In our practice, owners of commercial real estate are among the most interesting clients with whom we work. As an asset class, real estate presents some of the best leveraging opportunities available to an estate planner. If the real estate produces income and/or has appreciation potential, planners can employ sophisticated strategies to remove that income and/or appreciation from the transfer tax system. Moreover, because most real estate isn’t publicly traded and intra-family transfers often consist of fractional interests, discounts may well apply to transfer tax valuation. But, planning for commercial real estate also presents unique challenges. Among the most important of these is the need to carefully choose the form of ownership through which the real estate operations will be conducted. Will the real estate be owned individually, or will an entity, such as a corporation, partnership or limited liability company (LLC), be used? The right entity choice can vastly improve the results of an estate plan. Often, a planner doesn’t have the luxury of choosing an entity; many clients will come to us with properties pre-wrapped in an entity. Accordingly, it’s equally important to understand how to work with less than ideal entity choices.
Ramifications of Entity Choices
The typical ownership structures for commercial real estate are individual ownership (including tenancy-in-common and joint tenants with right of survivorship) and ownership by a C corporation, S corporation, general partnership (GP), limited partnership (LP) or LLC. Each ownership structure presents its own set of advantages and disadvantages. Below, we describe the common issues for estate planners to consider and how each entity responds to those issues.
Limitation of Liability
Owning real estate individually or through a GP provides no liability protection. In the event of a damage claim arising out of the real estate, not only the real estate itself, but also the owner’s personal assets are exposed. For this reason, we almost never recommend these forms of ownership. On the other hand, if real estate is owned by a properly structured and administered LP, LLC, S corporation or C corporation and a damage claim arises, that claim is collected against only the assets of the entity itself—not against the personal assets of the owner of the entity.1 As among the C corporation, S corporation, LP and LLC, we’re largely indifferent. All provide, generally, the same level of liability protection, subject to the following caveats.
An LP must have a general partner. In the main, a general partner is personally liable for claims arising out of partnership operations. If an individual serves as general partner, the LP form of ownership has provided him no liability protection.2 Accordingly, the GP interest should be owned by a corporation or LLC. Usually, an S corporation or LLC, as opposed to a C corporation, will be used so as to provide pass-through status for income tax purposes.
Entity ownership can provide a different kind of creditor protection, too. Suppose an individual owns an LP interest and a creditor seeks to have the interest assigned to him in satisfaction of a damage claim. Under the laws of many states, if a damage claim3 is made against an individual owning an LP or LLC interest, the claimant’s remedy is a “charging order.” The claimant is assigned the economic rights in the individual’s LP interest equal to the award but has no rights to vote the interest or to liquidate it. Instead, his recourse is to await distributions from the entity if, as and when declared by the general partner or LLC manager. This is an undesirable position for a creditor and may incent the creditor to settle for cash equal to cents on the dollar rather than seek a charging order remedy. Take note, however, that the charging order isn’t the end of the story in every state. For instance, under the Connecticut Limited Liability Company Act, a charging order is the remedy expressly provided a judgment creditor of an LLC member.4 The statute doesn’t, however, state that this is the sole remedy available. This has led at least one Connecticut court to conclude that strict foreclosure may be had upon the interest.5 In contrast, the Delaware Limited Liability Company Act expressly states that the charging order is the judgment creditor’s sole remedy.6 The concept of a charging order doesn’t apply to interests in C corporations or S corporations.
Virtually all sophisticated estate-planning strategies for business owners involve the use of trusts. While it’s easy to place C corporation stock, LP or GP interests or LLC membership interests in a trust, that’s not the case with S corporation stock. Grantor trusts are allowed to be S corporation shareholders, so the intentionally defective irrevocable trust (IDIT) sale, grantor retained annuity trust (GRAT) and spousal lifetime access trust (SLAT) are good candidates for planning with S corporation stock. But, those trusts won’t be grantor trusts forever. And, some clients want to make gifts to trusts that aren’t grantor trusts in the first instance. So, a planner needs to be aware that the extent to which a trust can be an S corporation shareholder is limited. Non-grantor trusts that are permitted shareholders of S corporation stock are the qualified subchapter S corporation trust (QSST) or the electing small business trust (ESBT). The requirements of a QSST are:
• All the trust income is, or is required to be, distributed currently to a single income beneficiary.
• The current income beneficiary is a U.S. citizen.
• The trust agreement requires that, during the life of the current income beneficiary, there will be only one current income beneficiary, and the beneficiary’s income interest terminates on the earlier of the beneficiary’s death or the termination of the trust.
• The trust agreement provides that if the trust terminates during the beneficiary’s lifetime, all the trust assets be distributed to the beneficiary.
• The beneficiary of the trust makes an election.7
The primary benefit of QSST ownership is that the introduction of a trust doesn’t change the pass- through characteristics of the S corporation. However, QSST rules require that there be only one income beneficiary and that income be annually distributed to that beneficiary. This requirement is detrimental to creditor protection planning. Moreover, the QSST requirements frequently make effective generation-skipping planning impossible. ESBTs, however, may have multiple beneficiaries, accumulate income, sprinkle income and principal among the beneficiaries and serve as a generation-skipping vehicle. The requirements of an ESBT are:
• All beneficiaries of the trust must be individuals, estates, charities and other organizations described in Internal Revenue Code Section 170(c).
• No interest in the trust was acquired by purchase.
• An election is made by the trustee.8
The flexibility of an ESBT comes at a price, which is that, with the exception of capital gains, all S corporation income attributable to the trust is taxed at the highest marginal rate applicable to trusts.9
While the C corporation, generally, is a disfavored entity choice for real estate owner estate planning, it can have advantages for certain charitable strategies. For example, if an owner gives an interest in an LLC, LP or S corporation to a charitable entity, such as a private foundation, the income earned by the real estate inside the entity will constitute unrelated business income (UBI), subject to a 100 percent excise tax in the foundation. On the other hand, if C corporation stock is used, the UBI tax issue generally isn’t present. The use of closely held business entities for charitable planning is complex and fraught with numerous other tax risks that are beyond the scope of this article.10 It shouldn’t be undertaken without the advice of a lawyer with solid experience in that area.
Capital Structure Flexibility
Some estate-planning strategies are predicated on the ability to slice up economic rights in a real estate venture into multiple classes, with varying economic rights associated with each class. The LLC and LP both provide significant flexibility in terms of how the capital structure of the entity is set up. The capital structure of a C corporation also can be designed in multiple ways. An S corporation, on the other hand, is prohibited by the tax law from having more than one class of stock (other than classes whose sole variance is in voting rights).11
Distributions from the Entity
For many powerful estate-planning strategies to work optimally, cash or asset distributions from the entity should be subject to as little tax friction as possible. Consider, for example, the tax effects of distributions necessary in an IDIT sale or GRAT. If the real estate is held in a C corporation, the tax drag associated with accessing cash to make annual interest or annuity payments is significant. The corporation must earn income, which is subject to income tax at the corporate level, and then declare a dividend, which is subject to tax at the trust/grantor level, to make the interest or annuity payment. By contrast, if a pass-through entity, such as an S corporation, LLC or LP is used, tax is paid only at the shareholder, member or limited partner level.
At times, an estate-planning strategy will require a distribution of the real estate itself. For example, if there’s insufficient cash in the entity to make a balloon payment of principal on an IDIT sale note or the annuity payment on a GRAT, the entity may distribute assets in-kind as payment. The extent to which such a distribution attracts an income tax varies depending on the type of entity owning the property, but the corporate forms generally are disfavored and the partnership and LLC forms favored. Generally, appreciated property may be distributed by an LP or LLC to the owners without the recognition of taxable gain,12 unless the distribution is subject to the “deemed sale” rules.13 On the other hand, when assets are distributed from an S corporation or C corporation, tax may be assessed. In an S corporation, taxable gain is recognized at the corporate level when the corporation distributes appreciated assets to its shareholders. The gain flows through pro rata to all of the S corporation shareholders. The same tax treatment applies to distributions from C corporations, except that the gain is taxed at the corporate level rather than at the shareholder level.
The Problem of Negative Capital
Regardless of whether real estate is owned individually or through an S corporation, LP, GP or LLC, planners must carefully consider the problem of negative capital. Negative capital typically results from income tax deductions, such as depreciation, or from refinancing debt on the property when the loan proceeds are distributed to the owners, reducing the owners’ capital accounts to the extent the cash distributions were derived from nonrecourse borrowings. Upon a disposition of all or part of the owner’s interest in the real estate or in the entity owning the real estate, phantom gain will be recognized to the extent of the negative capital associated with that interest. Note that a transfer by an owner to a grantor trust won’t cause recognition,14 but this may merely represent a deferral of recognition. If grantor trust status ceases during the owner’s lifetime, gain is recognized. While the law is unclear on whether termination of grantor trust status at the grantor’s death will cause gain recognition, there’s a serious risk that it does.15 For these reasons, real estate subject to negative capital generally isn’t the ideal asset for most planning devices, such as the SLAT, GRAT and IDIT sale.
On the other hand, the multi-class freeze partnership (MCFP) may present a planning opportunity for a negative capital account asset. Under the MCFP, the owner retains ownership of a significant portion of the entity owning the real estate in the form of the owner’s preferred equity interest. If the interest remains in the owner’s name at death, there will be a step-up in basis under the basis rules of IRC Section 1014, and negative capital will be erased.16 If a transfer strategy, such as the SLAT, GRAT or IDIT sale, is chosen instead of the MCFP, the applicable trust agreement should contain language permitting the grantor to reacquire the trust assets. Using such language, an owner could choose to buy the negative basis asset back from the trust. The buy-back doesn’t generate taxable gain.17 It locks post-transfer appreciation inside the trust and puts the negative basis asset back in the grantor’s estate, where the basis step-up rules will wipe out the negative capital associated with the interest. The problem of negative capital isn’t present if an estate-planning exercise involves a transfer of shares in a C corporation owning real estate.
State and Local Conveyance Taxes
In our experience, planners often are so focused on estate, gift, generation-skipping transfer and income taxes that they forget to consider state and local conveyance taxes. It’s beyond the scope of this article to survey the real estate conveyance tax laws of the 50 states and the District of Columbia. The rules of our home state of Connecticut, however, are illustrative. Under Connecticut’s rules, a transfer of an interest in real estate for consideration will generate a state conveyance tax of between .75 percent and 1.25 percent and a municipal conveyance tax of .25 percent or .50 percent, with the applicable rate depending on the value and/or location of the property.18 However, a transfer for no consideration won’t incur either tax. This regime can mean, for example, that a gift of real estate to a SLAT or a GRAT won’t generate a conveyance tax, but a sale to an IDIT will generate a tax.
Connecticut’s conveyance tax applies only to transfers of real estate and not to transfers of interests in entities that own real estate. Therefore, use of a C corporation, S corporation, LP or LLC may be a means of avoiding conveyance tax in certain circumstances. However, Connecticut imposes a controlling interest transfer tax (CITT). The CITT applies to a transfer of a greater than 50 percent interest in an entity owning real estate.19 Transfers that are a part of one transaction or a series of related transactions, generally are aggregated for purposes of the 50 percent test.20 As such, it’s generally not possible for an owner to transfer a 49 percent interest in an entity to two separate trusts and avoid the tax. The CITT applies to transfers for consideration.21
Several states have conveyance and CITT tax systems similar to those in place in Connecticut. The moral of the story is that planners should take care to check their state’s conveyance tax laws before proceeding with a real estate transfer strategy.
Death of the Owner
On an owner’s death, her interest in a real estate entity receives a step-up in basis equal to the fair market value (FMV) of the interest at the date of death under the rules of IRC Section 1014. The step-up, however, applies to the owner’s interest in the entity itself, commonly referred to as “outside basis.” It’s not an adjustment to the “inside basis” of the real estate or other assets of the entity. Accordingly, a sale of appreciated entity assets could generate a capital gain to a decedent’s estate notwithstanding the automatic step-up in basis rules.
You can avoid this result if real estate is owned in a partnership or LLC. IRC Section 754 permits a partnership or LLC to make an election to adjust inside basis to FMV. If this election is made, the inside basis is adjusted to equal the outside basis. But, there are instances when the Section 754 election won’t be made. First, the election must be made on the entity tax return. If the decedent’s estate doesn’t control the filing of that return, the entity may simply refuse to make the election because of the increased recordkeeping required. Second, a Section 754 election isn’t always beneficial. The election will cause an inside basis adjustment to FMV whether the adjustment increases or decreases that basis.22 Accordingly, the decedent’s executor should carefully analyze each instance to determine whether the Section 754 election will be beneficial rather than succumb to a knee-jerk reaction that the election should always be made. For instance, the election shouldn’t be made if discounts applied in valuing the decedent’s outside basis to FMV for estate tax purposes will reduce the decedent’s inside basis below cost basis. It should be noted, however, that if the adjusted basis of all entity property exceeds the FMV of such property by more than $250,000 on the date of death, the decedent’s inside basis must be stepped down to decedent’s outside basis regardless of whether a Section 754 election is made.23
A Section 754 election isn’t available for a decedent’s shares in an S corporation. In some cases, however, it may be possible to achieve a step-up of inside basis by liquidating the S corporation in the year of the deceased shareholder’s death. A corporate liquidation is considered a deemed sale of the corporation’s assets, resulting in capital gain or loss.24 Because the gain at the corporate level is passed through to the deceased shareholder’s estate, there may be an opportunity to obtain a step-up of outside and inside basis of the shares to FMV as of the decedent’s date of death. For example, let’s say that a decedent was the sole shareholder in ABC, Inc., which owned, as its sole asset, real estate with a basis of $100,000. At the decedent’s death, the basis in his shares (outside basis) is stepped up to FMV, which we’ll assume was $500,000. The inside basis remains at $100,000. Assuming the FMV of the real estate is $500,000, a corporate liquidation creates a capital gain of $400,000, which results in a basis in the real estate of $500,000. The deemed gain on the corporate liquidation passes through to the estate, thereby increasing the basis of its stock to $900,000. The liquidating distribution of the corporate assets (the real estate) to the estate is considered payment in exchange for the estate’s shares.25 Consequently, the estate will recognize a capital loss offsetting the gain from the liquidation. That is, the estate receives an asset with a value of $500,000 in exchange for its stock with a basis of $900,000 generating a loss of $400,000. This loss is subtracted from the deemed gain of $400,000, thereby producing a net of zero. Whether the liquidation technique will make sense in a given estate depends on a variety of factors, including whether there are surviving shareholders, whose outside stock basis wouldn’t be stepped up on the death of the decedent shareholder and who may have no interest in distributing the real estate or in liquidating the corporation.
The death of an S corporation shareholder can raise concerns regarding the continuation of the S corporation election. As noted above, only particular types of trusts qualify as S corporation shareholders. Advisors sometimes fail to plan for these requirements with the result that S corporation shares may pass to a trust that isn’t a qualified shareholder, thereby eliminating the corporation’s S status. A decedent’s estate is a qualified S corporation shareholder. Any trust to which the estate will transfer the shares has a 2-year grace period in which to qualify as an S corporation shareholder. This 2-year grace period runs while the estate holds the stock, and if the trust doesn’t qualify at the end of the period, the S election for the corporation will terminate.26 These rules make it critical to determine during the grace period whether the trust to which the estate shares are distributable will qualify as an S corporation. If the trust doesn’t constitute a QSST, perhaps an ESBT election is viable, or outright distributions of the shares can be made to avoid termination of S corporation status.
C corporation shares owned by a decedent shareholder also obtain a step-up in outside basis to FMV as of the date of death. However, as with an S corporation, no Section 754 election is available to a C corporation to provide an inside basis step-up. Moreover, because of the corporate level tax, the liquidation strategy described above, which may make sense for an S corporation, won’t provide an income tax benefit for a C corporation that must recognize gain on a liquidation as if the property had been sold pursuant to IRC Section 336.
Planning for owners of commercial real estate is a complex undertaking in virtually every case, because challenges unique to real estate are found within the context of both the planning process and during estate administration. While we would, of course, prefer to be involved in the entity selection process, the entity choice decision has often been made prior to our engagement. Occasionally, our first introduction to a family’s real estate entities isn’t during an estate planning engagement, but during an estate administration. Each of these situations generates questions and issues regarding the benefits and limitations of the various entities used to hold real estate. The foundation for effectively managing these challenges and providing the best results possible is a comprehensive working knowledge of the various entities used to hold real estate.
1. Planners typically recommend holding each parcel of real estate in its own entity. This approach insulates each parcel from claims involving any of the other parcels.
2. See, for example, Connecticut Uniform Limited Partnership Act, Connecticut General Statutes Sections 34-1 to 34-8; Section 34-17, which provides that a general partner of a limited partnership shall have all of the liabilities of a partner in a general partnership (GP). Connecticut Uniform Partnership Act, Connecticut General Statutes Sections 34-300 to 34-399; Section 34-327 provides that partners of a GP shall be jointly and severally liable for all obligations of the partnership.
3. The claims being considered here are claims against an entity owner’s ownership interest unrelated to the operations of the entity, such as a claim by the divorcing spouse of the owner.
4. Connecticut General Statutes, Section 34-171.
5. Madison Hills Ltd. P’ship II v. Madison Hills, Inc., 35 Conn. App. 841 (1994). Under strict foreclosure, the creditor becomes an owner (as an assignee) of the entity. See also Kriti Ripley, LLC v. Emerald Invs., LLC, No. 27277, 2013 WL 3200596 (S.C. June 26, 2013).
6. Del. Code Ann. Tit. 6 Section 18-703(d). A charging order is the exclusive remedy available to the creditor, including when the limited liability company (LLC) is a single member LLC.
7. Treasury Regulations Section 1.361-1(j).
8. Internal Revenue Code Section 1361(e).
9. IRC Section 641(c)(2)(A); Treas. Regs. Section 1.641(c)-1(e)(1).
10. For a more detailed discussion, see Daniel L. Daniels and David T. Leibell, “Planning for the Closely Held Business Owner: The Charitable Options,” 40 Fortieth Ann. Heckerling Inst. on Est. Plan., Ch. 14 (2006).
11. An S corporation may be able to obtain some of the benefits of a multi-tier freeze partnership. The corporation and a trust for the owner’s family could enter into a partnership agreement. The corporation would contribute its real estate in return for preferred units, and the trust would contribute assets in return for common units. See, however, the discussion below on the possible income and conveyance tax consequences of distributing the real estate out of the corporation.
12. IRC Section 731(b).
13. See IRC Sections 707(a)(2)(B), 704(c)(1)(B) and 737.
14. See Treas. Regs. Section 1.1001-2(c) Ex. 5; Madorin v. Commissioner, 84 T.C. 667 (1985).
15. Commentators have come to different conclusions. See Deborah V. Dunn and David A. Handler, “Tax Consequences of Outstanding Trust Liabilities when Grantor Trust Status Terminates,” 95 J. Tax’n 49 (2001), arguing that there’s recognition. See Jonathan G. Blattmachr and Mitchell M. Gans, “No Gain at Death,” Trusts & Estates (February 2010) at p. 34, arguing that termination of grantor trust status as a result of the grantor’s death shouldn’t cause recognition.
16. See Crane v. Comm’r, 331 U.S. 1 (1947).
17. Revenue Ruling 1985-13.
18. Connecticut General Statutes, Section 12-494.
19. Connecticut General Statutes, Section 12-638b (a)(1).
20. Connecticut General Statutes, Section 12-638b(a)(2).
21. Connecticut General Statutes, Section 12-368n; see also Connecticut Department of Revenue Services Special Notice 2003(11).
22. Treas. Regs. Section 1.541-1(a).
23. IRC Sections 743(a) and 743(d).
24. See IRC Section 336.
25. IRC Section 331.
26. Treas. Regs. Section 1.1361-1(j)(7(ii).