I’ve previously written a blog post about the pitfalls of incorporating too early. Incorporating too early can be a costly mistake, but so can including the wrong kinds of assets in a corporation. Assets that tend to go up in value, such as real estate, investments, and collectibles rarely belong inside of a corporation. This mistake is much more costly for C-corporations than for S-corporations, but even businesses who are organized as S-corporations should be cautious about what assets to include when they incorporate, and how to purchase appreciating assets in the future.
The biggest category of appreciating asset I tend to see in corporations is the business’s real estate. Often, this may be the corporate offices, a workshop, or other structure used in carrying on a trade or business. While it may seem normal that an incorporated business would own its own building, the truth is that it rarely makes sense for a closely held corporation to buy any kind of real estate. A better alternative is for the business owner to buy the real estate in his or her own name and lease it back to he corporation. There are a number of reasons why this makes sense.
First, if the corporation is organized as a C-corporation, it faces two layers of tax. Any profits that the corporation makes are taxed at the corporate level, and then taxed again to the shareholder when they are distributed. If a corporation owns its real estate, it probably has lower occupancy costs than it would if it rented the real estate from the shareholder or a third party. If the shareholder owned the real estate and collected rent from the corporation, the corporation’s profits might be similar to what they would be if rented from an unrelated third party, but the shareholder gains a stream of rental profits that are subject to only one level of tax, instead of two levels like corporate dividends.
Owning the real estate inside the corporation is a relatively minor mistake while the business is operating and using the building, but most business owners plan to retire eventually, and that usually means selling the business. If a potential buyer can’t afford the rel estate or doesn’t want to maintain the same location, the shareholder can be stuck owning a corporation that is nothing but a holding company for the corporate real estate. This creates an ongoing tax and paperwork burden that could have been avoided if the real estate was held personally.
Additionally, the company will eventually want to sell the real estate. C-corporations don’t get capital gains rates, which means that selling a piece of real estate that’s been held for some time can quickly drive the corporation’s income into the higher tax brackets. 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%, C-corporation shareholders who sell real estate inside of the corporations might see over 40% of their gains lost to taxes before they even get the money out of their companies. Withdrawing the after-tax profit from the corporation will subject it to a tax on dividends that could be as high as 20%, state taxes that top out at 7.75% in Maine, and the dividends could be subject to 3.8% in the new federal Net Investment Income Tax. Altogether, this means that a corporate shareholder might be left with as little as 42% of his or her real estate gains simply for making the wrong decision about how to hold real estate decades earlier. These approximations mostly ignore the minor tax benefit that comes from deduction state taxes for federal income tax and the net investment tax, but should be ballpark figures for a high-income shareholder.
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, 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 would pay less than half of that in taxes if the building were held personally.
S-corporations don’t pay tax at the shareholder level, so organizing as an S-corporation mitigates a lot of this problem, but even S-corporations are still better off keeping the 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. This can also make 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.
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.
Many of the problems caused by owning real estate in a corporation can be mitigated after the fact through tax and transaction planning, but it is better to avoid them entirely by keeping the real estate out of the corporation. Even if the money to pay for the land or building is coming from the corporation, it is almost always possible to structure it such that the corporation pays the shareholder and the shareholder buys the asset. In the long run, the potential tax savings from doing this are well worth the additional paperwork hassle.