation (e.g., real estate and possibly equipment), the business value within the corporation is reduced. This can allow the incorporators to more easily sell or make gifts of the stock. This can be particularly advantageous when the intent of the incorporators is to pass on the control and management of the business while retaining some of the asset value for lease to the entity during retirement years.

Splitting business assets among heirs: In many family business situations, only one or two of the owner’s heirs are active in management. When the owner has other children and the business represents the great majority of his or her estate, a dilemma occurs. The owner wants to provide comparable value to all children but also recognizes the need to direct the ownership and control of the business only to those heirs who are actively involved and employed. Segregating passive assets (e.g., real estate or royalty-right intangibles) from the business upon incorporation can help meet these objectives. For example, by placing only the active operating assets (e.g., receivables, inventory, and equipment) within the corporation, the owner can direct corporate stock to those heirs who are active in the enterprise and place the real estate and other passive assets within a separate entity, such as a trust or family limited partnership, for lease to the corporation. To the extent it is desirable to retain control of the passive assets in the hands of those who operate the active business/corporation, the general partnership management interest or the trustee’s role could be directed to the active business heirs.

Stepping up basis at death: Assets retained outside the corporation usually are included in the owner’s estate. At the owner’s death the assets’ basis is generally stepped up to FMV. Assets placed within a corporation do not receive a basis step-up at the death of the shareholder; only the corporation’s stock owned by the shareholder receives a basis adjustment. By retaining assets with a low basis or appreciation potential outside the corporation and passing those assets through an estate, the incorporator eliminates pre-death gain from a subsequent sale of the asset by his or her heirs.

Example: J plans to incorporate his sole proprietorship. His assets are as shown in Exhibit 1. J’s combined marginal federal and effective state tax rate for the current tax year will be 38%. He plans to transfer all assets to the corporation. However, within a year or two the corporation intends to sell the building; at that time the corporation will be in a 34% tax bracket and the building’s FMV will have decreased by $10,000 to $90,000.

If J transfers the assets in a Sec. 351 tax-free exchange, the assets, including the building, will retain his basis of $150,000. Assuming the corporation is in the 34% tax bracket at the time it sells the building and the FMV of the building declines $10,000 (the same amount as depreciation on the building), the corporation will pay federal income tax of $10,200 (34% × ($90,000 − $60,000)) on the sale of the building. If the corporation has earnings and profits, J will then be taxed on the net proceeds distributed to him as dividends, as shown in Exhibit 2 (assume these are not qualified dividends). Together, J and the corporation will pay a total of $40,524 ($10,200 + $30,324) in tax on the sale.

Instead, if J sells the building to the corporation in exchange for notes totaling $100,000, he will recognize $30,000 of gain and will pay tax of $11,400 ($30,000 × 38%) on the sale. The corporation’s basis in the building will then equal its FMV. When the corporation sells the asset at a later date, it will not recognize further gain or loss (assuming the FMV of the building decreases in the same amount as depreciation on the building). Because the proceeds of the sale will be used to help pay off the note due to J, the amount distributed to him from the sale of the building will not be taxable to him.

A sale of assets to a controlled corporation can be more beneficial than a Sec. 351 tax-free transfer when the corporation intends to sell the assets shortly after acquisition. This alternative is appropriate if the assets to be sold cannot be retained by the shareholder outside the corporation.

Disadvantages of Retaining Assets Outside the Corporation

There are several disadvantages of retaining assets outside a corporation.

Failing to limit exposure to personal liability: Placing assets in a corporation provides some liability protection to the owner. Retaining the asset individually, where the asset might be used or operated in a way that creates a tort liability, forgoes the protection of the corporate entity. For example, a shareholder who owns trucks individually for lease to a controlled corporation is likely to be exposed to personal liability if one of those trucks causes personal or economic injury. On the other hand, a more passive asset, such as farmland or a warehouse, may generate little exposure if retained individually and properly insured. Furthermore, placing high exposure assets within a corporation may provide little protection when the shareholder is individually involved in operating the asset. For example, if a corporation has its controlling shareholder as its only employee, it is very likely that any tort liabilities generated by the corporation would involve the employee, thus exposing the individual assets of the shareholder-employee.

Losing control over assets: Assets retained outside the corporation must be leased or otherwise made available to the corporation if the business is to continue using the property. However, if the lessor and the corporate shareholder are not the same parties, the business risks losing access to the use of the assets. For example, when a parent incorporates a family business but retains the real estate individually, the eventual plan may be for the corporation’s stock to be owned by those heirs employed by the business and the real estate to be owned by the other heirs who are not active in the business. If a dispute arises between the heirs, the corporation may lose access to the assets. This risk may be minimized by placing those assets that are retained outside the corporation within a trust or family limited partnership. This can allow control of the assets to be in the hands of the parent(s) or those who actively operate the business but permit most of the equity and income flow to be owned by heirs uninvolved in the family business.

Increasing the sales tax risk: When assets are retained outside a corporation and leased to the business entity, the lease payments may be exposed to state sales tax. While the rental of real estate is generally not subject to sales tax exposure, equipment that an individual leases to a corporation can, in some jurisdictions, result in sales tax imposed on the lease payments.

Increasing the self-employment tax risk: The rental of real estate by an individual to a corporation is exempt from the definition of self-employment (SE) income (Sec. 1402(a)(1)). This exclusion from the SE tax applies to rentals received from real estate and rentals from personal property leased with the real estate. However, no exemption exists if personal property alone (i.e., without real estate) is leased. Thus, when an individual leases equipment to a controlled corporation and this equipment lease cannot be tied to the lease of real estate, any net rental income on the equipment faces exposure to SE tax. This assumes the individual conducts the leasing activity with enough regularity and continuity to rise to the level of a trade or business.

Recharacterizing rent: When rents are used to extract funds from a corporation to shareholders/lessors, the IRS has authority to recharacterize the rents as compensation or dividends if they are in excess of market value (Sec. 482). For a C corporation, the IRS is likely to treat excessive rents as a dividend; this disallows the deduction but retains the taxable income treatment to the shareholder/lessor (Maschmeyer’s Nursery, Inc., T.C. Memo. 1996-78; Thorpe, T.C. Memo. 1998-115).

This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 24th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Mary C. Danylak, Timothy Fontenot, James A. Keller, Brian B. Martin, and Robert Popovitch, published by Thomson Tax & Accounting, Ft. Worth, TX, 2011 ((800) 323-8724; ppc.thomson.com).

EditorNotes

Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.