What Happens When You Pass Away and Your S Corporation Holds a Rental Property?

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:

S Corporations and Payroll Requirements

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.

FICA Taxes and S Corporations

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:

• FICA Taxes: As an owner-employee of an S corporation, you must pay FICA taxes (currently 15.3% combined for both employer and employee portions on the first $160,200 of wages, with 2.9% continuing for Medicare on all wages).
• Increased Administrative Burden: Maintaining proper payroll records, filing quarterly payroll taxes, and managing other payroll-related obligations can be a hassle, especially if the primary activity is passive real estate ownership.

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.

Alternative Structures: LLCs and Trusts

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:

• LLCs (Limited Liability Companies): LLCs offer liability protection without the need to run payroll or deal with FICA taxes. They provide flexibility in how income is distributed, and they are not required to pay FICA taxes on rental income.
• Trusts: Using a trust, such as a living trust, in conjunction with an LLC can simplify estate planning. The trust can hold LLC membership interests, allowing for easy transfer of ownership upon death and avoiding the complications of probate.

What Happens When You Pass Away and Your S Corporation Owns the Rental Property?

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:

• Heirs Inherit S Corporation Stock: Your heirs will inherit the S corporation stock at its stepped-up fair market value. While the rental property itself doesn’t get a step-up in basis, the stock does.
• Sale of the Rental Property: When the S corporation sells the rental property, it recognizes a gain, which increases the basis in the S corporation stock.
• Liquidation Outcome: Upon liquidation of the S corporation, your heirs may recognize a capital loss, which offsets the gain. This sequence can result in little to no federal income tax liability for your heirs.

However, if you find yourself in a situation where your S corporation does own a rental property, it's important to understand what happens when you pass away. A common concern in this scenario is how the step-up in basis is handled, and how this affects your heirs.

Understanding the Step-Up in Basis

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.

The Good News for Heirs of S Corporation Stock

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:

1. 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.

2. 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.

3. 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.

4. 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.

Achieving a Tax-Neutral Outcome

The sequence above allows your heirs to potentially sell the property without incurring any federal income tax liability. Here’s why:

• The gain on the property sale, recognized by the S corporation, increases the basis of the inherited stock.
• Upon liquidation, the increased basis often leads to a capital loss that can offset the gain recognized on the sale of the rental property.

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.

Structuring Real Estate Holdings: Trusts, LLCs, and S Corporations

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:

1. 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.

2. 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.

3. 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.

• Avoid S Corporations for Direct Real Estate Ownership: They are not ideal due to restrictions on ownership transfers and limited tax benefits.
• Use LLCs for Real Estate Holdings: LLCs offer flexibility, liability protection, and are favorable for estate planning.
• Consider a Trust for Estate Planning: Trusts can manage the transfer of assets smoothly and privately, avoiding probate and maintaining control over how assets are distributed.

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.