While most investors own real estate today in the name of an LLC, partnership or S Corporation, there are still those who own property in a C Corporation. A C corporation is a separate taxable entity and pays tax on profits at the corporate level. When a C corporation sells appreciated real estate, it will owe tax on the profit at the corporate tax rate. When proceeds from the sale are then distributed to the shareholders as dividends, the shareholders will also have to pay tax on this income at their personal tax rate. Consequently, due to this double taxation, it is possible that the total tax due from the sale of appreciated real estate in a C corporation could easily exceed 50%.
C Corporation 1031 Exchange
One way to avoid this double tax consequence is for the C Corporation to perform a 1031 exchange. While it is not normally advised to perform a 1031 exchange on the total sale value, this is one situation where it may make sense to consider an exchange on the entire amount.
Converting from C Corporation to S Corporation
Under the 1986 Tax Act, personal rates were reduced and C Corporations were permitted to convert to an S Corporations (a pass-through entity similar to a partnership), thereby avoiding the double tax. Some C Corporation shareholders never took the opportunity to convert and therefore remain subject to double taxation.
A potential solution to eventually avoid the double taxation on the liquidation of real estate in a C Corporation is to convert the C Corporation to an S Corporation. In order to become an S corporation, a C corporation must file IRS Form 2553 with the IRS. This form must be signed by all shareholders, meaning that each shareholder has veto power over conversion from C corporation to S corporation. Approval of Form 2553 by the IRS is routine (not discretionary) as long as the corporation meets the formal eligibility requirements.
Ten-Year Holding Period and Built-In-Gain Tax
A 10-year holding period exists for conversions from C corporations to S corporations. If the S corporation is liquidated prior to this 10-year holding period, a Built-In-Gains (BIG) Tax may be imposed. This tax equals the highest corporate tax rate, currently 35%.
BIG Tax requires a company to measure the amount of unrecognized appreciation that existed at the time an S election is made. Obviously, BIG Tax will not apply to a newly formed S corporation. If a prior C corporation makes an S election, the company needs to measure the fair market value at the effective date of the S election as compared to the tax basis. The amount of unrecognized gain is determined for each asset. The net of unrecognized built-in gains and built-in losses is the company’s unrecognized built-in gain.
The BIG Tax ends after the tenth S corporation tax year. Accordingly, you can avoid the BIG Tax if the unrecognized built in gains are not recognized until after the tenth year as an S corporation.