S.E.C. Real Estate Observer

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Co-authored by: Jim Wilson, S.E.C., CCIM (Orlando, Florida)

Editor’s Note: Walt Ricker is involved with corporate acquisitions for MidCoast Financial, Inc. of Lake Worth Florida, a Society of Exchange Counselors meeting sponsor. We think you’ll enjoy his company’s unique approach to real estate and C Corporations.

It is not necessary to pay out a majority of your profits in taxes just because you own investment property or a business in a “C” corporation, which would normally result in taxation first at the corporate level and then AGAIN at the personal level. A self-directed tax-exempt trust (charitable remainder trust) can be employed to eliminate either the corporate tax or the personal tax in most cases. Further on we will introduce another tool that can be used to reclaim a substantial portion of potential corporate taxes stemming from the sale of an asset in a “C” corporation.

The Roberts family has owned and operated a hotel on the beach in North Carolina for over 25 years. It has provided a very nice income to the family during those years but the hotel is now over 40 years old. They are having more difficulty every year competing with all the new hotels and timeshare properties on the beach. Although the hotel is located on nearly three acres of prime beachfront property the estimates are that it will cost more than $1.5 million dollars to complete a major renovation and upgrade to the property to make it competitive. The property is nearly free and clear of current debt but the family is reluctant to put major debt on the property, close down operations and go through the nine months to a year of hassle to complete the renovations and upgrades. In addition, the hotel franchisor is pressuring the family to undertake the renovations and upgrades with the threat of taking away their franchise. Dad and Mom are seriously ready to retire and the son and daughter are very tired of the long hours and lifestyle limitations of managing and OPERATING a hotel on a day-to-day basis.

Fortune has smiled on the Roberts family because a major timeshare developer has offered $4 million cash for their property to build a new timeshare project. Unfortunately, the review of the offer with the tax advisor was not encouraging. The current adjusted basis in the property is only $400,000 and the Roberts family owns the property in Hotel, Inc., which is a “C” corporation. Dad and Mom did do some estate/succession planning and began gifting stock ownership each year to each of the children and their spouses. Currently, Dad and Mom own 44% of the stock and the children and their spouses each own 28% of the company stock. The bad news from the tax advisor was that they would be paying state and federal taxes of almost 39% on the $3,600,000 of profit recognized by the corporation from the sale of real estate. This equates to roughly $1,400,000 in corporate taxes, which would leave only $2,600,000 to be distributed to the stockholders. All family members have a low basis in their stock, and the distribution of cash from the corporation will result in ordinary income taxes of approximately 37% to each of the stockholders. That means another $962,000 goes out to personal taxes. The end result is that the Roberts family will net only $1,638,000 from their $4,000,000 sales price after $2,362,000 in corporate and personal taxes. This is a long way from their vision of a luxury retirement and financial independence of the Roberts family when they received the $4 million offer on their property.

There is a tremendous tax impact upon the sale described that can be substantially moderated by employing a self-directed charitable remainder trust (CRT) strategy. There are two choices. One is to have the corporation establish the self-directed CRT for a specific number of years up to 20. Since a corporation may technically continue forever, the tax law requires that a CRT for other than a natural person must have a specified term in years not greater than 20. The corporation would establish the CRT, move title to the hotel to the trust and let the trust sell the property tax-exempt. The tax-exemption is only inside the trust. The trust payments to the beneficiary corporation would still be taxable to the corporation prior to distribution to the stockholders who would be taxed again at ordinary income rates. There are a couple of additional limitations on using the CRT at the corporate level. One is that the corporation cannot under most circumstances fund life insurance or use most of the other methods usually employed to pass the assets on to the heirs tax-free in cash. The other is that the corporation must continue as an operating business. In the case of the Roberts family, the hotel is the only asset of the corporation. Consequently, the Roberts family would not be able to use the CRT at the corporate level. That means that the CRT cannot be used to eliminate or even reduce the $1,400,000 corporate tax on the sale of their property. We will come back to this problem a bit later.

The other choice is for Dad and Mom and each of the children and their spouses to establish individual CRTs with companion Wealth Replacement Trusts or some other effective structure to pass the asset value on to each of their heirs. This is the usual structure of a CRT strategy that has been discussed in previous articles. Dad and Mom can structure their trust to fit their retirement plans. Each of the children can structure their individual trusts to fit their specific financial needs, wants and objectives WITHOUT ANY OF THE FAMILY MEMBERS HAVING TO COORDINATE OR EVEN CONSULT WITH ANY OF THE OTHER FAMILY MEMBERS. Each of the family members transfers their company stock to their individual CRT and has the CRT collect the distribution from the corporation tax-exempt. Fortunately, none of the family members owns controlling interest in the corporation because controlling interest in a closely held corporation is a prohibited asset for CRTs. Each family member then retains control of the reinvestment of the assets inside of their individual trusts and receives income from their trust for life. Each family member can decide the manner in which they want to pass their assets on to their heirs. Potential family conflict over such a large amount of money can be greatly moderated by using this CRT strategy. Each trust beneficiary will pay taxes only on their distributions from their individual trust. However, there is considerable flexibility in how distributions can be structured to fit individual needs, wants and objectives. Each family member’s trust could be structured entirely differently from both of the other family members’ trust. If each family member were to structure their trust to receive at least the same trust payments as they were receiving from operating the hotel, they would be in exactly the same tax position before the sale. However, they would have avoided a total of $962,000 in taxes on the sale of the property. If these tax dollars were reinvested inside each of the individual trusts at 6%, the family would share in $57,720 per year of additional income FOR THE REST OF THEIR LIVES and then be able to pass the $962,000 that would have gone to taxes on to their heirs tax-free and in cash.

Now, lets go back to that $1,400,000 in corporate taxes that we were not able to avoid or eliminate by using a CRT. As we have already mentioned, since the Roberts family owns the hotel property in a C corporation, any gain on the sale of the real estate will be treated as income to the corporation, which is subject to state and federal corporate income taxes. In this instance the corporation has no losses or other means to offset or defer gains (income), and mitigate the corporate tax resulting from the real estate sale.

One solution that the shareholders could pursue would be to sell the stock of the corporation to a financial buyer that can add value through its ability to offset or defer income and manage liabilities. After the corporation closes on the sale of its real estate, such a financial buyer could purchase the stock of the corporation from the shareholders (either the individual family members, or trusts into which the family members have contributed the C corporation stock). If we go back to our example, we will recall that the sale of the hotel property for $4,000,000 against an adjusted basis of $400,000 would result in a gain (income) of $3,600,000 recognized by the corporation. The resulting corporate tax of approximately $1,400,000 would leave only $2,600,000 of the $4,000,000 sale price to be distributed to the shareholders. If the shareholders, which again could be either the family members or the trusts they established, were to sell the shares of the corporation for greater than $2,600,000, they will have partially mitigated the impact of the double tax on C corporation income.

In this situation, a financial buyer with the ability to manage corporate gains and liabilities might have an interest in acquiring the stock of the Roberts’ corporation, Hotel, Inc., after the close of the real estate sale. Let’s assume that this financial buyer buys the stock of Hotel, Inc. for $3,000,000. That would represent a $400,000 premium over the $2,600,000 alternative after (corporate) tax value the shareholders would be able to distribute out of the corporation.

As the new owner of the corporation, the financial buyer would assume responsibility for satisfying any liabilities (including taxes) remaining on the corporation’s balance sheet, providing an attractive exit opportunity for the Roberts family or their respective trusts. The Roberts’ gain on their $3,000,000 sale of Hotel, Inc. stock would be subject to personal long-term capital gain tax rates, but they are no longer responsible for dealing with the corporate tax. In effect, for the Roberts family the sale of stock serves as a partial solution to the corporate tax issue, while the use of CRTs has enabled them to manage taxes at the personal level.