C Corp since the 1963s, clients want advice

A family of three shareholders are the surviving shareholders in a small strip mall that files as a traditional corporation.

They have retained earnings of $218,000 and an outstanding loan of $176,000.

The corporation earns about $25,000 per year in rental net profit.

Their prior preparer told them that they couldn't take distributions because of the loan - and this advice may have been given back when the retained earnings were less than the loan.

They are asking me:

1) Can they take distributions
2) How they can avoid the double taxation on them
3) How to fix the double taxation issue for the future.

I'm thinking:

1) Yes but not to exceed the loan?
2) Can't - but pay off the loan with the retained earnings instead?
3) Convert to a multi-member LLC taxed as a partnership - but that will cause a large realized gain and tax on the remaining retained earnings after the loan is paid off?

These days that's a bit unusual set of facts. But maybe with a better description we can answer.

You speak of 3 related surviving shareholders. How related? Basis of their stock? FMV of stock?

Is the 176k loan from an outside lender? Is it secured by the mall?

Are the retained earnings close in amount to the accumulated E&P?

What's the tax basis and what's the FMV of the mall?

How much cash do they have?

Who manages the mall and how much are they paid for that?

Are the shareholders active in the business and do they take compensation?

Does the loan restrict them from paying distributions, as you seem to imply?

Did the restriction stop when retained earnings exceeded the loan balance?

Are any major expenditures contemplated?

There may be more questions. We may not need all the answers. But it's good to have the facts.

And are the shareholders eligible S corporation shareholders?

The built in gains would be enormous! Usually the only hope is death in this situation where you can arguably step up the basis in the stock to the underlying value of the properties. But you've got three s/h's.

if the shareholders' income is pretty low, the LTCG rate on qualified dividends might result in zero federal tax.

Can the shareholders take any sort of 1099 fees (directors' fees, etc.) as a deduction to the corporation ?

Planning consideration - make S Election now, wait for BIG period to pass, wait for step-up on death and then liquidate S Corp after BIG period is passed (convert to LLC, gain on property distribution would be offset with capital loss on stock disposition). Gets rid of the double-tax issue on annual rental earnings, and fixes the future problem on property sale (5 years from now).

Rental property probably wouldn't be eligible for any of the small-business stock gain exclusions.

A couple questions - what is the FMV of the property? What is the specific issue with the loan?

These days that's a bit unusual set of facts. But maybe with a better description we can answer.

You speak of 3 related surviving shareholders. How related? Basis of their stock? FMV of stock?

Is the 176k loan from an outside lender? Is it secured by the mall?

Are the retained earnings close in amount to the accumulated E&P?

What's the tax basis and what's the FMV of the mall?

How much cash do they have?

Who manages the mall and how much are they paid for that?

Are the shareholders active in the business and do they take compensation?

Does the loan restrict them from paying distributions, as you seem to imply?

Did the restriction stop when retained earnings exceeded the loan balance?

Are any major expenditures contemplated?

There may be more questions. We may not need all the answers. But it's good to have the facts.

A couple questions - what is the FMV of the property? What is the specific issue with the loan?

Siblings. Outside lender, secured by the mall.

Dad formed the c corp which bought the property for $50,000. Perhaps it was worth $1,200,000 when he died and the shares went to the 3 kids.

Now it's perhaps worth $1,400,000.

There is a paid property manager. They are all 98% passive owners. They have a meeting or two each year and one shareholder hires a bookkeeper/tax preparer. Very little admin.

The last preparer told them that having the loan meant that "for tax purposes" they couldn't take distributions. One one hand, I think the tax preparer is confused about another rule. On the other hand, I don't want to judge him because I know so much less than I should about c corporations.

Planning consideration - make S Election now, wait for BIG period to pass, wait for step-up on death and then liquidate S Corp after BIG period is passed (convert to LLC, gain on property distribution would be offset with capital loss on stock disposition). Gets rid of the double-tax issue on annual rental earnings, and fixes the future problem on property sale (5 years from now).

This is what I was thinking. Just elect and pay. They are going to have to take the dividends on all of the retained earnings when they elect, right?

Planning consideration - make S Election now, wait for BIG period to pass, wait for step-up on death and then liquidate S Corp after BIG period is passed (convert to LLC, gain on property distribution would be offset with capital loss on stock disposition). Gets rid of the double-tax issue on annual rental earnings, and fixes the future problem on property sale (5 years from now).

This is what I was thinking. Just elect and pay. They are going to have to take the dividends on all of the retained earnings when they elect, right?

There is no tax or deemed income from making the S Election; dividends are only triggered if distributions are made in excess of AAA (***the TCJA made this a bit more complicated, I haven't looked at this in the last couple years).

Once the corporation is outside the BIG period, there is no tax at the C Corp level once the property is disposed of.

What state is the corporation / property in? May want to confirm how the state treats C Corps making S elections.

The rental net profit on a $1,400,000 value property is $25,000?

There is no tax or deemed income from making the S Election; dividends are only triggered if distributions are made in excess of AAA (***the TCJA made this a bit more complicated, I haven't looked at this in the last couple years).

Once the corporation is outside the BIG period, there is no tax at the C Corp level once the property is disposed of.

What state is the corporation / property in? May want to confirm how the state treats C Corps making S elections.

So a c corp can make $200,000, keep it in the bank without distributing it, and then elect s corporation taxation and the shareholders can then take it tax free?

Am I perhaps confusing AAA with retained earnings? Again, my apologies for my lack of experience with C corporations. I'm sure I knew this when I passed the EA exam, but with no life experience for several years after, I dumped it. It's embarrassing.

The rental net profit on a $1,400,000 value property is $25,000?

Very typical in Honolulu. Not much land supply and high demand. Add an inability for local businesses to make enough profits to cover the rent.

An upper-middle class residence runs about 1.4 million as well.

So this place must be pretty small - or perhaps I'm under estimating its FMV.

C Corp earnings come out as dividends, unless they are liquidating distributions. AAA refers to S Corp earnings - those come out tax-free, since the S Corp earnings are taxed at the individual shareholder level. In your example, the $200k distributed out would be a taxable dividend.

I dig HenryDavid's thinking....since it's unlikely you'll convert any assets since they're real estate, you can avoid the BIG....that idea has merit.

Please forgive my ignorance, but converting in your example still triggers tax on the $218,000 but avoids the gain on the property (until disposed of)?

If so, that does sound like a great option.

No, converting creates no tax. When I said converting assets, I meant selling....effectively. BIG raises problems with cash to accrual conversions and C to S, since AR is immediately collected, inventory sold, etc. triggering the BIG tax. It's not a huge deal, since they would have paid the C corp rates on that income anyway....but if you're trying to avoid it, you can't convert/sell/collect anything on your assets. Real estate here would presumably be held...and I think the BIG period is down to 5 years now? So if you hold everything for that period after electing S status, all taxes will then drain down to the S/H's depending on what your state does. They're still free to take distributions, no problems....those are current profits. You have a separate thing to consider what to do with the retained earnings of the C....you can pay those out as dividends at 15% or less plus your state, which is a nice deal. And you don't have to actually pay them, you can elect to have paid them, issue the 1099DIV and now they're just part of previously taxed money in the S that you can distribute at any time.

If none of this makes sense, I'd strongly suggest you connect with a more experienced tax guy who's been thru this a few times. It's not tricky...but you need a map.

I wonder where actionbsns is in HI....just checked, she's on the big island. No help there....

If you do decide to elect S, you should definitely get rid of the Accumulated E&P. You do not want a passive activity (the only corporate activity) inside an S corp with Accumulated E & P due to the additional tax and also possibly having S status revoked in three years.

Thanks, I totally agree, and I will definitely refer them away for this, though it's hard to find people

If you do decide to elect S, you should definitely get rid of the Accumulated E&P. You do not want a passive activity (the only corporate activity) inside an S corp with Accumulated E & P due to the additional tax and also possibly having S status revoked in three years.

Absolutely, thanks for pointing this out - don't want to blow the S Election in the future! Can't have undistributed E&P in the S Corp for more than 3 years if the S Corp is only generating passive income.

So if I have to get rid of that anyway - can't I have them pay out the dividends, eat the tax on it, and elect s corp taxation once the retained earnings are at zero? Or would I be doing them a disservice?

Not in my opinion - gets them on the right footing sooner to get out of double tax on the sale of the property (but you should explain it to the client)

Thanks to all of you and your help!

I'll find someone to back me up and I'll handle it with them. I will be sure to disclose the BIG limitations very carefully to the clients.

You don't have to pay out the divs first, tho'. But Seaside's caution is important...you don't want those sitting there with only passive income.