The S corporation was borne in 1958, after the Senate and President Eisenhower developed its pass-through tax provisions. Due to its limited liability and pass-through income tax provision, it was a popular entity to hold real estate in the 1960’s and 1970’s before the states began to introduce LLCs in 1977. Accordingly, many older investors and their heirs may hold appreciated real estate in an S corporation.
The key tax disadvantage of a S corporation, in contrast to an LLC, is that when appreciated property is distributed or sold there is a capital gains tax on the appreciation at the entity level that passes through to the shareholders. When considering the most tax-advantaged way to distribute appreciated real estate from an S corporation, several factors must be considered.
S Corporation Rules:
· The S corporation may conduct a like-kind exchange for the sale of the entity’s real property and continue to indefinitely defer tax on capital gains under IRC § 1031.
· The S corporation recognizes gain on the distribution of appreciated property as if the property were sold at its fair market value (IRC § 311(b)).
· This gain is passed through to the shareholders (both father and son based on shareholder interest), increasing their basis in the S corporation shares (IRC § 1366).
Stepped-Up Basis:
· The heir’s shares will receive a stepped-up basis to the fair market value at the date of death under IRC § 1014(a).
Distributions to Shareholder Heirs
When considering the most tax-advantaged way to distribute appreciated real estate from an S corporation to the heirs of a deceased shareholder (the father), who have inherited shares with a stepped-up basis, there are several strategies to consider:
Potential Strategies:
a. Redemption of Shares
Redeem the father’s shares by distributing 50% of the real estate (50% of the DSTs in the portfolio) to the heirs.
b. Liquidating Distribution
Liquidate the father’s interest in the S corporation by distributing 50% of the real estate (50% of the DSTs in the portfolio) to the heirs.
c. Continuing to Keep all DSTs in the S Corporation with Future Section 1031 Exchanges
Consider keeping all DSTs in the S corporation and continuing to Section 1031 like-kind exchange until son’s children (grandchildren) receive a stepped-up basis on 100% of the S corporation shares when son passes.
a. Redemption of Shares:
Tax Consequences:
· The S corporation recognizes gain on the DST real estate which are distributed.
· The gain increases the basis of the remaining shareholders, including the son.
· The heirs receive the real estate with a stepped-up basis equal to its fair market value.
· Potential capital gains tax on the appreciated value.
Advantages:
· Heirs receive the DST real estate directly and free of the S corporation tax on further appreciation.
· Step-up in basis minimizes future capital gains tax on subsequent sale by heirs.
Disadvantages:
· Son realizes pass-through capital gains tax on his percentage interest of the DSTs that were distributed (50%) as entity gain is passed through to shareholders ratably per share interest.
· Possibility of deferring this capital gain by investing the gain (or a portion of the gain) into a Qualified Opportunity Zone (QOZ) fund within 180 days of the distribution (IRC § 1400Z).
b. Liquidating Distribution:
Tax Consequences:
· Similar to redemption, the S corporation recognizes gain.
· The gain increases the basis of the remaining shareholders.
· The heirs receive the real estate with a stepped-up basis.
· Liquidation could involve additional administrative complexities.
Advantages:
· Direct transfer of real estate to heirs with stepped-up basis.
· Simplifies ownership structure if heirs do not wish to continue with the S corporation.
Disadvantages:
· Son realizes pass-through capital gains tax on his percentage interest of the S corporation’s gain at the time of liquidation (50%) as entity gain is allocated to shareholders ratably per shareholder interest.
· Possibility of deferring this capital gain by investing the gain (or a portion of the gain) into a Qualified Opportunity Zone (QOZ) fund within 180 days of the distribution (IRC § 1400Z).
c. Continuing to Keep all DSTs in the S Corporation with Future Section 1031 Exchanges:
Tax Consequences:
· The S corporation exchanges the appreciated real estate for similar property, deferring the recognition of gain.
· The corporation retains ownership of the new property, and son’s heirs ultimately receive shares with a stepped-up basis.
Advantages:
· Defers all capital gain tax on the appreciation of the real estate.
· Retains investment in real estate without immediate tax liability.
· Son’s heirs (grandchildren) ultimately receive a stepped-up basis on 100% of the S corporation shares and S corporation is liquidated with no tax consequences.
Disadvantages:
· Does not result in direct distribution of real estate to heirs.
Recommended Strategies:
Given the goal of minimizing tax liability, directly benefiting the heirs, and the desire to free some of the real estate from the S corporation at father’s passing, redeeming the father’s shares by distributing the appreciated DST real estate, appears to be the most tax-advantageous approach:
a. Steps:
· The S corporation redeems the father’s shares by distributing the appreciated real estate to the heirs.
· The S corporation recognizes gain on the distribution.
· The gain increases the basis of the remaining shareholders.
· The heirs receive the real estate with a stepped-up basis equal to its fair market value.
· If desired, the gain passes through to the son is deferred by reinvesting in a QOZ fund.
b. Benefits:
· Direct transfer of real estate to heirs.
· Heirs receive the father’s DST property with a stepped-up basis, minimizing future capital gains tax.
· Simplifies estate and tax planning for the heirs.
If there is no desire to free the DSTs from the S corporation, the most tax advantaged strategy is to keep all the DSTs in the S corporation until the son passes and his heirs (father’s grandchildren) liquidate the S corporation with a full stepped-up basis and no tax exposure.
In conclusion, by following this strategy, the heir (son) benefits from the stepped-up basis and the direct transfer of real estate, potentially reducing future tax liabilities but must realize capital gains tax based on the FMV of the DSTs at the time of the distribution and based on his ownership interest in the corporation. Alternatively, if there is no desire to free the DSTs from the S corporation, the most tax advantaged strategy is to keep all the DSTs in the S corporation until the son passes and his heirs (father’s grandchildren) could liquidate the corporation with a full stepped-up basis.
Tax Code References: IRC § 1014: Basis of property acquired from a decedent; IRC § 311(b): Gain or loss on the distribution of property by a corporation; IRC § 1366: Pass-through of items to shareholders; IRC § 302: Redemption of stock; IRC § 1400Z: Qualified Opportunity Zones.
Court Cases:
General Utilities Doctrine (Repealed):** Historically, S corporations could distribute appreciated property without recognizing gain (General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)). However, this doctrine was repealed by the Tax Reform Act of 1986.
Estate of Schuler v. Commissioner, 282 F.3d 575 (8th Cir. 2002):** The court held that gain recognized by the S corporation on the distribution of property is passed through to shareholders.