Protecting Business Real Estate from Creditors and Taxes

Question: I intend to purchase real estate for the business operated by my S corporation. Should I purchase the property in the corporation’s name?

Answer:  Many business owners create separate entities to own their business real estate.  Business operations are inherently risky and separating real estate ownership from business assets can prevent valuable real estate assets from being subject to the claims of business creditors.  In situations such as yours, business real estate property is often purchased in a separate entity and leased to the operating entity. By leasing the real estate to the business pursuant to a bona fide lease, the business creditors are generally unable to reach the equity of the leased real estate.

As for purchasing real estate in a S corporation, it is relatively easy from a tax perspective to transfer real estate into a corporation and often difficult to transfer the property out of the corporation.   The distribution of non-cash assets from a corporation to its shareholders is treated for tax purposes as if the assets were sold.  If the corporation’s real estate property has appreciated in value which is often the case over a long-term period, the S corporation must report gain upon the corporation’s distribution of the property to the shareholders.  The gain is based on the difference between the fair market value of the real estate at the time of the distribution and the corporation’s basis in the property.  The gain passes through to the shareholders and is reportable and taxable to them on their personal income tax returns.  The shareholders in turn increase the tax basis of their S corporation stock equal to the amount of the gain they report.  While the basis increase prevents the gain from being reported and taxed a second time when the property is sold, gain must nevertheless be reported on a distribution in which no cash is received.  

A better alternative is to purchase the real estate through a non-corporate entity such as a limited liability company (“LLC”).  Whether one or more persons own the LLC, the distribution of the real estate or other appreciated assets out of the LLC will generally not create the same tax consequence that arises on a distribution of appreciated assets from a S corporation.  The LLC can lease the real estate to the S corporation operating the business pursuant to a bona fide lease which will likely prevent the LLC assets from being subject to the claims of the creditors of the operating entity.  Essentially, you will enjoy the same creditor protection as if a S corporation owned the real estate but without the adverse tax consequence.

Assets such as real estate are valuable and do not carry the same risks as business assets. Oftentimes, business owners are unable to ultimately liquidate their business interests at a profit and must rely on other assets to sustain themselves. To the extent that real estate is purchased and leased to a closely-held business, the appreciation in real estate over an extended time period may provide an alternative source of funds for the business owner without being subject to the claims of business creditors.

The Tax Corner addresses various tax, estate, asset protection and other business matters.  Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to bruce.bell@sfnr.com.