Leasing property to a corporation.

• Author: Bland, Larry N., Jr.

Shareholders of closely held C corporations commonly lease real estate, equipment, and other property to the corporate entity, either directly or through a separate partnership, a limited liability company, or an S corporation. Advantages that can motivate these rental arrangements include the following:

* Avoiding payroll taxes: Rental income from real estate is not subject to the self-employment (SE) tax; a lease of real estate to a closely held corporation represents the ability to withdraw funds from the corporation without incurring Federal Insurance Contributions Act (FICA) taxes (i.e., Social Security and Medicare) or SE tax.

* Avoiding corporate-level gain: Retaining ownership of real estate and other valuable tangible or intangible assets outside the corporation avoids the potential for triggering a gain within the corporation upon a distribution or liquidation of the assets. Conversely, if appreciated assets (i.e., those with a fair market value (FMV) in excess of adjusted tax basis) are distributed from a corporation, whether in liquidation or other form of distribution, gain must be recognized (Secs. 311(b)(1) and 336(a)).

* Retirement cash flow: Retaining valuable assets outside a controlled corporation allows the shareholder-lessor to continue to receive a cash flow stream from the corporation in the form of rents or royalties, even though the shareholder is not employed by the corporation. This can allow a portion of the corporate income to flow to a retired shareholder or a shareholder who is uninvolved in the business operations.

* Business transition: Retaining assets outside the corporation allows the ownership of the business operation and the ownership of business assets to be segregated. For example, a controlling shareholder-lessor may want to divest ownership and control of the business operations by disposing of some or all of the corporate stock but retain a significant portion of the business assets for lease to the entity. This can help transfer ownership and control to the successor generation by minimizing the value of the corporation (e.g., where the corporation contains only operating assets such as receivables and inventory, with fixed assets retained by the founder).

Example 1. Leasing land to a corporation to minimize payroll taxes and avoid double taxation: A recently formed WInc. with a capital contribution of $1,000.A is the only shareholder. He intends to transfer the assets of AJ's Car Wash (AJ), a sole proprietorship, to the new corporation. AJ's profits are A's only income and are required to meet his personal expenses.

The car wash is located on two acres of prime real estate. A originally paid $30,000 for this land, which now has an appraised value of $75,000. A believes that the land will continue to appreciate in value. AJ also has equipment with an adjusted basis and FMV of $20,000.

IfA leases the land and real property improvements to W, A receives rent that would otherwise be withdrawn from the corporation in the form of compensation or dividends. By renting the land instead of transferring it to the corporation, A avoids payroll taxes (i.e., if the payments were compensation) and double taxation (i.e., if the payments were dividends) on the rent amounts. Also, by not transferring the land to the corporation, A avoids double taxation later.

Transferring the property to the corporation would result in A's tax basis in the land of $30,000 carrying over to the corporation (Sec. 362(a)). When the appreciated land or the proceeds from the sale of the land are extracted from the corporation, both A and Wwould recognize gain. The equipment would not appreciate in value and would probably depreciate and need to be replaced from time to time. Thus, there is less risk of double taxation arising from placing the equipment...