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AICPA 2002 - Removing Real Estate from Corporations (00147476DOC;1)

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AICPA 2002 - Removing Real Estate from Corporations (00147476DOC;1) ...

    Removing Real Estate from Corporations

    (An Advanced Workshop and Interactive Discussion)

    AICPA NATIONAL TAX EDUCATION PROGRAM

    IUPIU

    INDIANAPOLIS, INDIANA

    JULY 24, 2002

     BRIAN T. WHITLOCK, CPA, JD, LLM

     Blackman Kallick Bartelstein, LLP

     300 S. Riverside Plaza

     Chicago, IL 60606

     Phone: (312) 980-2941

     Fax: (312) 207-1066

     e-mail: bwhitlock@bkadvice.com

    Removing Real Estate from Corporations

    (An Advanced Workshop and Interactive Discussion)

    Real Estate is an asset that most businesses acquire at some point. Our preference is generally to hold it outside of the regular corporation, but all too frequently we come across clients whose corporation balance sheet includes land and buildings. The reasons for originally holding the real estate in the corporation seemed valid at the time it was acquired, but now? The value of the real estate is increasing. The shareholders would like to remove the real estate at the least possible cost.

    This advanced interactive discussion will give you the opportunity to work with other practitioners and experts as we identify and analyze numerous theoretical and practical solutions for removing real estate from a corporation with the least Corporate Income Tax, Individual Income Tax, and Gift and Estate (Transfer) Tax exposure.

    Participation will be flexible, but come prepared to learn. You have the opportunity exchange your ideas and explore new strategies with others. You will have the opportunity work through the calculations and the theories to see the potential traps and solutions as they unfold. You WILL learn practical solutions that you can employ to save your clients tens of thousands of dollars.

    Overview Putting the Issues in Perspective

Your client is holding real estate inside of a Corporation. It is a common scenario. The real estate

    might be vacant land, investment property, rental property, or it may serve as the corporation’s place

    of business. The real estate may have been put inside the corporation to avoid a perceived threat of

    legal liability, to capture an interest deduction, to avoid the accumulated earnings tax, or merely

    because it was expedient (i.e., the company had an established credit relationship with the bank.

    Regardless of the reason it was acquired, once the real estate was inside of the corporation, it gave

    rise to numerous tax and family considerations.

If the real estate is held inside the corporation, it cannot be used by the family to generate passive

    income for the benefit of senior family members. Real estate generally appreciates in value. Inside

    the corporation that value benefits only the members of the family that are active in the business, or

    shareholders in the business.

From a tax perspective, there are three potential tax traps for appreciated real estate:

Corporate Income Taxes

    ? Accumulations of investment assets may be subject to Accumulated Earnings Penalty Tax under

    Internal Revenue Code (IRC) Sections 531-537.

    ? Passive assets and the passive income that they generate may trigger Personal Holding Company

    Taxation under IRC Sections 541-547.

    ? Sales and exchanges of appreciated real estate can be subject to corporate level income taxes.

    Inside of C Corporations gains are taxed at ordinary rates not the typical 20% capital gains rates.

    ? Distributions of appreciated assets can trigger corporate income taxes under IRC Section 336.

Individual Income Taxes

    ? Transfers of appreciated assets to corporation can be subject to taxation under IRC Section 351.

    ? Gain (loss) is recognized upon the receipt of property distributions from a corporation IRC

    Section 301.

Gift and Estate (Transfer) Tax

    ? Holding real estate inside of corporations creates large monolithic entities that are difficult to

    share with junior family members that have diverse financial goals.

    ? Holding real estate inside of corporations restricts the family’s ability to transfer wealth equitably.

    ? Holding investment real estate inside of corporations may limit the estate’s access to deductions

    under IRC Section 2057 and tax deferral under IRC Section 6166

    ? Holding appreciated assets inside of a corporation restricts estate liquidity.

This discussion will attempt to advance numerous solutions. Some solutions will be better suited to

    avoid or reduce corporate income tax; other may be better suited to avoid or reduce individual

    income taxation or the transfer tax. There is no “Silver Bullet;” rather as creative CPA tax

practitioners it is our challenge to mix, match, and create comprehensive solutions to our clients tax

challenges That’s why we get paid the Big Bucks!”

     Sale of Assets / Liquidation of a C Corporation

Facts

    The sole shareholder of ABC Inc. is interested in retiring. ABC owns a building with a FMV of

    $500,000 and zero adjusted basis, and land with a FMV of $100,000 and a $50,000 basis. A buyer is

    interested in purchasing the real estate and not the stock of the corporation.

Strategy

    ABC Inc. sells the assets and liquidates the corporation; ABC distributes the proceeds to the sole

    shareholders in exchange for their stock.

Tax Consequences if ABC is a C Corporation.

    ABC Inc. - will recognize a $550,000 gain on the sale of the land and building. ABC will pay tax at

    regular corporate rates (as high as 35%) on the recapture of depreciation as well as the capital gain. ABC

    will distribute the proceeds, less the corporate tax of $192,500 and miscellaneous liabilities, to the

    shareholder.

    The Shareholder - will recognize capital gains equal to the proceeds received in liquidation, less his/her basis in the stock. The shareholder will pay tax at the reduced individual capital gains rates (generally

    20%).

Common Strategies for Deferring or Reducing the Corporate in a Sale

    Seller Makes Payments of Current and/or Accrued Deferred Compensation

    ABC can also pay compensation and/or a bonus to its key employee for negotiating a successful sale of

    its business assets. Obviously, in order for compensation to be deductible, it must be reasonable. If the

    Seller can anticipate a sale of its business by more than one year, then the Seller may be able to accrue a

    larger amount of compensation deduction as an inducement to the key employees to stay.

    Seller controlled Gain Deferral Like Kind Exchange IRC Section 1031 allows taxpayers selling real estate to defer the income tax on the sale of real estate, if

    the Seller engages in a like kind exchange. The Seller must follow specific rules laid out in the

    Regulations under Section 1.1031 regarding the handling of the proceeds and the identification and

    acquisition of the replacement property.

    Seller controlled Deferral of Gain Private Installment Sale The gain on installment sales is generally reported over the term of the installment note. Where the installment note

    is to a related party Section 453(e) requires that the real estate be retained for at least two years by the installment

    buyer. After two years the real estate may be resold without triggering a gain in the installment note. Note can stay

    in corporation until shareholders death. Annual interest and capital gain in corporation can be offset by operation

    expenses and benefits inside the corporation. WARNING: Transfer of note will accelerate remaining gain on

    uncollected balance of note.

Allocation of Purchase Price

    Buyers of entrepreneurial businesses generally wish to acquire assets rather than the shareholder’s equity

    interest. The purchaser will generally wish to deduct its purchase price in the form of depreciation or

    business expenses. Proceeds may be allocated towards the purchase of the following assets:

    ? Inventory will be recovered in the first business cycle (generally less than 1 year)

    ? Real estate will be recoverable through depreciation deductions over 39 years

    ? Equipment, furniture, etc. may recoverable over 5 7 years ? Goodwill over 15 years (IRC Section 197)

    ? Land is not depreciable.

Purchaser Makes Payments direct to Equity Seller under Covenant Not to Compete

    A portion of the proceeds may be paid directly by the purchaser to the seller and not pass through the

    corporation. Payments under a Covenant Not to Compete are generally deductible by the corporation

    as paid. Payments received by the individual are taxable as ordinary income.

Purchaser Makes Payments direct to Equity Seller for Personal Goodwill

    In Martin Ice Cream Company v. Commissioner, 110 TC 189 (March 17, 1998), the Tax Court held that the customer relationships were the property of the Shareholder who personally developed the

    business relationships and contacts. The Shareholder never signed an employment agreement with

    the company and he never transferred the relationships to the corporation. The relationships were the

    property of the Shareholder, not the corporation. Since the payments never pass-through the

    corporation, they are not subject to corporate taxation. The payments received by the individual

    qualify as the sale of an asset and thus qualify for capital gain treatment.

    Strategies for Reducing or Avoiding Tax by Removing Assets

    Distributions in Liquidation Asset Management Tools

A corporate level tax will generally be due upon the distribution of an asset from a corporation under

    IRC Section 336. The tax will be assessed on the difference between the fair market value and the

    adjusted basis. Absent a sale to a third party, the fair market value will be determined by an appraisal.

“Fire Sale” (Get low and go)

     - The lower the appraisal the lower the corporate tax.

    Timing the Transfer The lower the differential between the appraised value and the adjusted basis, the lower the corporate tax.

    Additions and improvements rarely add to the market value in the same measure as they add to basis.

    Example: ABC Inc., currently owns a building and land with a basis of $100,000 (accumulated

    depreciation $100,000) and $50,000, respectively. The fair market value (FMV) of the building and land

    are $500,000 and $100,000, respectively. In order to accommodate its ever growing business, ABC

    decided to expand its building at a cost of $500,000. ABC also spent an additional $100,000 on land

    improvements. Due to the nature of the additions, the building's FMV increased by only $150,000, and

    the land's FMV increased only marginally. The gain differential shrunk from $550,000 to $100,000.

    Transferring the real estate after the improvements are complete will reduce the corporate tax.

    Asset Compression If the corporation contributes the real estate to Family Limited Partnership or Limited Liability Company,

    in exchange for a restricted equity interest, then a business appraiser may be able to discount the value of

    the equity interest for lack of marketability and/or lack of control.

Asset Fractionalizations: Vertical and Horizontal Divisions

    The ownership of real estate can be divided both vertically and horizontally. Vertical divisions include:

    tenancies in common, and partnerships. (For Example: the corporation could sell and undivided interest

    in the real estate prior to liquidation). Horizontal divisions include: leasehold interests, life estates and

    remainder interests, and land only sale and leasebacks.

    Asset Compression: Family Limited Partnership Rollout

The Facts

    ABC Inc., a C Corporation, owns a building with a FMV of $500,000 and zero adjusted basis, and land

    with a FMV of $100,000 and a $50,000 basis. The land and building will likely continue to appreciate

    over the years.

The Strategy

    ABC Inc. contributes the land, building, and improvements to a Family Limited Partnership in exchange

    for limited partnership interests at lowest reasonable appraised values. The shareholder contributes cash

    and property at highest reasonable appraised values to the Family Limited Partnership in exchange for a

    general partnership interest.

    Tax Consequences The contribution of property to the Family Limited Partnership will be a nontaxable transfer under

    Section 721 of the Code.

ABC will recognize a gain on the sale or distribution of the limited partnership interest. The gain will be

    equal to the discounted value of the limited partnership interest, less its basis. The basis of the limited

    partnership interest is that of the property contributed to the partnership for said interest. CAUTION:

    The transfer of the limited partnership interest should not be near the time of the formation of the limited

    partnership. In Pope & Talbot, Inc., 104 T.C. No 29 (1995), the Court ruled that the distribution of the

    partnership interest triggered gain under Section 311 based upon the value of the property without

    valuation discounts. The anti-abuse rules in Treasury Regulation Section 1.701-2 may also enable the

    IRS to challenge the partnership.

    Vertical Division: Sale of Land - Retention of Building

The Facts

    ABC Inc., a C Corporation, owns a building with a FMV of $500,000 and zero adjusted basis, and land

    with a FMV of $100,000 and a $50,000 basis. ABC has no plans to move its operations. The land and

    building will likely continue to appreciate over the years.

The Strategy

    ABC Inc. sells the land, on which its building stands, to a Family Limited Partnership created by the sole shareholder of ABC. The land will be subject to a 40-year lease with ABC. At the end of the 40 years the Family Limited Partnership need not renew its land lease with ABC. Consequently, the land and

    anything on it (building and improvements) will belong to the Family Limited Partnership.

    Tax Consequences ABC Inc. will recognize a gain on the sale of the land (($100,000-$50,000)*.35 = $17,500 tax). It will also deduct rent payments paid to the Family Limited Partnership.

     Vertical Division: Split Interest Purchase of Real Estate

    The Ultimate Section 1031 Exchange

The Facts

    ABC Inc., a C corporation, is selling its existing business real estate and is considering the purchase of

    new land valued at $200,000 and constructing a building valued at $2,000,000 to be used in operations.

    They would like to avoid purchasing the replacement real estate inside the corporation, since this will

    trap an appreciating asset inside the corporation.

The Strategy

    Instead of purchasing the entire interest, the corporation and the shareholder could each purchase a split

    interest in the land. ABC would purchase a 40-year term interest, and the 100% shareholder would

    purchase the remainder interest in the land. Richard Hansen Land, Inc., 65 TCM 2869, TC Memo 1993-

    248. Split interest purchases and sales have been used in intra-family transactions prior to the 1990

    enactment of IRC Section 2702. If the shareholders buy the remainder in proportions equal to the

    shareholdings, Section 2702 should not apply.

    Tax Consequences ABC Inc. - The cost of the term interest in the land would make up most of the cost ($169,050). ABC could amortize this amount, but it would not be deductible under IRC Section 167(e)(3)(B). The

    amortization would flow to Schedule M-1. ABC would depreciate and deduct the building cost. At the

    end of 40 years, the land and building would pass to the shareholder without any tax consequences to

    ABC.

    Shareholder The cost of the remainder interest would be nominal ($30,950). This amount would not be deductible. At the end of 40 years, the land and building would pass without any tax consequences to

    Shareholder.

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