Sale-and-leaseback of real property.

• Author: Fink, Philip R.
• Position: Close corporations

EXECUTIVE SUMMARY

* A sale-and-leaseback may be entered into to infuse cash into a corporation.

* The property's depreciable basis in the shareholder's hands should be substantially greater than it was in the corporation's hands.

* Stock ownership is not material in determining whether income is passive; the key is whether the shareholder materially participates.

A closely held C corporation and its controlling shareholder may be able to realize tax benefits if the former sells real property to the latter, who then leases it back to the corporation. However, there are issues to be aware of in structuring such a transaction, including timing and economic-substance questions, disguised dividends and the self-rental rule. This article addresses these matters and offers planning suggestions.

A closely held C corporation (close corporation) may seek to sell real property to its controlling shareholder, then lease it back. For this purpose, a "controlling" shareholder is one who owns more than 50% (directly or indirectly) of the value of the corporation's outstanding stock. There are many tax and financial advantages in executing a sale-and-leaseback; there also tax traps. This article addresses the advantages and disadvantages.

Why Enter into a Sale-and-Leaseback?

Often, a sale-and-leaseback is entered into when a corporation is short of cash, and its controlling shareholder has an abundance of cash or can liquidate investments. This might occur, for example, when a corporation is growing at an accelerated pace and needs extra cash to meet its growth demands. On the other hand, a corporation may have a loan outstanding that requires it to meet certain financial ratios or a minimum cash balance. In most cases, a corporation can raise more funds by selling its real property than by mortgaging it; doing so can also make its balance sheet appear healthier. Thus, a sale-and-leaseback with a controlling shareholder can be a viable strategy for a close corporation in need of cash.

Gain/Loss Recognition

If a corporation sells real property to a controlling shareholder at a gain, the gain's character depends on the nature of the property. The gain on depreciable real property (e.g., a building) will be ordinary income under Sec. 1239(a). However, any gain on the sale of the land will be Sec. 1231 gain.

If a corporation sells real property at a loss, none of the loss will be recognized, as the sale is to a related party under Sec. 267(a)(1). However, when the controlling shareholder eventually sells the property to a third party, any gain then realized will be recognized, according to Sec. 267(d), only to the extent that it exceeds the corporation's prior disallowed loss.

Advantages and Disadvantages

Eliminating Future Appreciation

A sale-and-leaseback between a controlling shareholder and a close corporation removes future appreciation from the corporation. If there were no sale-and-leaseback and the property were eventually sold, the additional appreciation would result in an increase in the corporation's earnings and profits. This increase can result in greater double taxation when the corporation makes subsequent distributions to its controlling shareholder.

Rental Deduction Higher than Depreciation

If real property used by a close corporation has been in service for many years, a sale-and-leaseback could generate a much larger rent deduction for the corporation than its current depreciation deduction. Such property could very well be fully or substantially depreciated. Before a sale-and-leaseback, the corporation could depreciate only the building, not the land, predicated on the property's original cost. When the property is leased back by the corporation from a shareholder, the rent paid by the corporation is typically predicated on the fair market value (FMV) of both the land and building(s). This could...