S-Corporations, with similar tax rules to partnerships, would seem like a logical alternative to the partnership as an owning entity for real estate. Losses of an S-corp, just as income, are passed through to the shareholders and the separate legal existence shields its shareholders against personal liability. In this respect, the S-corp may offer the non tax advantage of a corporation combined with the tax advantages of a partnership. However, the dissimilarities between the taxation of S-corps and partnerships should be enough to dissuade investors from choosing an S-corp as a holding entity.
The main benefit for using an S-corp as a holding entity would be the protection of shareholders from personal liability. As a general rule, a corporation’s shareholders cannot be held personally liable for the debts, obligations or any other liability that may attach to the corporation. Also, assets within the corporation generally cannot be reached by the creditors of the individual shareholders. However, this protection is not absolute; there are many instances where a court may have “pierced the corporate veil” to reach the shareholders in a closely held corporations. This may occur when shareholders disregard the separate identity of the corporation or fail to follow corporate formalities.
General partners in a partnership do not share in this limited liability, however, liability protection similar to that afforded by an S-crop can be built into a partnership with liability insurance, qualified non-recourse financing and exculpatory provisions. Insurance will cover damages, qualified non-recourse debt will remove the partners from personally liability and an exculpatory clause in a mortgage will allow the partners to surrender the property to the lender without any personally liability or deficiency.
Transfer of Real Estate Interest
Another reason individuals may chose an S-corp as a holding entity for real estate is the fact that the shares of stock are freely transferable and transfers of stock do not affect the corporate entity. As a general rule, all shareholders may sell their ownership (within specified limits subject to S-corp ownership rules) without disturbing the legal structure of the corporation. The corporation must have no more than 100 shareholders, all shareholders must be individuals or certain qualifying trust, estates or charitable organizations, no shareholder can be a non resident alien and the corporation must have only one call of stock. If the sale of stock meets these criteria then the sale of stock will not impact the S-corps legal status.
Unlike an S-corp, transfers of partnership interest may terminate the legal structure of the partnership itself. However, just like S-corporations restrict stock transfers to protect the S election, partnership agreements can be drawn to allow the continuation of the partnership following the death of a partner or any other transfer of partnership interest.
Loss Limitation Rules
Similar to partnerships, S-Corps cannot take losses that exceed the shareholder’s adjusted basis for the stock plus the adjusted basis of debt owed to the shareholder by the corporation. While this rule is similar to the loss limitation rules for partnerships, there is one distinct difference. Unlike a partner’s basis, a shareholder’s basis in an S-corp does not include debt owed to outside parties. This tax treatment has two significant effects. Firstly, shareholders may not fully utilize loss deductions if mortgaged real estate produces a tax deduction in excess of income. Secondly, in the case of refinancing, the distribution of proceeds from new financing to shareholders may trigger a taxable event. Lets look at these two examples in detail.
Lets say Sara has an adjusted basis in a 10% owned real estate activity of $5,000 and her share of current year losses is $7,000. The real estate activity has a $100,000 mortgage so Sara’s share of this liability is $10,000 (10% of $100,000). If the holding entity was a partnership then Sara’s adjusted basis, when factoring in the loss limitation rules, would be $15,000; allowing her to take the $7,000 loss. However, if the holding entity was an S-corp then the $10,000 would not be used in calculating the adjusted basis. This means that only $5,000 would be deducted in the current year and $2,000 of losses would be carried forward to future years.
Now lets say in the same year the entity refinances the mortgage and distributes the excess proceeds to the owners; of which Sara receives $3,000. If this was a partnership Sara would not have a taxable event but her adjusted basis would be reduced to $5,000 ($5,000 basis + $10,000 share of mortgage – $7,000 loss – $3,000 distribution). If this was an S-corp then Sara could potentially owe tax on $3,000 ($5,000 basis – $5,000 allowed loss – $3,000 distribution). Since the distribution was in excess of the shareholder’s basis the distribution is treated as a taxable dividend.
Another potential drawback of choosing an S-corp over a partnership is the rigid rules of ownership. In an S-corp, there can’t be more than 100 shareholders and only one class of stock while in a partnership, and especially in a limited partnership, various classes of partnership interest can be created. Additionally, allocation of income and losses to shareholders in an S-corp must be strictly made according to stock ownership. Special allocation rules that apply to partnerships permit flexibility and allow partners to divide income and losses on another basis other than share of partnership interest (subject to some limitations).
Distribution of Appreciated Property
Lastly, S-corps, just like C-corps, present some tax complications when it comes to the distribution of appreciated property. Unlike partnerships, where the distribution of property to partners generally produces no immediate tax, distribution of appreciated property to shareholders requires recognition of the gain as if the corporation had sold the property. While this distribution does not cause a tax at the entity level, shareholder’s must report and pay taxes on their share of the recognized gain. If the gain recognized by the shareholders is a built in gain then the corporation would be subject to the tax as well.
Although there are downsides to choosing an S-corp as the holding entity for a real estate activity, in some situations this may be a viable alternative to a partnership. However, the tax differences between an S-corp and a partnership may be significantly broad enough to warrant a careful analysis to determine which holding entity is most beneficial. The potential tax disadvantages, however, may be enough to dissuade many investors from using an S-corp as the holding entity for real estate activities.