Sale-and-leaseback of real property.

EXECUTIVE SUMMARY

* A sale-and-leaseback may be entered into to infuse cash into a corporation.

* The property's depreciable basis in the shareholder's hands should be substantially greater than it was in the corporation's hands.

* Stock ownership is not material in determining whether income is passive; the key is whether the shareholder materially participates.

A closely held C corporation and its controlling shareholder may be able to realize tax benefits if the former sells real property to the latter, who then leases it back to the corporation. However, there are issues to be aware of in structuring such a transaction, including timing and economic-substance questions, disguised dividends and the self-rental rule. This article addresses these matters and offers planning suggestions.

A closely held C corporation (close corporation) may seek to sell real property to its controlling shareholder, then lease it back. For this purpose, a "controlling" shareholder is one who owns more than 50% (directly or indirectly) of the value of the corporation's outstanding stock. There are many tax and financial advantages in executing a sale-and-leaseback; there also tax traps. This article addresses the advantages and disadvantages.

Why Enter into a Sale-and-Leaseback?

Often, a sale-and-leaseback is entered into when a corporation is short of cash, and its controlling shareholder has an abundance of cash or can liquidate investments. This might occur, for example, when a corporation is growing at an accelerated pace and needs extra cash to meet its growth demands. On the other hand, a corporation may have a loan outstanding that requires it to meet certain financial ratios or a minimum cash balance. In most cases, a corporation can raise more funds by selling its real property than by mortgaging it; doing so can also make its balance sheet appear healthier. Thus, a sale-and-leaseback with a controlling shareholder can be a viable strategy for a close corporation in need of cash.

Gain/Loss Recognition

If a corporation sells real property to a controlling shareholder at a gain, the gain's character depends on the nature of the property. The gain on depreciable real property (e.g., a building) will be ordinary income under Sec. 1239(a). However, any gain on the sale of the land will be Sec. 1231 gain.

If a corporation sells real property at a loss, none of the loss will be recognized, as the sale is to a related party under Sec. 267(a)(1). However, when the controlling shareholder eventually sells the property to a third party, any gain then realized will be recognized, according to Sec. 267(d), only to the extent that it exceeds the corporation's prior disallowed loss.

Advantages and Disadvantages

Eliminating Future Appreciation

A sale-and-leaseback between a controlling shareholder and a close corporation removes future appreciation from the corporation. If there were no sale-and-leaseback and the property were eventually sold, the additional appreciation would result in an increase in the corporation's earnings and profits. This increase can result in greater double taxation when the corporation makes subsequent distributions to its controlling shareholder.

Rental Deduction Higher than Depreciation

If real property used by a close corporation has been in service for many years, a sale-and-leaseback could generate a much larger rent deduction for the corporation than its current depreciation deduction. Such property could very well be fully or substantially depreciated. Before a sale-and-leaseback, the corporation could depreciate only the building, not the land, predicated on the property's original cost. When the property is leased back by the corporation from a shareholder, the rent paid by the corporation is typically predicated on the fair market value (FMV) of both the land and building(s). This could result in a rent deduction much greater than the available depreciation deduction.

Example: W Corp. is owned 80% by H and 20% by H's children. In 1983, W purchased land and a building that were worth $200,000 and $800,000, respectively. The building was depreciated under the accelerated cost recovery system (ACRS) over 15 years, using 175% of straight-line; the building is now fully depreciated. Currently, the land is worth $400,000 and the building $1,200,000. In 2001, W sells the property to H, who then leases it back to W. In determining a fair rental value, the combined FMV of $1,600,000 would have to be taken into account. As a result, W will take a substantial rent expense deduction, instead of owning fully depreciated property.

Timing: A close corporation that leases property from a controlling shareholder may have its rent deductions deferred if it is on the accrual basis and the shareholder is on the cash basis. Under Sec. 267(a)(2), the corporation cannot claim a rent deduction until the year the cash-basis shareholder includes the rent in income.

Example: X Corp., a calendar-year corporation, accrues a rent deduction as of Dec. 31, 2001, but does not pay rent to its controlling shareholder until Jan. 15, 2002. X cannot deduct the rent payment until 2002.

If the corporation is in a higher tax bracket than its controlling shareholder, it should pay the rent before year-end.

Rental Income Inclusion

Generally, a controlling shareholder-lessor will be on the cash basis and include rental income in the year received. However, the constructive-receipt doctrine may require him to include rent prior to the year of actual receipt. If a corporation is controlled by a cash-basis sole shareholder or officer-shareholder, the constructive-receipt doctrine applies if the corporation (1) has incurred an obligation, (2) makes an accrual on its books and (3) can afford to make payments.(1)

If a corporation is on the accrual basis and has properly accrued a rental deduction before year-end to its sole shareholder-lessor (or officer-shareholder), the constructive-receipt doctrine would require the shareholder to include the rental income in the year of the corporation's accrual; the corporation would be allowed a deduction in the accrual year. If the close corporation is consistently in a higher tax bracket than its controlling shareholder, the constructive-receipt doctrine will reduce the present value of the corporation's and shareholder's combined tax payments.

Disguised dividends: Often, a retired (or retiring) controlling shareholder will enter into a sale-and-leaseback so that the rent payments will supplement his retirement income. It is not unusual for a close corporation to have only a single class of common stock outstanding. If a shareholder is considering retiring from day-to-day company management, he could exchange his common stock for preferred that would pay substantial and regular dividends. But if the shareholder would like to retain a controlling stock ownership, he can keep his common stock and instead receive rent payments.

If excessive rent is paid to a controlling shareholder, the excess over a fair and reasonable rent is treated as a nondeductible dividend paid by the corporation to the shareholder.(2) A corporation may contend that the excess was intended to be compensation; this argument will fail if the payment was not intended to be paid as compensation.(3) In a case involving a sole shareholder, president and general manager who proved that he was underpaid for his services, the court held that a deduction is allowable only for amounts actually paid for services, not for other reasons (e.g., rent).(4)

Additional Depreciation

After a sale-and-leaseback has been entered into, the controlling shareholder will receive a step-up in the depreciable basis of the building for the portion of the purchase price allocated thereto. The property's depreciable basis in the shareholder's hands should be substantially greater than it was in the corporation's hands.

Anti-churning rules: Under Prop. Regs. Sec. 1.168-4(a) and (d), a shareholder-lessor may not be able to use ACRS to depreciate the property, depending on when the property was originally acquired by the corporation. If the property was originally placed into service by the corporation after 1980, the shareholder-lessor can use ACRS. However, if the property was placed into service by the corporation before 1981, the property will not qualify for ACRS in the shareholder's hands; he will have to use the estimated useful life system.

Recharacterization/Self-Rental Rule

A shareholder may seek to enter into a sale-and-leaseback to generate passive rental income to offset against passive losses. However, characterization of the rental income as passive depends on the facts and circumstances.

Generally, rental income is passive income; however, a controlling shareholder who purchases real estate from his close corporation and leases it back may be considered to have received nonpassive income. For purposes of the passive-loss rules, a close corporation is defined by Sec. 469(j) as one in which more than 50% of the value of its outstanding stock is owned (directly or indirectly) by or for not more than five individuals.

The rental income will be recharacterized by Regs. Sec. 1.469-2(f)(6) as nonpassive if the shareholder materially participates in the close corporation. Taxpayers have argued that this "self-rental" rule is invalid, because it allows rental income to be characterized as nonpassive. However, the courts have stated that the regulation is consistent with the underlying statutory purpose of limiting the deductibility of passive losses.(5)

Example: S owns 60% of G Corp. and is its chief executive officer and president. S works for G on a regular, continuous and substantial basis. G sells all of its real property to S, who leases it back to G for a net rent of $50,000 per year. In 2001, S has passive losses of $40,000 from other sources. Because S is involved on a regular, continuous and substantial basis with G's activities, the $50,000 net rental income is nonpassive; he cannot offset this income against his losses.

Stock ownership is not material in determining whether income is passive; the key is whether the shareholder materially participates.

Retired shareholder: If a retired controlling shareholder has entered into a sale-and-leaseback and no longer materially participates in the business, the net rental income will be passive. Thus, the rent supplements the retired shareholder's income and can offset passive losses.

Shareholder's Sale to Third Party

The tax rate on gain from the sale of real property is generally lower for an individual than a corporation. Corporate long-term capital gain and Sec. 1231 gain are taxed at ordinary rates. In addition, any part of the gain that is a corporate preference item under Sec. 291 will convert otherwise Sec. 1231 income into ordinary income.

When an individual sells real property, the tax ramifications are more beneficial. The gain on the sale triggers a three-part analysis. First, under Sec. 1250, the excess of accelerated depreciation over straight-line is recaptured and taxed at ordinary income rates. Second, the unrecaptured Sec. 1250 gain (i.e., the straight-line depreciation) will be taxed at 25% under Sec. 1(h)(7). Finally, the difference between selling price and basis is taxed at long-term capital gain rates.

Example: B Corp. is wholly owned by D. B purchased a building in 1988 that it sold to D in 1993 for $500,000, its FMV. In 2001, D sold the building for $700,000. D took $102,500 in modified accelerated cost recovery system (MACRS) straight-line depreciation deductions, reducing the property's adjusted basis to $397,500. The gain on D's sale is as follows: a 25% rate applies to $102,500 of unrecaptured Sec. 1250 gain, for a $25,625 tax. In addition, $200,000 ($700,009 - $500,000) of the gain (the difference between the selling price and D's basis) will be taxed at the 20% long-term capital gain rate, or $40,000. Thus, D's total tax on the sale gain is $65,625.

On the other hand, if B still owned the property and sold it (at the same adjusted basis and selling price), its tax bill (at 34%), would be $102,850 ($60,500 Sec. 291 gain x 0.34 + $242,000 Sec. 1231 gain x 0.34). Thus, a tax savings of $37,225 ($102,850 - $65,625) results by having D, rather than B, sell the property.

Leasehold Improvements 

Generally, a lessee's leasehold improvements are excluded from the lessor's gross income by Sec. 109. However, if the corporation makes improvements on the property it leases from a shareholder, the shareholder may have to include the FMV of the improvements in income as a dividend. In Jaeger Motor Car Co.,(6) a year-to-year lease required the corporate lessee to construct improvements with a life considerably longer than the lease term. The court concluded that the lease was a device to pass a portion of the corporation's earnings to the shareholder tax-free until he disposed of the property. The corporation had never paid dividends and was very close to having an accumulated earnings problem. The controlling shareholder exercised considerable influence over the lease, which had a 30-day termination clause. No reasonable tenant would have entered into the lease and made improvements to the property, as the lessor could have regained possession on 30 days' notice.

However, in Weigel,(7) leasehold improvements made by a pipeline construction corporation to property leased by a shareholder to a corporation was not a constructive dividend, because the property was leased under commercially reasonable terms and the rent charged was fair and equitable. Further, the improvements were made for the long-term benefit of the corporation's business.

Is the Sale-and-Leaseback Valid?

The benefits of a sale-and-leaseback will be available only if there is both a valid sale and a valid leaseback.

Whether there has been a valid sale depends in part on whether the controlling shareholder has taken an equity interest in the property and assumed the risk of loss.(8) For instance, an equity interest exists if the funds for the purchase of the property came directly from the shareholder or if the shareholder took a loan. If the shareholder purchased an insurance policy on the property, that would evidence that he has assumed the risk of loss.

Four tests must be met for a leaseback to be considered valid. First, the useful life of the leased real property must exceed the lease term. Second, if the close corporation may repurchase the real property at the end of the lease term, it must do so at FMV, not at a discount. Third, if the transaction allows for renewal at the end of the original lease term, the renewal rate must be set at fair rental value. Finally, the controlling shareholder must have a reasonable expectation that he will generate a profit from the sale-and-leaseback, taking into account both the value of the property when it is eventually sold and the rent during the lease period.(9)

No one key factor determines whether a valid sale-and-leaseback has occurred; the facts and circumstances determine the outcome.(10) The Supreme Court has held that a transaction will not be labeled a sham, even if there are some tax-avoidance features, if the transaction has economic substance.(11)

Conclusion

A sale of real property by a close corporation to its controlling shareholder, followed by a leaseback to the corporation, offers the parties many financial and tax benefits. It is important that the form and substance of the transaction be scrutinized, so that the transaction will be valid and the parties can reap the benefits.

(1) Elmer J. Benes, 355 F2d 929 (6th Cir. 1966), aff'g 42 TC 358 (1964); Rev. Rul. 72-317, 1972-1 CB 128.

(2) See, e.g., Limericks, Inc., 165 F2d 483 (5th Cir. 1948), aff'g 7 TC 1129 (1946); C.E. Hightower, 187 F2d 535 (5th Cir. 1951); Kerrigan Iron Works, Inc., 17 TC 566 (1951).

(3) Mark R. Switz Inc., TC Memo 1979-162.

(4) Jefferson Block and Supply Co., 492 F2d 1243 (6th Cir. 1974), aff'g 59 TC 625 (1973).

(5) See, e.g., Thomas P. Krukowski, 114 TC 366 (2000); A. Remy Fransen, Jr., 191 F3d 599 (5th Cir. 1999); Stephen Schwalbach, 111 TC 215 (1998); Chester F. Sidell, TC Memo 1999-301.

(6) Jaeger Motor Car Co., 284 F2d 127 (7th Cir. 1960), aff'g TC Memo 1958-223.

(7) Raymond R. Weigel, TC Memo 1996-485.

(8) See Est. of Jerry Thomas, 84 TC 412 (1985); Aditya B. Mukerji, 87 TC 926 (1986); Hardy Co., Inc., TC Memo 1987-63.

(9) See id., see also Jack & James, 899 F2d 905 (10th Cir. 1990), aff'g 87 TC 905 (1986); Leonard Lansburgh, TC Memo 1987-164.

(10) IRS Letter Ruling 9748005 (8/19/97).

(11) Frank Lyon Co., 435 US 561 (1978), rev'g 536 F2d 746 (8th Cir. 1976).

For more information about this article, contact Prof. Fink at [phone] or [e-mail]

Philip R. Fink, J.D., CPA Professor of Taxation College of Business Administration The University of Toledo Toledo, OH