I generally advise against using S corporations to hold real estate for several reasons. One of the biggest drawbacks is the need to run payroll and deal with FICA (Federal Insurance Contributions Act) taxes. Here’s why this matters:
When you own an S corporation, you're required to take a "reasonable salary" if you're actively involved in the business. This means running payroll and withholding FICA taxes, which include Social Security and Medicare taxes. This payroll requirement can be an unnecessary administrative burden if the S corporation's primary asset is a rental property, as rental income is generally considered passive and not subject to self-employment tax in other entities like LLCs.
The necessity to pay FICA taxes on a salary taken from the S corporation can result in additional costs that wouldn't apply to an LLC or a trust holding real estate. Here’s the breakdown:
In contrast, if you own rental property through an LLC, you typically avoid these complications. Rental income reported on a Schedule E is not subject to self-employment tax, and you don’t need to run payroll, making it a more streamlined and cost-effective option for holding real estate.
To avoid these payroll requirements and the associated tax implications, structuring real estate holdings through an LLC or placing them in a trust is often more advantageous. Here’s a quick overview of how these structures work:
However, if your S corporation does own a rental property, understanding what happens upon your death is crucial. A primary concern is how the step-up in basis—a provision that adjusts the value of an inherited asset to its fair market value at the time of your death—is managed. Here’s the breakdown:
A step-up in basis is a tax provision that adjusts the value of an inherited asset to its fair market value at the date of the decedent’s death. This adjustment is crucial because it reduces the capital gains tax liability for heirs when they eventually sell the inherited asset. However, things work a bit differently when the asset in question is owned by an S corporation.
Even though the rental property held within the S corporation does not receive a step-up in basis, your heirs can achieve a similar tax outcome through a different mechanism. Here's how it works:
Inheritance of the S Corporation Stock: Upon your death, your heirs inherit the S corporation stock. The basis of this stock is stepped up to its fair market value as of the date of your death.
Sale of the Rental Property by the S Corporation: If the S corporation decides to sell the rental property, it will recognize a gain based on the difference between the property's original basis and the sale price.
Increase in Basis of S Corporation Stock: The recognized gain from the sale of the rental property increases your heirs' basis in the S corporation stock. This is a crucial point because it sets the stage for a potential tax-neutral outcome.
Liquidation of the S Corporation: When the S corporation is eventually liquidated, your heirs may recognize a capital loss. This loss results from the stepped-up basis of the S corporation stock exceeding its liquidation value after accounting for the gains on the property sale.
The sequence above allows your heirs to potentially sell the property without incurring any federal income tax liability. Here’s why:
This combination results in a wash for tax purposes—effectively achieving the same result as if the rental property itself had received a step-up in basis.
To optimize estate planning and tax benefits, consider structuring your real estate holdings through a combination of a trust, LLC, and possibly an S corporation. Here’s how each plays a role:
Real Estate LLC: An LLC (Limited Liability Company) is generally the preferred vehicle for holding real estate. LLCs provide liability protection, tax flexibility, and the ease of transferring ownership. Real estate held in an LLC can be transferred into a trust or sold as part of estate planning with relative ease.
Trusts: Placing the LLC interests into a trust can offer significant estate planning benefits. A living trust, for example, allows you to avoid probate and directly pass the ownership of the LLC to your heirs. Trusts also provide a level of privacy and can help manage how assets are distributed after death.
S Corporation Structure: While I don’t generally recommend holding real estate directly in an S corporation, there may be situations where an S corporation is used to manage certain aspects of real estate activities, like property management or holding certain business assets. However, real estate itself should ideally be owned by an LLC, which is then placed into a trust.
Owning a rental property through an S corporation can provide your heirs with a tax-advantaged way to inherit and eventually sell the property. Although the rental property does not receive a direct step-up in basis, the strategy of inheriting S corporation stock at its stepped-up fair market value can lead to a similar tax-neutral outcome. As always, working closely with a qualified tax advisor is crucial to tailor this strategy to your specific circumstances and ensure it aligns with your overall estate planning goals.
Ready to dive deeper and tailor a strategy specifically for your needs? Set up a FREE discovery call with Tax Code Advisors to learn more.
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