Entity choice to hold appreciated land

[MJG CPA]

What is the best choice of entity to hold appreciated land?

Client currently has general p/s but wants liability protection. Asset is farmland [quit-claimed from parents] with very low basis.

Eventually, the land will be sold with potentially large cap gain.

Are there any advantages of using LLC over s-corp to hold land?

[kcjenkins]

To an extent, that depends on the state involved. Some states tax LLCs more than they tax Ss. But it's really a question for a local attorney, not a tax question. Also depends on what the planned 'destination' of the land is. Planning to pass it on to family? Or sell?

[MJG CPA]

To an extent, that depends on the state involved. Some states tax LLCs more than they tax Ss. But it's really a question for a local attorney, not a tax question. Also depends on what the planned 'destination' of the land is. Planning to pass it on to family? Or sell?

I agree an atty s/b consulted, but my concern is with the tax implications of the entity choice. Land in IL was gifted to the grown children by parents, with their very low carryover basis. Eventually, land will be sold and proceeds distributed. At that time, there will be a large cap gain.

I'm just wondering if there are any tax considerations in choosing one form of entity over another.

[RoyDaleOne]

http://www.taxschool.uiuc.edu/taxbookarchive/2002/index.html

See Business Entities.

Really like this site, see all the archives.

[joelgilb]

Personnally as an Illinois Attorney, I like LLC's for a number of reasons.

Have a 7 page article from an attorney online, that summarizes many of not all of the reasons very well that I can e-mail to you. PM me you email addy and I will send it.

[jainen]

>>I like LLC's for a number of reasons<<

The original post only gave one reason -- liability protection. As an attorney you must admit there is far less case law supporting liability protection for LLCs than for corporations.

One thing I have seen little mention of in the popularity contest is how the less formal procedures of an LLC may tend to blur the distinction between the entity and the owners, which is one of the key elements of liability protection.

[MJG CPA]

>>I like LLC's for a number of reasons<<

The original post only gave one reason -- liability protection. As an attorney you must admit there is far less case law supporting liability protection for LLCs than for corporations.

Yes, that was the client's reason for wanting to incorporate. But I'm trying to look at it from a taxation point as well. If both an LLC and s-corp provide liability protection, but there is any tax benefit to be gained by going one way or the other, then I would try to steer the client in that direction.

So far, I have not come across anything that would lead me to believe the ultimate tax on the capital gain would be computed any differently if sold within an LLC vs. an s-corp.

If anyone else has a better idea, I would appreciate a nudge in the right direction.

Thanks!

[RoyDaleOne]

Nudge ----> easier to accomplish some other tax things, cheaper to operate.

[joelgilb]

>>I like LLC's for a number of reasons<<

The original post only gave one reason -- liability protection. As an attorney you must admit there is far less case law supporting liability protection for LLCs than for corporations.

One thing I have seen little mention of in the popularity contest is how the less formal procedures of an LLC may tend to blur the distinction between the entity and the owners, which is one of the key elements of liability protection.

Jainen I originally had no intention of going over the reasons in this post due to the length and complexity of the discussion. I only intended to have MJG PM me so I could send her the information directly, which I did. However, since you ask, below is the email I sent the original poster MJG. I also sent her 6 documents with additional information that I thought were beyond the scope of this forum. Note that I steer most clients away from LLC for other types of entities due to cost, lack of support for case law etc, but for RE it does tend to make sense and we do have the bank of law for Limited Partnerships to fall back and analogize to. Hope this helps.

SENT VIA EMAIL TO MJG:

Note that I have done this research in the past for several clients and although an S-Corp can work, the general

consensus among attorneys that assist in entity choice for holding real estate is that has too many

pitfalls. I have copied a few of the concerns with S-Corporations as an entity (from previous research),

some of which might not apply to CLIENT. Still I do not think it is the entity of choice.

Taxation of a Corporation.

Corporations should generally be avoided as entities to hold real estate because of the a potential for a double income tax on gains - once at the corporate level, and a second tax at the shareholder level. (While people often get steamed about getting taxed once, you should see their reactions when they learn they get to pay twice.) While "S" Corporations can potentially negate the issue of double taxation, it can still arise through a number of unfortunate circumstances. Additionally, pass through of tax losses to shareholders may also be limited with a corporate entity. With the growing popularity and availability of LLC's there are typically few instances warranting placement of investment real estate in a corporate entity. When the S corporation sells the real estate, no tax is levied at the S corporation level. The gain on the sale is passed through to the shareholders who will report this gain on their individual income tax returns. The gain is then taxed at individual income tax rates. If the sale were considered long-term capital gain then the 15 percent capital gain rate would apply. Thus, with an S corporation the shareholders avoid the onerous burden of double taxation, which occurs with C corporations.

Pass Through Entity.

S corporations are intended to assist businesses that operate in corporate form by permitting operating losses to be passed directly through to shareholders so that the losses can offset outside income of the shareholders. Thus, the shareholders enjoy the benefits of having a corporate entity that offers them the usual advantages - limited liability, continuity of corporate life, centralized corporate management -- while at the same time enjoying the tax

advantages of partnerships. S corporations are limited to 100 shareholders.

No debt basis for third-party loans made to an S-Corporation.

Unlike partners in a partnership, S-Corporation shareholders do not receive debt basis for loans made by a third party to their corporation. The only way the shareholders can acquire debt basis is to personally make loans to the corporation. Even a personal guarantee of a third party loan will not give a shareholder debt basis. And since basis (both stock basis and debt basis) is the driving force in determining the taxation of distributions and the deductibility of losses, not receiving any debt basis from third party debt is a major disadvantage for S-Corporations holding real estate. S-Corporations cannot refinance their properties and distribute the proceeds to the shareholders tax-free unless the shareholders have adequate stock basis or debt basis. Since the shareholders receive limited tax benefits from leveraging the real estate inside an S-Corporation, this scenario is unappealing for real estate investors.

No step-up in basis for your beneficiaries.

If you own real estate individually or through a partnership, your heirs may inherit the real estate at its fair market value when you die (this is known as a step-up). They can then sell the property without incurring any (or very minimal) capital gain. However, if you die owning shares of stock of a corporation that owns real estate, there is no step-up available for the real estate. The shares of stock will be passed on at their fair market value, but the real estate inside the corporation will not. If you heirs want to sell the real estate, they will either have to sell the stock of the corporation or will likely incur double taxation if they sell the real estate separately. And you may have a difficult time selling the stock in the corporation. If you decide to sell the stock of your corporation, you will likely run into resistance from potential buyers if there is real estate inside of it. Buyers will generally not want to buy the stock of a corporation that owns real estate because they will not get a step-up in basis for the real estate and they will also be responsible for any mortgages on the property owned by the corporation. Buyers will usually want to buy the real estate only, which may lead to additional tax to the heirs.

Ease of Sale.

LLC's have an extra advantage over an S-corp. (or a C-corp.) where you want to convert a property to personal use, or trade it (called a "like-kind exchange" and subject to special rules) for another home of similar value. If held in an S-corp. the conversion or trade of property would be considered a sale with the accompanying tax consequences. Held in an LLC, there are no tax consequences to converting or trading the property.

Tax-Favored Status.

An S corporation can lose its tax-favored S status if it fails to carefully monitor passive rental income. This risk occurs when an S corporation has prior accumulated earnings and profits at the close of three consecutive tax years and when passive investment income exceeds 25% of gross receipts [see IRC section 1362(d)(3)(A)(i)]. The loss of S corporation status can result in adverse tax consequences. Corporate earnings would be subject to a two-tier tax along with gains from the sale of corporate assets. Gains from the sale of capital assets would be taxed at corporate tax rates. In addition, the personal holding company tax and the excess earning tax penalty might

apply. Even worse for an unsuspecting S corporation, IRC section 1375 provides for a tax on the excess net passive income, computed at the highest corporate income tax rate of 35%. To avoid the imposition of the section 1375 tax and the potential loss of S corporation status, many S corporations distribute their accumulated earnings and profits at the reduced dividend rate of 15% (through 2008). If that is not possible, a recent private letter ruling (PLR 200527013) highlights how, with proper planning, an S corporation’s rental income can escape classification as passive investment income.

[joelgilb]

Nudge ----> easier to accomplish some other tax things, cheaper to operate.

and which entity would this be that you are nudging? S-Corp or LLC?

[jainen]

>>a number of unfortunate circumstances<<

I agree that holding real estate in a small corporation has potential tax disadvantages and other risks. And even if a corporation is chosen for maximum liability protection, the first line of defense should still be excellent insurance.

[MJG CPA]

and which entity would this be that you are nudging? S-Corp or LLC?

Currently, the client is a general partnership, looking to form either an s-corp or an LLC for liability protection.

From a tax and cost standpoint, initially I favored the idea of s-corp due to low cost (in IL). The client has no debt - owns the land outright, so debt basis is of no concern.

The sec 754 election available to the LLC may warrant another look - so that's where I'm at right now.

[joelgilb]

>>a number of unfortunate circumstances<<

I agree that holding real estate in a small corporation has potential tax disadvantages and other risks. And even if a corporation is chosen for maximum liability protection, the first line of defense should still be excellent insurance.

Definitely agree that adequate insurance is necessary in any entity. Courts like to burst the bubbles of protection we create when they see empty shells. Also, would rather see an insurance claim than lose my properties.

One more thing I forgot to say, you can tier the LLC's to protect each property from the others and still have one tax reporting entity. Similar to a consolidated corporation.

Currently, the client is a general partnership, looking to form either an s-corp or an LLC for liability protection.

From a tax and cost standpoint, initially I favored the idea of s-corp due to low cost (in IL). The client has no debt - owns the land outright, so debt basis is of no concern.

The sec 754 election available to the LLC may warrant another look - so that's where I'm at right now.

Glad I could help.

[jainen]

>>you can tier the LLC's to protect each property from the others and still have one tax reporting entity.<<

Although the IRS accepts this position, most states do not allow it. California, for example, has specifically ruled against it. The idea also, once again, triggers my concern that the owner would not be treating the activity as a separate entity, which is the foundation for liability protection.

[joelgilb]

>>you can tier the LLC's to protect each property from the others and still have one tax reporting entity.<<

Although the IRS accepts this position, most states do not allow it. California, for example, has specifically ruled against it. The idea also, once again, triggers my concern that the owner would not be treating the activity as a separate entity, which is the foundation for liability protection.

I believe that CA has recently started accepting Tiered LLCs and besides, the original poster is from Illinois and Illinois allows Tiered LLCs.

Jainen, it appears you are against the LLC. What entity would you suggest and why, to satisfy the issues and concerns that MJG's client has?

[jainen]

>>Jainen, it appears you are against the LLC<<

All I'm against is boilerplate answers.

[joelgilb]

>>Jainen, it appears you are against the LLC<<

All I'm against is boilerplate answers.

I think all I did was provide information for MJG to make her own decision based on her clients needs.

And rather than get antagonistic, I asked you a serious question. What entity do you think works here and why? I am open to listen to your ideas and was seriously soliciting one.

I think you don't like my gray hair...

[jainen]

>>What entity do you think works here and why?<<

Although the client was concerned about liability protection, MJG's original question was about the tax effects. There really isn't enough info to answer either.

In my opinion, the established case law history and formal structure of corporations generally offers greater liability protection. The strengths and weaknesses of limited liability companies have not been fully tested yet. That fact in itself could attract legal challenges, and we can't expect consumer-friendly courts to always give businesses the benefit of the doubt.

You might think MJG's farmland has fairly low risk if there is no public access. My county was the location of that tainted spinach a few years ago, where business operations literally killed people across the country. This week a local organic farmer filed a very big suit about a neighbor's pesticide applications. Damages in cases like this far exceed insurance coverage, and I wouldn't count for protection on some standard form filed in the state capitol. It is best to be able to show that the business entity is clearly separate from the owners, with a life of its own.

The tax question is the same as ever, when you consider that the LLC is a disregarded entity. Any partnership has the choice of being taxed as a corporation, and being an LLC changes that but a little.

And now I'm going on vacation, and won't post anything else for a while.

[RoyDaleOne]

For real estate I nudge to LLC's.

For non-real estate I nudge S Corp elections or C Corp elections.

However, you should review the business plan and act accordingly.

Stock for stock swap going public is in two or three years for a couple billion is a good plan.

It depends on situation as we all know. However for real estate I recommend the LLC structure as a parntership.

The flexability of changing the ownership structure and the allocation of earnings or profits in the future is the reason behind my recommendation.

[joelgilb]

... the established case law history and formal structure of corporations generally offers greater liability protection. The strengths and weaknesses of limited liability companies have not been fully tested yet. ...

This is very true. The lack of case law does mean that there is risk when using LLC for liability protection. Although, the LLC is supposed to be designed to provide limited liability similar to corporations, we are not certain how courts will deal with this issue in every case. Even though we can argue that corporate case law should apply on this issue, the Courts, Judges and Jurys may treat the liability issues differently for this entity. And although, I and a growing bank of attorneys believe that the liability issue will be treated the same, there is no-where near the depth of case law on the LLC entity.

It is one of the things I routinely warn clients about when they request the LLC entity.

It is best to be able to show that the business entity is clearly separate from the owners, with a life of its own.

Totally agree that the determination of the entity for the business operations should be considered separately and that a corporate entity may make the most sense here.

Even before the LLC existed, choice of entity has been a planning issue for both CPA's and Attorney's. Do we separate the business from the real estate? Do we use one entity for one and a different one for the other? And do any of the traditional choice of entities still make sense in a particular situation (ie: Limited Partnerships, General Partnerships, S-corps, C-Corps, Trusts, etc.)? There is no one perfect boiler plate answer to these questions, and every choice does have its own trade offs.

Geesh, I feel like I am spouting off boiler plate answers too.

[michaelmars]

THE long and excellent analysis above left out one other item concerning real estate, refinancing. When you refinance in an llc you put the money in your pocket and walk away. in an S corp you have a taxable event if you take the money out of hte corp. Almost every major RE transaction now a days is either a LLC or a Reit. if you are going to hold and operate it. only if you are going to flip it does an s corp make sense.

[joelgilb]

THE long and excellent analysis above left out one other item concerning real estate, refinancing. When you refinance in an llc you put the money in your pocket and walk away. in an S corp you have a taxable event if you take the money out of hte corp. Almost every major RE transaction now a days is either a LLC or a Reit. if you are going to hold and operate it. only if you are going to flip it does an s corp make sense.

Good catch Mike, sorry I missed that one. And if you have no objection, I am going to plagiarize that point and add it to the letter I tend to send my clients.

[michaelmars]

PLS DO