Actually, the proposed law covers more than that. But real estate usually causes the biggest problem.
Here’s the problem. Due to bad advice, someone (not you — you got good advice) buys real estate but owns it through a corporation. The real estate appreciates. Time to sell at a massive profit. Tax time hits, and the news is bad. Net profit on sale is taxed at corporate tax rates (somewhere in the mid-30%’s for Federal tax) rather than the long term rate of 15% for human beings.
Then, like the old Creedence Clearwater Revival song, “Lodi,” things got bad, then things got worse.
You have a corporation full of cash after having paid a high tax. The shareholders want the cash. The corporation distributes the cash to them. Hey presto, probably a dividend. Another tax is imposed on the recipient of the dividend.
Two taxes on the same profit. Misquoting Martha Stewart, “It’s a Bad Thing.”
A TRADITIONAL SOLUTION
One solution that we think about (for U.S. resident taxpayers only, unfortunately) is to have the corporation make an “S” election. This is a tax election whereby the corporation changes from a taxpayer which pays taxes on its own net profits (a “C” corporation) to a corporation that pays no tax itself, but instead the shareholders are taxed on the corporation’s profits.
In other words, you elect to make the corporation transparent for income tax purposes–income is taxed to the shareholders.
(Jargon alert: “C” and “S” refer to subchapters of the Internal Revenue Code. Subchapter C is the section of the Internal Revenue Code that covers corporations generally. Subchapter S is the section of the Internal Revenue Code that covers corporations which make this special election.
You do this with IRS Form 2553.
HOW THE TRADITIONAL SOLUTION WORKS
By owning real estate through an S corporation (the jargon-y name for a corporation that makes this election) you can see how the first tax is eliminated. The corporation sells the real estate. But instead of the corporation paying tax on the net profit at corporate tax rates, the shareholder of the corporation now reports the profit on his/her income tax returns, and pays tax at the 15% tax rate.
And the second layer of tax (the tax on distribution of the cash from the corporation that is treated as a dividend) doesn’t apply at all.
The impact? You’ve eliminated a Federal corporate income tax at 34%-39% PLUS a second tax at 15% on the dividends, and replaced it with a single 15% tax on the net profit from sale of the real estate.
If you buy real estate in a corporation that makes the S election from scratch, you have no problems.
But if you buy real estate in a corporation that makes the S election years after the purchase of the real estate, then you have a lot of appreciation for all of the years that the real estate was owned by the corporation before it made the S election.
This is called “built-in gain” and the benificent results described above don’t apply to built-in gains. These are taxed at normal corporate tax rates even though the corporation is now a S corporation. (Confused? This is what we deal with all day as tax lawyers).
SUNSET PERIOD — 10 YEARS
Thankfully, there’s a sunset period. Buy real estate inside a corporation. Massive appreciation occurs, creating built-in gain. Corporation makes S election. Ten years later, the corporation is treated as if it didn’t have any built-in gain at all.
THUS, THE CORRECT SOLUTION IS “ELECT AND WAIT 10 YEARS TO SELL”
Thus, the correct way to deal with real estate inside a corporation is to make the S election and wait 10 years to sell the real estate. By then the built-in gains have expired.
FINALLY, THE POINT OF THIS DISCUSSION
Finally, we get to the point of this discussion. 🙂
There’s a bill just introduced in the United States Senate, S. 965. It is one of those little proposals that cleans things up at the edges and produces a bit more sanity and simplicity into the tax law. Thank you, Senator Gordon H. Smith (R-OR).
What will this proposed law do? Simple — cut the waiting time from 10 years to 7 years.
I hope it passes. This will mean we can cut 3 years off of a complex calculation.
MORAL OF THE STORY
If you have real estate inside a corporation, don’t hesitate. Get some competent advice now and take action now.
Otherwise you (or your heirs) will pay better than twice as much tax on the profit on sale of this real estate as necessary. You need those 10 years (7, if the laws change) to run by from the date of the election to the date of sale of the real estate.
(Man. That’s an awesomely wordy explanation, eh?)