3. Creating The Corporation Option 1: Contributing Property That Is Already Owned Shareholders will: Own real estate or buy real estate before creating the corporation Contribute such real estate in a §351 transaction, solely in return for stock Any shareholders who do not own property, must contribute cash or other property. Option 2: Gathering Capital To Form The Corporation and Purchase Assets Shareholders: Do not own any property They contribute cash or other property to the corporation in a §351 transaction, capitalizing it with enough money to purchase real estate, solely in return for stock.
4. Personal Holding Company Concerns The corporation cannot be deemed a personal holding company or the tax benefits will be erased What is the effect? Any undistributed Personal Holding Company Income (PHCI) is deemed distributed and taxed at 15% to the shareholders. §541. What is a PHC? PHCI comprises over 60% of adjusted ordinary gross income. §542(a)(1), AND During the last half of the taxable year 50% of the stock is owned by 5 or less individuals, directly or indirectly. §542(a)(2). What is PHIC? Generally, it is passive income and is defined in §543. It will be discussed more in-depth later in the presentation. There are essentially two solutions to avoid PHC classification: The first would be to avoid income classified as PHCI. There is an exception for rental income in §543(a)(2). The second would be to have at least 10 shareholders, owning the corporation in even proportion, avoiding the 50% ownership test.
5. §351 -- Mechanics No Gain or Loss Recognized – §351(a) For the corporation For the shareholder (property transferor) Property Transferred (By Shareholder) – §351(d) “Property” does not include Debt Transferred (or interest on such indebtedness) If the corporation assumes liabilities on the property transferred it will not be considered boot. It will be considered boot if there is a tax avoidance purpose, or a non-bona fide business purpose to the transfer/assumption In any situation, gain will be recognized if the liabilities assumed exceeds the basis of the property transferred. §357(c) Services Solely In Exchange For Stock (Transfer By Corporation) – §351(b) A loss will never be recognized A gain will be recognized (by the shareholder) if the corporation also transfers: “Boot” – cash or other property (such as corporate debt) Constituting Control Under §368(c) Look at control immediately after the exchange Look at the control of all the transferors, not of each individual . Therefore, if four people contribute property, in varying proportions, those 4 must have control as a group, not each individually. §368(c) – 80% of the voting stock; 80% of each additional class of stock Calculating Control When Non-Qualified Property Is Transferred Along With Qualified Property Treas. Reg. §1.351-1(a)(2) – Example 3 – For purposes of control, all the stock received by the shareholder is considered, although gain will still be recognized on the stock given in consideration of the services rendered. “E, an individual, owns property with a basis of $ 10,000 but which has a fair market value of $ 18,000. E also had rendered services valued at $ 2,000 to Corporation F. Corporation F has outstanding 100 shares of common stock all of which are held by G. Corporation F issues 400 shares of its common stock (having a fair market value of $ 20,000) to E in exchange for his property worth $ 18,000 and in compensation for the services he has rendered worth $ 2,000. Since immediately after the transaction, E owns 80 percent of the outstanding stock of Corporation F, no gain is recognized upon the exchange of the property for the stock. However, E realized $ 2,000 of ordinary income as compensation for services rendered to Corporation F.” Treas. Reg. §1.351-1(a)(1)(ii) – Any property transferred must not be a relatively small amount compared to the value of the services performed “Relatively Small Amount” = Less than 10%, therefore, the property transferred must be 10% or more of the services rendered.
6. §351 -- Consequences Basis Shareholder: §358 – Transferred Basis The shareholder’s basis in the stock received is the same as their basis was in the property transferred It will be decreased by any “boot” received It will be increased by any gain recognized (think of a transferor of property and services) Corporation: §362 – Transferred Basis The corporation’s basis in the property is the same as that of the shareholder who transferred such property, Increased by gain realized, if any, by the shareholder in the transfer to the corporation (this will come into play if “boot” is present) Holding Period: §1223(a) Since the basis is determined, in whole, by what it was in the hands of the transferor, the holding period of any property transferred will tack to the corporation, from the transferor-shareholder.
7. §351 and Creating the Corporation – Recap of Concerns Control: Control will be100% if it is just the property transferor, or if they contribute with a group of others, the group as a whole will have 100% control, therefore, qualifying under §351. Services transferred by a shareholder: the services will be taken into account in determining control only if they are not of relatively small value (must be 10% or more) in comparison to the property such shareholder must contribute. The transferor still recognizes ordinary income, to the extent the stock received represents compensation for such services. Gain Recognition on Property Transferred: The shareholder (transferor) will recognize gain when: They transfer property which is subject to liabilities in certain circumstances: Debt on any qualified property may be transferred, but any liabilities transferred in excess of the basis of the property transferred will be treated as gain to the transferor of such property. §357(c). The shareholder will also realize gain if they transfer any non-qualified §351 property, such as solely debt. The shareholder (transferee) will recognize gain when: The corporation transfers property other than stock, or “boot” property (cash or other non-stock property, including corporate indebtedness) to the shareholder.
8. Expenses One-Time Expenses – Capitalized into the basis Legal Fees in Acquiring Property or Defending Title To Property. §1.263(a)-2(c). Improvements that prolong the property’s useful life, substantially beyond the tax year. §1.263(a)-2(a). Recurring Expenses -- Deductible Business Expenses -- §162 Reasonable Salaries Officer Compensation If you make the officers independent professionals you would hire anyway, you can save money. For example, if you hire a lawyer, accountant, fiduciary, etc., you can pay them a salary as an officer opposed to a fee as an independent contractor. Hire a full-time super? Any reasonable compensation given to the super is a deductible expenses Office Expenses Interest Payments -- §163 Expenses Paid to market to potential lessees Improvements That Do Not Prolong The Property’s Useful Life In other terms: improvements that merely keep the property functional
9. Sources of Income Income from the sale of property This will not be frequent income; it will happen if the property is sold There is also the possibility of doing a tax-free like kind exchange under §1031. It is not Personal Holding Corporation Income (PHCI) Dividends from Stock Ownership Classified as PHCI. §543(a)(1). Derived From Investment in Stocks The corporation will likely own stock of less than 20% in a distributing corporation, therefore the deduction will be 70%. Rental Income Classified as personal holding income under §543(a)(2). There is a significant exception though under §543(a)(2) that excludes it from PHCI classification. The following two requirements must be met. The sum of: Rental Income must constitute 50% or more of ordinary adjusted gross income, AND Dividends paid to the corporation minus dividends paid by the corporation - is 10% or less of ordinary gross income (unadjusted) Are the dividends retained in the corporation less than 10% of gross income?
10. Depreciation Deductions Depreciation deductions are allowed to account for the wear and tear on the property. §167(a). Residential Rental Property and Non-Residential Real Property Used in a trade or business is subject to the straight line depreciation method. §168(b)(3). Residential Rental Property has a useful life of 27.5 years. §168(c) Non-residential Real Property has a useful life of 39 years. §168(c) Both use the mid-month convention. Therefore, in the month the property is put in service or disposed, such property will be treated as put in service of disposed of in the middle of such month. §168(d). Depreciation can only be taken on the building, not the land. Treas. Reg. §1.167(a)-5.
11. Dividends Currently taxed at a 15% rate. §1(h) Dividends should not be given, unless necessary. The corporation should act like a long-term investment tool. Dividends can be given, but the more dividends that are paid will deteriorate the tax shelter. Dividends may be needed to avoid PHCI characterization for some of the income, but planning should prevent this. The examples at the end will show some of the effects of making dividends Dividends will certainly hurt the tax benefits, but they won’t erase them all, necessarily. For example, if the corporate income is taxed at 15%, along with the dividend payment, the total tax will be 30%. Any taxpayer at a 33% marginal tax rate, or above, will realize the tax benefit still, although greatly minimized.
12. Stock Transfer and Liquidation As mentioned before, this is a long-term business. Nonetheless, there are essentially two options if you do want to get out early. First, there is liquidation, but this may ruin the tax benefits, because realizing a certain amount of gain on the sale of property can put the corporation into a higher tax bracket. Any corporate income in excess of $75,000 is taxed at a 34% Corporate income between $50,000 and $75,000 is taxed at 25% Corporate income up to $50,000 is taxed at 15% Second, you could sell the stock to another party. Here, a few options come into play, including the possibility of a tax free merger, but if it were sold for cash the shareholder would recognize the gain taxed at the capital gains rates. It would be taxed at 15% if held for over a year. The other option is to treat this business as a family business, which is recommended. If treated as so, the stock will be transferred upon death to the taxpayer’s heir. This maximizes the tax benefits of the corporation by erasing all the built-in gain on the stock for tax purposes. The heir will receive a basis in the stock of its FMV at the taxpayer’s day of death. Therefore, if the home has appreciated $200,000, such appreciation will be taken into account in the stock’s FMV. When the basis “steps-up” from the taxpayer’s adjusted cost basis, to the heirs FMV basis, the $200,000 of appreciation reflected in the stock is completely sheltered, becoming tax free. The stock can then be sold by the heir with minimal gain, creating minimal tax liability.
13. Examples David owns a piece of property with a FMV $320k, and he has an adjusted basis in the property of $220k, subject to a $40k mortgage. David, Dean, and Duncan create the corporation DDD Rentals. David contributes his property, Dean contributes $140k in cash, and Duncan contributes $135k in cash and $5k of legal services. Under §351, David will realize no gain and receive $280k, or 1/2 of the corporation’s stock. Dean will receive a 1/4 of the stock in return for his cash contribution. Duncan will receive 1/4 of the stock and will realize 5k of ordinary income in compensation for his legal services. DDD Corporation purchases another piece of property for $200k, expending $10k for legal services. They pay $12.5k for maintenance repairs They have 5k in miscellaneous expenses. They invest $50k in stocks. DDD Corporation has $40k in rental income from the two properties. They also have $3k income from the sale of their investments, along with $1k in dividends. In total, they have $44k of unadjusted gross income. DDD Corporation may take a deduction on their expenses $12.5k in repairs and 5K of business expenses. They must capitalize the legal fees spent in purchasing the property in their basis, making it $210k. With the deductions taken into account DDD Corporation has $19k of gross income. They also get $7.5k in depreciation deductions. They also receive a 70% dividend received deduction, totaling $700, and lowering their adjusted gross income to $18,300. This will be taxed at a 15%, totaling $2,645. DDD Corporation will take home $15,635 for the year. The corporation received $1k in dividends. This is under 10 % of ordinary gross income (4.4k). Therefore, it no dividends need to be paid out under §543. If they were taxed at individual rates they would have paid a tax of: $6,650 at 35% $6,270 at 33% $5,320 at 28%.
14. Examples The following year DDD Corporation spends $2k in repairs,$5k in miscellaneous expenses, and they invest $10k into stocks. They receive $45k in rental income, $4k in income from the sale of investments, and $6k in dividends. The dividends paid are in excess of 10% of ordinary gross income (5.5k), so DDD must pay out dividends to avoid PHCI classification. 10% of ordinary income is $5.5k, therefore DDD must dividend out at least $500. Assuming they do, this is taxed at a 15% rate to the individuals, totaling a liability of $75 for the individuals. DDD can deduct $7k spent on business and repairs and $6k of depreciation from their $45k of rental income, totaling $32k. They also have $10k of income from their investments, totaling $42k. Their dividends grant them a 70% deduction, totaling $4.2k, bringing their adjusted gross income to $37.8k. This is taxed at 15%, creating a $5,670 liability. DDD takes home $32,130 at the end of the year. They paid a total of $6,170 (including the individual liability on the dividend distribution) in taxes for the year. At individual rates they would have paid: $14,770 at 35% $13,860 at 33% $11,760 at 28%.
