Shareholders of closely held C corporations commonly lease real estate, equipment, and other property to the corporate entity, either directly or through a separate partnership, a limited liability company, or an S corporation. Advantages that can motivate these rental arrangements include the following:
- Avoiding payroll taxes: Rental income from real estate is not subject to the self-employment (SE) tax; a lease of real estate to a closely held corporation represents the ability to withdraw funds from the corporation without incurring Federal Insurance Contributions Act (FICA) taxes (i.e., Social Security and Medicare) or SE tax.
- Avoiding corporate-level gain: Retaining ownership of real estate and other valuable tangible or intangible assets outside the corporation avoids the potential for triggering a gain within the corporation upon a distribution or liquidation of the assets. Conversely, if appreciated assets (i.e., those with a fair market value (FMV) in excess of adjusted tax basis) are distributed from a corporation, whether in liquidation or other form of distribution, gain must be recognized (Secs. 311(b)(1) and 336(a)).
- Retirement cash flow: Retaining valuable assets outside a controlled corporation allows the shareholder-lessor to continue to receive a cash flow stream from the corporation in the form of rents or royalties, even though the shareholder is not employed by the corporation. This can allow a portion of the corporate income to flow to a retired shareholder or a shareholder who is uninvolved in the business operations.
- Business transition: Retaining assets outside the corporation allows the ownership of the business operation and the ownership of business assets to be segregated. For example, a controlling shareholder-lessor may want to divest ownership and control of the business operations by disposing of some or all of the corporate stock but retain a significant portion of the business assets for lease to the entity. This can help transfer ownership and control to the successor generation by minimizing the value of the corporation (e.g., where the corporation contains only operating assets such as receivables and inventory, with fixed assets retained by the founder).
Example 1. Leasing land to a corporation to minimize payroll taxes and avoid double taxation: A recently formed W Inc. with a capital contribution of $1,000. A is the only shareholder. He intends to transfer the assets of AJ's Car Wash (AJ), a sole proprietorship, to the new corporation. AJ's profits are A's only income and are required to meet his personal expenses.
The car wash is located on two acres of prime real estate. A originally paid $30,000 for this land, which now has an appraised value of $75,000. A believes that the land will continue to appreciate in value. AJ also has equipment with an adjusted basis and FMV of $20,000.
If A leases the land and real property improvements to W, A receives rent that would otherwise be withdrawn from the corporation in the form of compensation or dividends. By renting the land instead of transferring it to the corporation, A avoids payroll taxes (i.e., if the payments were compensation) and double taxation (i.e., if the payments were dividends) on the rent amounts. Also, by not transferring the land to the corporation, A avoids double taxation later.
Transferring the property to the corporation would result in A's tax basis in the land of $30,000 carrying over to the corporation (Sec. 362(a)). When the appreciated land or the proceeds from the sale of the land are extracted from the corporation, both A and W would recognize gain. The equipment would not appreciate in value and would probably depreciate and need to be replaced from time to time. Thus, there is less risk of double taxation arising from placing the equipment directly into the corporation.Avoiding constructive income when renting property to a corporation
Renting property to a closely held C corporation is an effective way to extract wealth from the business in a form other than wages (subject to FICA taxes) or dividends (nondeductible). However, rental payments that are too high in relation to the property's fair rental value face possible reclassification as constructive dividends or compensation (Sec. 482; Maschmeyer's Nursery, Inc., T.C. Memo. 1996-78). On the other hand, taxpayers who receive too little or no rent for the use of property by their closely held corporation may find that the IRS, upon examination, determines that there has been constructive receipt of rental income.
Example 2. Establishing a fair rental value for property leased to a corporation: Assume the same facts as in Example 1. A and W are related parties, since A owns more than 50% of AJ's stock (Sec. 267(b)). A should set the rent payments at fair rental value. Also, W should pay a reasonable salary to A for the services he performs. Otherwise, the IRS can reallocate income and expenses to clearly reflect income. Such a reallocation could result in a recharacterization of the rent income as a constructive dividend.
Fair rental value can be determined by calculating the rate of return A would expect if he were to sell the real estate and invest the proceeds. A rate of return of 15% (taking the various risks involved into consideration) will be used to make this determination. Based on these factors, a fair rental rate of $1,750 per month is calculated. A also decides that he will set his salary at $4,000 per month, which he believes is a fair amount for the services that will be performed. A should document these decisions in the corporate minutes and have a valid real estate lease prepared by his attorney.
Example 3. Avoiding constructive receipt of unpaid rent from a corporation: D and J are the sole shareholders and directors of P, a cash-method C corporation. During the current tax year, they lease a warehouse to the corporation at a fair rental value of $2,000 per month. The corporation pays rent to the shareholder-lessors for the period of January to May, but in June the rental payments are discontinued. The corporation has sufficient cash on hand to make the rental payments, but D and J decide to waive the collection of the rental payments because of the discrepancy between the lower corporate rates and their high individual return rates.
In a similar fact pattern, the Tax Court held that controlling shareholders may be in constructive receipt of unpaid rent when the corporation has both the obligation to pay the rent and the necessary funds on hand (Hooper, T.C. Memo. 1995-108; Regs. Sec. 1.451-2). The corporation would be entitled to claim a deduction on its books for the additional rent, and this would be treated as additional rental income to D and J. In addition, because the rent was not actually paid, D and J make a constructive contribution of capital to P; this is nondeductible by them and a nontaxable receipt of capital byP.
Observation: In the Hooper case, the shareholder was required to report rental income but received no cash from the corporation with which to pay the tax on the income. Furthermore, since the rent income was considered to be constructively received by the shareholder and then contributed to the corporation's capital, actual payment of the rental amount to the shareholder would be a distribution subject to dividend treatment. In other words, the shareholder could not withdraw the cash in the future without paying tax once again.
Given the maximum tax on dividends of 20%, it is possible that reducing rental payments and paying dividends might produce an overall lower combined tax burden if the shareholder is in a high tax bracket and the corporation is in a lower tax bracket. Care should be taken if restructuring an existing lease agreement, as the IRS may challenge the original rent level as being a partial dividend taxable at the higher rates in effect in prior years.
Caution: Shareholders may be subject to the additional 3.8% net investment income tax on rent received from leasing tangible property to the company. The net investment income tax applies to rent (among other categories of income) less properly allocable deductions (Regs. Sec. 1.1411-4(a)(1)(i)). However, rent is excluded from the net investment income tax if it is derived in the ordinary course of a trade or business that is not a passive activity (Regs. Sec. 1.1411-4(b)). According to the preamble to the final Sec. 1411 regulations, due to the differing factual combinations that can exist in determining whether a rental activity rises to the level of a Sec. 162 trade or business, bright-line definitions are impractical. Instead the preamble lists factors to consider, including the type of property (commercial real property, residential condominium, etc.), the day-to-day involvement of the owner or an agent, the type of rental (net lease versus traditional lease, short-term versus long-term lease), and the number of properties rented.Considering the risk of SE tax on equipment rental income
An individual who rents real estate to a corporation receives income that is exempt from self-employment (SE) income (Sec. 1402(a)(1)). The exemption also applies to personal property that is leased with real estate. However, there is no exemption from SE income if personal property alone (i.e., without real estate) is leased to a corporation. Thus, when an individual leases equipment to a controlled corporation, whether an S corporation or a C corporation, and this equipment is not leased in conjunction with real estate, any net rental income on the equipment faces exposure to SE tax. This assumes that the leasing activity is conducted with regularity and continuity, so as to rise to the level of a trade or business (Stevenson, T.C. Memo. 1989-357).
Example 4. Leasing equipment to a corporation may generate SE income: D recently formed T Inc. with a capital contribution of $1,000. D is the only shareholder. D intends to operate his sole proprietorship, DK Cleaners, in the new corporation. The profits from DK are D's sole source of income and are required to meet his personal expenses. D intends to lease the cleaning machinery to T. Under audit, the IRS could assert that D is in the business of equipment rental or leasing. In that case, D's rental income would be subject to SE tax.
Example 5. Conducting an equipment leasing trade or business: R is the sole shareholder of RI Inc., a corporation that does printing and binding of publications and advertising brochures. Since forming the corporation over 10 years ago, R has retained all equipment personally for lease to the corporation. R buys or trades all annual replacement equipment for the business and likes the flexibility of adjusting his personal income through the use of the Sec. 179 deduction and the timing of asset purchases. On average, R owns 20 to 30 pieces of equipment that are leased to his corporation. Under the lease, the corporation is responsible for maintenance and repair, but R insures the equipment.
Because of the duration of this arrangement and the number of items of equipment involved, it is likely that R is really conducting a leasing trade or business, which would be subject to SE tax. The reporting of this activity within R's Form 1040, U.S. Individual Income Tax Return, should be on Schedule C, Profit or Loss From Business, rather than Schedule E, Supplemental Income and Loss.Complying with self-rental property regulations on passive income
Normally, rental income arrangements, such as leasing real estate to a corporation, produce passive income to the extent of any net rental income received by the lessor (Sec. 469(c)(2)). Passive rental income can be very valuable to an individual lessor, since it can serve to absorb passive losses from other activities. However, the IRS has issued self-rental property regulations that prohibit using net income from the rental of property to offset other passive losses if the property is rented to a business in which the taxpayer materially participates (Regs. Sec. 1.469-2(f)(6)).
These rules, converting what would otherwise be passive income into nonpassive income, apply only if the rental activity produces net income. If the rental activity produces a loss, the loss continues to retain its passive character. The Tax Court upheld the validity of the passive income recharacterization regulations in a 1998 decision (Schwalbach, 111 T.C. 215 (1998)).
In Carlos, 123 T.C. 275 (2004), the taxpayer owned two separate buildings. Each of the buildings was leased to one of two S corporations solely owned by the taxpayer. One of the properties incurred a loss, and the other incurred income. The taxpayer netted income and loss from the two properties, which he had grouped as a single activity for Sec. 469 purposes. The result was that the taxpayer reported nonpassive net rental income and no passive activity loss. In doing so, the taxpayer contended that the passive activity loss computation requires the netting of income and loss from all items of rental property grouped within the passive activity, and only after that computation is passive income recharacterized as nonpassive. The Tax Court disagreed, holding that under Regs. Sec. 1.469-2(f)(6), self-rental income should be removed from the computation of the passive activity loss. After this was done, the taxpayer was left with no passive income to offset against the passive loss from the other property.
Example 6. Leasing property to a business in which the lessor materially participates: B owns all the stock of N Inc., a C corporation in which he materially participates. B leases a building to N netting $30,000 of rental income annually. Since B will materially participate in the operation, the $30,000 of income from leasing the building is nonpassive.
In addition to self-rental arrangements, net income from rental property will also be recharacterized as nonpassive if less than 30% of the unadjusted basis of the property is depreciable (Temp. Regs. Sec. 1.469-2T(f)(3)). The net income is recharacterized as portfolio income. Again, as with self-rented property, the rule only applies to net income; if the activity produces a loss, it retains its passive character.
Example 7. Characterizing net income from partially depreciable rental property: T Corp. recently purchased undeveloped land for a future project. Since the planned relocation is several years away, T rented the land to a farmer. Less than 30% of T's basis in the property is depreciable. Although rental income is normally passive, T must treat the rental income as nonpassive because less than 30% of the unadjusted basis of the property is depreciable. T will not be able to offset its passive activity losses against the net income from this rental property. On the other hand, if the rental activity results in a loss, the loss will be characterized as a passive activity loss.Renting home office and storage space to a corporation
Sec. 280A(c)(6) disallows any deduction attributable to the rental of the taxpayer's residence to his or her employer during any period in which the individual uses the residence in performing services as an employee of the employer. Despite this constraint on deducting expenses, shareholders may still wish to consider the strategy of leasing an office, or perhaps a storage area, in their home to their corporation. The obvious advantage of extracting cash from the corporation this way is that the rental payments are exempt from payroll taxes. However, practitioners must consider the effect this may have on the exclusion of gain from the sale of the residence.
Example 8. Tax savings from home office space rental: A and her daughter, K, are the shareholders of a successful retail chain that is organized as a C corporation. A has been making annual gifts of the corporation's stock to K in an attempt to reduce her estate and also to shift more of the dividend income from the corporation to her daughter.
The corporation enters into a lease with K for both an office and a storage area within her residence. These are used by the corporation for its business activities and by K in the performance of her duties as an employee of the corporation. The reasonable rental value of this space is $12,000 per year. Accordingly, the corporation will pay $12,000 of deductible rent to K, and K will report $12,000 of rental income on Schedule E of her Form 1040. Because K is an employee of the corporation, Sec. 280A(c)(6) prohibits any offsetting deductions on K's Schedule E. However, as real property rental income, the payments are not subject to SE tax or payroll taxes.
This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 31st Edition, by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck retires
|Albert B. Ellentuck, Esq., the longtime editor of the Case Study, has retired. He was most recently of counsel with King & Nordlinger LLP in Arlington, Va., and spent his professional career in practice with both law and CPA firms emphasizing estates and trusts, as well as tax planning for individuals, businesses, and not-for-profit organizations. In addition to editing the Case Study since 1988, he served in many volunteer positions with the AICPA Tax Division and in 2008 was recipient of the AICPA Tax Division's Arthur J. Dixon Memorial Award. The staff of The Tax Adviser wish him well in retirement and thank him for his many contributions to the magazine.
|Larry N. Bland Jr., CPA, is a technical editor with Thomson Reuters Checkpoint. For more information about this column, contact firstname.lastname@example.org.