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Subchapter S Corp to give Tenant In Common Interest to Shareholder

Last post 08-29-2007 11:15 AM by Bill Exeter. 8 replies.
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  • 08-25-2007 8:54 AM

    Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Is it possible to give a Shareholder a Tenant In Common interest in the real estate held by a Sub S Corp in exchange for the shareholder's shares prior to the sale of the real estate to help facilitate a 1031 exchange for the remaining shareholders?

    • Post Points: 16
  • 08-25-2007 12:04 PM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Hi Sam,

    There are a couple of potential issues that need to be addressed here.  The first issue, which I will address, is structuring the transaction so that it will qualify for 1031 exchange treatment.  The second issue is whether deeding the property out of the S corporation will create any corporate taxation such as a liquidating dividend, etc.  I will ask Tim Folkers, CPA to address this issue.

    First, the answer to your question is yes, you can accomplish what you are tyring to do.  This transactional structure is what we refer to in the 1031 exchange industry as a drop and swap.  You deed the property out (drop) of the S corporation into the individual shareholder(s) name as a tenant-in-common and the tenant-in-common can not treat his or her interest in the real estate as their own and proceed as they desire including pursuing a 1031 exchange (swap) upon the sale of the property.  There are, however, a few additional steps that should be taken before proceeding with a 1031 exchange, including checking with your tax advisor to ensure that you do not create any other corporate taxation issues.

    The most important concept here to understand is that the taxpayer completing a 1031 exchange must have the intent to hold the property as investment property, so the shareholder(s) receiving the deeded interest in the real property should treat the property as their investment property, including reporting it on their own individual income tax return as investment real estate.  The majority of tax advisors recommend that the shareholder (now a tenant in common or TIC) hold title for at least 12 or more months in order to demonstrate they did in fact have the intent to hold the property for investment.  Remember, the S corporation has held title for quite sometime, but the shareholder (a different taxpayer) just received title to the real property through the drop. 

    Taxpayers that drop the property out of the S corporation and then immediately turn around and complete a 1031 exchange (swap) run a huge risk that the tax-deferred exchange would be disqualified under audit because they did not hold the property sufficiently long enough to demonstrate their intent to hold for investment purposes.  You may not have a choice, but you will be assuming a substantial risk during an audit. 

    There may be other solutions depending on the other shareholders' goals and objectives and their willingness to cooperate.  You could structure a swap and drop, which is essentially the opposite of the above transaction if the other shareholders are all willing to stay together for 12 to 18 months.  This is essentially completing the 1031 exchange (swap) inside the S Corporation where the S corporation sells the relinquished property and the S corporation acquires one or more like-kind replacement properties and holds these properties for 12 months or more to complete the 1031 exchange transaction.  The properties could then be deeded (dropped) to the various shareholders after the 12 to 18 months has passsed. 

    There are many versions of this, so you should make sure that you have a good legal and tax advisor and an expert Qualified Intermediary that has experience in structuring these transactions such as Exeter 1031 Exchange Services, LLC. 

    Tim, can you comment on the corporate taxation issue?

    William L. Exeter
    President and Chief Executive Officer


    Exeter 1031 Exchange Services, LLC
    A Qualified Intermediary (Accommodator) for 1031 Exchanges

    Exeter Fiduciary Services, LLC
    A Private Professional Fiduciary Services Company

    Exeter IRA Services, LLC
    Third Party Administrator for Self-Directed IRAs


    1031 Tax Deferred Exchanges
    Self-Directed IRAs
    Private, Professional Fiduciary Services

    (619) 239-3091
    • Post Points: 1
  • 08-27-2007 9:45 PM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Sam -

    You're question requires additional information about your S-Corporation.   Please seek the advice of your CPA and have him research your situation specifically.   Basically if you distribute amounts greater than your stock basis + your share of earnings & profits will be treated as a short term or long term capital gain.   The amount of the distribution is the current fair market value at the date of the distribution; therefore the drop and swap from an S-Corporation will not work unless the property is equal or less in value than the basis held by the S-Corp.  

    With real estate you will want to get an appraisal to prove the value at the date of distribution.

    In this situation you would want to complete the exchange in the S-Corporation and ideally hold the exchanged property in the S-Corp.   Check with your CPA to determine if there is a way to buy out the other shareholders interest in the S-Corp.

    Quoted From CCH 

    When property other than money is distributed, its value is the fair market value on the date of distribution, not its basis to the corporation. Distributions that are deemed to have been paid from corporate earnings and profits are taxed as dividends (ordinary income to the shareholder) unless the income has already been taxed under the S corporation rules.

    Earnings and profits

    If an S corporation has earnings and profits and it has not specifically elected to distribute them first, any distribution it makes is treated as coming first from previously taxed earnings of the S corporation. Previously taxed earnings of an S corporation are tracked through an account called the accumulated adjustments account (AAA). A distribution that exceeds the corporation's previously taxed earnings is taxed as a dividend to the extent of the corporation's earnings and profits. Amounts exceeding both previously taxed earnings and earnings and profits are treated as a return of capital under the rules for corporations with no earnings and profits.

    The sources, their order of application, and their tax effects are as follows:

    (1) A nontaxable return of capital up to the amount of the corporation's AAA. The AAA is reduced by the amount of the distribution that is treated as coming from it. If distributions during the tax year exceed the AAA at the close of the tax year, the AAA is allocated to each distribution made during the tax year.

    (2) If the S corporation shareholder has previously taxed but undistributed income that was accumulated prior to 1983, the previously taxed income is the next source for distribution up to the amount of the shareholder's previously taxed income account. A distribution of previously taxed income is nontaxable. The shareholder's previously taxed income account must be reduced by the amount of previously taxed income that is distributed.

    (3) A distribution of earnings and profits that is taxable as a dividend up to the amount of the shareholder's share of earnings and profits.

    (4) A nontaxable return of capital up to the amount of the shareholder's basis remaining in the S corporation stock. The shareholder must reduce the basis of this stock by the amount of the distribution that is treated as coming from it.

    (5) If the amount of the distribution is more than the total of the previous four sources, the amount of the excess is a gain from a sale or exchange of property. As such, the excess will be a long- or short-term capital gain.

    Timothy J Folkers, CPA
    Principal
    Folkers, Choi & Associates
    An Accountancy Corporation
    18818 Teller Ave., Suite 109
    Irvine, CA 92612
    (949) 399-1040 ext 126 -Direct
    (949) 399-1041 fax
    Tim@FCA-CPA.com
    www.FCA-CPA.com

    TAX ADVICE DISCLOSURE

    To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.
    • Post Points: 7
  • 08-28-2007 8:26 AM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Tim,

     Does the dropped shareholder receive a gain or the corporation?  Because the corporation gained nothing it deeded assets and received stock in return.  The individual that dropped received the property of greater value.

    • Post Points: 13
  • 08-28-2007 8:47 AM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Sam,

    Let's start looking at alternatives.  How many shareholders are there?  What are their individual objectives?  Is there only one shareholder that wants to complete a 1031 exchange?  Does the S corporation own any other assets or have any other operations other than the property being sold?

    William L. Exeter
    President and Chief Executive Officer


    Exeter 1031 Exchange Services, LLC
    A Qualified Intermediary (Accommodator) for 1031 Exchanges

    Exeter Fiduciary Services, LLC
    A Private Professional Fiduciary Services Company

    Exeter IRA Services, LLC
    Third Party Administrator for Self-Directed IRAs


    1031 Tax Deferred Exchanges
    Self-Directed IRAs
    Private, Professional Fiduciary Services

    (619) 239-3091
    • Post Points: 7
  • 08-28-2007 9:42 AM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Sam - the shareholder that receives the distribution picks up the majority of the gain.   However, the S-Corp's equity accounts are also affected so this transaction has to be looked at closely by your CPA.  If the shareholder that received the distribution plans to complete a 1031 exchange they would have just blown the opportunity and would have a tax basis (because of the distribution) equal to the fair market value.

    You should run this transaction by your CPA and have them prepare a comparison of various scenarios.

    Timothy J Folkers, CPA
    Principal
    Folkers, Choi & Associates
    An Accountancy Corporation
    18818 Teller Ave., Suite 109
    Irvine, CA 92612
    (949) 399-1040 ext 126 -Direct
    (949) 399-1041 fax
    Tim@FCA-CPA.com
    www.FCA-CPA.com

    TAX ADVICE DISCLOSURE

    To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.
    • Post Points: 1
  • 08-28-2007 9:48 AM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    Sam -

    From your original post - is it possible for the remaining shareholders of the S-Corp to buy out the shareholder that does not wish to complete a 1031 exchange?   This way you would have a purchase / sale of stock separate from the distribution of a TIC interest in the real estate.   Also, you may be able to bring in another party to buy out the interest of the dissenting shareholder.  

    These options may be cleaner with relation to the sale and exchange of the property. 

    Timothy J Folkers, CPA
    Principal
    Folkers, Choi & Associates
    An Accountancy Corporation
    18818 Teller Ave., Suite 109
    Irvine, CA 92612
    (949) 399-1040 ext 126 -Direct
    (949) 399-1041 fax
    Tim@FCA-CPA.com
    www.FCA-CPA.com

    TAX ADVICE DISCLOSURE

    To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication, unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.
    • Post Points: 1
  • 08-28-2007 11:15 PM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    There are 6 shareholders 1 shareholder with 25% interest wants to leave the corporation and is OK with paying the Tax.  The others want to stay together and purchase another property.  The sum to pay this one person for his interest is too large so we are looking to deed the 25% interest in the real estate for the 25% in stock.  The corporation holds title to only 1 property for the past 3 years. 

    • Post Points: 7
  • 08-29-2007 11:15 AM In reply to

    Re: Subchapter S Corp to give Tenant In Common Interest to Shareholder

    I was hoping it was something like this.  There is a strategy that could work for you, but it will take some careful planning with your tax advisors so that you do not create other income tax issues. 

    Liquidity is the problem in your situation until your property sells, so we need to find a way to "cash out" the 25% shareholder without creating a liquidating dividend event.  The problem is actually not that uncommon and we have developed a strategy to work around the issues involved.  It is important that you do not just take the strategy and "run" with it, but that you carefully and proactively work through it with your legal and tax advisors. 

    The strategy involves two (2) parts. 

    The first is the sale of the 25% interest back to the S corporation.  The purchase price should be relatively easy to figure out since the corporation does not have any other assets or operations.  The corporation would pay for the 25% interest by carrying back a note that would be secured by the subject real estate.  There are of course possible variations here depending your specific situation and income tax issues, so I can not stress how important it is to meet with your legal and tax advisors before proceeding.  The outcome is that you now have bought out the one shareholder that does not want to stay with the group and the remaining shareholders can complete the 1031 exchange at the S corporation level. 

    The second part of the strategy is the sale of the property using a 1031 exchange.  The property would continue to be owned by the S corporation, would be sold in the name of the S corporation, and the S corporation would structure the 1031 exchange and complete the transaction all the way through.  The note would be paid off at the close of the relinquished property sale. 

    The shareholder that was bought out would pay taxes and the S corporation would defer the taxes through the 1031 exchange. 

    William L. Exeter
    President and Chief Executive Officer


    Exeter 1031 Exchange Services, LLC
    A Qualified Intermediary (Accommodator) for 1031 Exchanges

    Exeter Fiduciary Services, LLC
    A Private Professional Fiduciary Services Company

    Exeter IRA Services, LLC
    Third Party Administrator for Self-Directed IRAs


    1031 Tax Deferred Exchanges
    Self-Directed IRAs
    Private, Professional Fiduciary Services

    (619) 239-3091
    • Post Points: 1
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