S Corp with Real Estate Exit Plan

This is a discussion tailor made for JR1!

I have a client with an "S" Corp that holds real estate as well as a successful business that uses the property. The shareholders (H&W) are contemplating retirement and are looking for options. We all know the reasons why the real estate should have never been placed in the Corp but it is what it is.

The financial advisors are wondering about distributing the property to the shareholders, presumably so that rent could be charged to the Oldco or the eventual sale of the business. I have briefly discussed the tax ramifications (not pretty) of a simple distribution. What I'm thinking is maybe a corporate spinoff with the Newco holding the business operations and the Oldco retaining the real estate. I know there are some issues with such a transaction but am wondering if anyone has been down this road?

Basic info:

FMV of RE $1mil
Basis of RE $40k

Why not just sell the biz assets and keep the real estate in the corp until someone dies? Sorry, that's the usual exit plan....

I do seem to think there may be a reorg for busting up one corp into two....but it'll accomplish the same thing. I think I'd wait until you see how the biz sale goes....and sometimes a buyer comes along that wants it all anyway and is willing to pay for it.

Why not just sell the biz assets and keep the real estate in the corp until someone dies? Sorry, that's the usual exit plan....

I do seem to think there may be a reorg for busting up one corp into two....but it'll accomplish the same thing. I think I'd wait until you see how the biz sale goes....and sometimes a buyer comes along that wants it all anyway and is willing to pay for it.

Unfortunately life is never that simple. There could be a child of the SH's who keeps the business in which case separating out the RE becomes more important due to considerations of other children who are not in the business.

A potential buyer may not want the RE, which I guess would be a good thing. Or at least simpler.

Shareholders are young and looking for future cash flows is a big part of the decision.

Like you said, "it is what it is", so let's back up. Actually, back up twice if FMV is $1million and tax basis is $40k and this is being considered. Why do the financial advisors want the property out of the S Corp? What's the objective? Furthermore, what's the long-term goal for the property? Furthermorer, why would financial advisors be advisoring on this?

I know there's a reorg for that, had two brothers in similar situation years ago. Don't recall what it is....

Someone here will know.

Push the RE down to a pship entity and transfer interest over time? Maybe a FLP?

But that's an awfully low basis to gift to the next generation...

What I'm thinking is maybe a corporate spinoff with the Newco holding the business operations and the Oldco retaining the real estate.. A spinoff requires that, after the transaction, both entities are active businesses. See 355(b)(1).

See Section 138509 of the Build Back Better bill passed out of Ways & Means Committee. It has a long ways to go to become law, but Section 138509 would, I believe, allow an S Corp which was in existance on 5/13/1996 to liquidate tax-free. Could be a real benefit to old S Corps that are still around.

How about distribute the active business?
Or create a new S-Corp and slowly transfer activities

How about distribute the active business?
A spinoff requires that, after the transaction, both entities are active businesses. See 355(b)(1).

Might a commercial rental activity qualify as an active trade or business?

For a sale of the business, if buyer doesn't want the Real Estate, a condition of the transaction will be to sell the real estate. (Just closed a transaction like this.) You can push the problem down the road. A sale will provide cash with which to pay the tax.

Nilodop, I was suggesting a distribution not a spin off.

Regarding the business sale, that will likely be an asset sale so no worries.

How about distribute the active business?
A spinoff requires that, after the transaction, both entities are active businesses. See 355(b)(1).

This is the direction I am headed. I can maybe make that work. There are two components to the active trade that could be split. I had mentioned this a couple of times in the last several years but always got push back as too complicated.

It may not sound so complicated now.

Nilodop, I was suggesting a distribution not a spin off.

Regarding the business sale, that will likely be an asset sale so no worries.

Or, the "sale" may end up being a gift to the son. It's a very fluid situation.

There are two components to the active trade that could be split.. And what about the real estate?

Why not just sell the biz assets and keep the real estate in the corp

That sounds like the best option. But, you're thinking: I want to sell an entity and bother with an asset sale.

I know there's a reorg for that

Why not an F under Rev. Rul. 2008-18? i.e., contribute existing S corp ("Target") into a Newco which will continue to be taxed as an S corp; Target elects to be a QSUB and becomes disregarded. The steps qualify as a reorg under 368(a)(1)(F). (If Target is a corporation legally, it is frequently also converted to an LLC under a formless conversion statute; this step has no consequence for the seller but helps the eventual buyer avoid unintended consequences when buying a QSUB). Prior to a sale of Target to a buyer, the real estate can be distributed from Target to Newco with no federal income tax consequence. Target can be sold to buyer without the need to effect an asset sale which might otherwise entail cumbersome assignments, waivers, consents, retitling, etc.

Newco can set up a defined benefit plan for H&W and fund it with any ordinary income triggered on the sale of Target under 1245, 1250, etc.

Are we getting far afield from what OP is (I think) asking, namely, what's a good way to have the retiring owners keep the real estate as an income-producing source at a lowtax cost? We don't know whether a sale or gift oor splir-up of the operating business is going to happen.

Well, either the sale of biz assets OR the F reorg does indeed do just that, for 0 tax cost.

Sale of assets for zero tax cost?

OK, so I exaggerated. But there will be decent basis in a biz selling assets....far more than the building. And if they don't want to sell the assets, do the F and figure it out later. Maybe a kid will buy the shares.