Wednesday December 6, 2023
Case of the Week
Exit Strategies for Real Estate Investors, Part 28 Subchapter S Corporation CRT Pitfalls
Case:Karl Hendricks was a man with the golden touch. Throughout his life, it seemed every investment idea that he touched turned to gold. Karl's passion was real estate, and he was very successful in his investments.
Karl Hendricks is age 85, and owns a Subchapter S corporation named KarHend. Ten years ago, KarHend bought two commercial properties. One is valued at $7 million with an adjusted basis of $2 million. The second property is valued at $8 million with an adjusted basis of $2.5 million. Both properties are commercial buildings with a long-term tenant on a fixed payment lease. Karl's CPA has taken straight line depreciation on the properties.
KarHend has received multiple offers for the two commercial buildings, but has not entered into a sale contract. Karl believes it is a good time to sell, but knows there would be a large state and federal tax with his potential gain of $10.5 million.
Question:Is there a way that Karl can sell the two properties and reduce his capital gains tax? Are there any pitfalls if KarHend decides to fund a CRT with the $8 million property?
Solution:After discussions with his CPA and attorney, Karl transferred the $8 million KarHend property into a 20 year term CRT with income distributed to KarHend. Karl sold both the CRT property and the $7 million building to a new buyer. The gain on the CRT property was bypassed and tax savings from the CRT deduction reduce the tax payable on the remaining $5 million gain. After closing, KarHend received $7 million and the CRT received $8 million. The $7 million sale produced a taxable gain of $5 million. This flowed through to Karl and he must pay tax at a federal and state rate of 29%, or a payment of $1,450,000. Karl received the funds from the sale and twenty years of income from the CRT. But are there potential pitfalls for Karl?
Outside and Inside Basis: The $8 million CRT produces an income tax deduction of $2,923,944. Each Sub S shareholder is only able to use the deduction to the extent of the basis in his or her S corporation shares. Sec. 1366(d)(1). Subchapter S corporations have both an outside basis in the stock by the shareholder and an inside basis in corporate assets. When gifts of appreciated property are made by the Subchapter S corporation, the deduction flows through to the shareholder. In this case there is an adjustment of the outside basis of the shareholder. Sec. 1367(a)(2). For a gift of appreciated property, the deduction flows through at fair market value, but the decrease in shareholder basis is equal to the adjusted basis of the gifted property to the Subchapter S corporation.
The $8 million CRT produces an income tax deduction of $2,923,944. The basis in the deduction is prorated at a $2.5 million divided by $8 million ratio. The $2,923,944 deduction has an inside allocated basis of $913,733. Because Karl has $1 million in outside basis on his stock, the charitable deduction flows through to him with a prorated basis of $913,733 and reduces his outside basis to $86,267. The shareholder's outside basis will be reduced by the amount of the proportionate corporate basis in the donated asset, but the basis cannot be reduced below zero. Because this is a 30%-type appreciated property deduction, Karl will be able to deduct about $2 million of this amount in the year of the sale. The balance of his deduction is likely to be spread over the next three or four years. Karl understands he will pay the tax on his gain in year one, but his full tax savings will be spread over several years. Because his outside basis is reduced by the prorated KarHend basis, Karl will benefit from the full $2,923,944 charitable deduction.
Unrelated Business Taxable Income (UBTI): When an S corporation contributes its assets to a charity or CRT, if the income generated by those assets is not passive income, the CRT will have UBTI. There is a 100% tax on UBTI within a CRT. However, the $8M property is subject to a fixed payment lease. If there were a share of profits provision or rental of tangible personal property in the lease, the CRT would be a Sec. 512(c) partner and would have UBTI. Fortunately, a fixed payment lease is passive income and not UBTI.
Passive Income Limit: If the Subchapter S corporation was previously a C corporation and held earnings and profits at the time of the Subchapter S election, then there is a 25% limit on passive income. Sec. 1375(a)(2). Because the CRT produces passive income, if there are undistributed earnings and profits the Sub S election will be terminated within three years. Sec. 1362(d)(3)(A). If there are earnings and profits, then it will be necessary for the Subchapter S corporation to distribute those prior to funding the CRT. Distribution of earnings and profits will be taxable income to the owner, but the charitable deduction from the CRT may offset that income. Fortunately, KarHend has been a long-term Subchapter S corporation and the 25% passive income limit does not apply.
Self-Dealing Concerns: If an S corporation contributes its assets to a CRT with the goal of selling those assets, potential self-dealing issues arise. Self-dealing rules under Sec. 4941 prohibit the CRT from selling or leasing assets to the S corporation or to any other disqualified person. In this case the third-party lessee is not a disqualified person and there is no self-dealing problem. A disqualified person with respect to a CRT is determined by facts and circumstances but generally includes the S corporation itself, anyone who owns more than 20% of the S corporation, a trustee of the CRT or a child or grandchild any disqualified person (not including his or her brothers and sisters). Sec. 4946.
Even if the lessee were a disqualified person, with a mature lease an "incidental exception" could apply to self-dealing. If the lease is mature and at fair market value, the benefit to a disqualified person will be incidental or tenuous and therefore not self-dealing. Reg. 53.4941(d)-2(f)(2).
Published July 1, 2022