It's generally not a good idea for a closely held C corporation to own assets with high appreciation potential. A classic example is real estate. If your corporation owns property, it's likely the appreciation will be hit with double taxation when the real estate is sold and you take the resulting cash out of the company.
The reason is because the capital gains of C corporations are not taxed at preferential rates plus you have to worry about double taxation. When a C corp sells an asset, it is taxed at its regular corporate rate, which is 21% for tax years beginning in 2018 and beyond. The capital gain may be taxed again when paid out to shareholders as a dividend.
A Solution to Double Taxation
Keep the ownership of valuable real estate assets in the hands of one of the owners and lease them to your C corporation. Or form an LLC, S corporation or partnership to own the assets and then lease them to the C corporation.
What can you gain from this transaction?
- On the C corporation's side, the lease payments are deductible business expenses.
- The payments are taxable income to you, but you can claim offsetting deductions for depreciation, mortgage interest, property taxes and operating expenses.
- The leasing arrangement is a way to get additional cash flow out of your C corporation without double taxation. Plus, double taxation is avoided on appreciation in the value of the real estate.
- Owning the real estate outside the corporation generally means protection from exposure to liabilities from the corporation's business.
For example, let's say your C corporation business needs a new building. You set up a new single-member LLC (owned solely by you) to buy the property and lease it to the corporation. After 10 years, the property is sold for a $500,000 gain. The entire gain will be taxed on your personal tax return. Part of your profit will be taxed at no more than 25% (the amount of gain equal to your depreciation deductions). The balance will be taxed at no more than 20% under current law. Of course you may owe the 3.8% net investment income tax (NIIT) on the gain too. Say, you pay a total of $130,000 to the U.S. Treasury for capital gains tax and the NIIT. There's no federal income tax at the LLC level, so your after-tax profit is $370,000 ($500,000 minus $130,000). (You may owe state income tax too, but we will ignore that factor in this analysis.)
Now let's see what happens if your C corporation buys the very same property. The $500,000 gain will be taxed at the 21% corporate rate. The firm pays the $105,000 federal income tax bill and distributes the remaining $385,000 to you. (We will ignore any corporate state income tax here.) We assume the $385,000 will be a dividend that is taxed at 20%. Plus we assume you will owe the 3.8% NIIT on the $385,000. The tax at your personal level is $91,630 ($385,000 times 23.8%). So the cash you receive after paying federal income taxes at both the corporate and personal level is only $303,370 ($500,000 minus $105,000 minus $91,630).
Compare that $303,370 figure with the $370,000 you would receive under the leasing alternative. With the leasing alternative, your after-tax cash is 22% higher.
Key Point Regarding Business Assets and Double Taxation
It's not necessary for business assets to appreciate for double taxation to occur. The conclusion in the preceding example would be the same if the entire $500,000 gain was caused by depreciation (although the tax bill would be a bit higher under the leasing alternative). Depreciation lowers the tax basis of the property, so a tax gain results whenever the sale price exceeds the depreciated basis.
Even if the business real estate is already inside your C corporation, you may be able to get it out before too much tax damage has been done. If the property was recently acquired, its market value may still be roughly equal to its tax basis. If so, you can buy the property from the corporation and lease it back with little or no harm done. Then, any future appreciation escapes double taxation. The lease payments come out free of double taxation as well.
You may also be able to use this leasing strategy for valuable intangible business assets such as patents, customer lists and copyrights. Such intangibles are likely to appreciate. So it's best to keep them out of the corporation and in your hands if possible.
Your Best Bet With Your C Corporation
Make sure lease payments from the C corporation to you (or to a entity controlled by you) are based on fair market rental rates for similar assets. Otherwise, the IRS can argue that any excess lease payments are just disguised dividends. In that case, you could wind right back in the double taxation trap.
There are lots of legitimate ways to get cash out of your profitable C corporation without double taxation. However, they take appropriate planning. Contact our office for more information.