Recently, a couple of clients approached the firm with the same situation – an S Corporation which owned highly depreciated real property with an elderly shareholder as owner of the corporation. The concern centered around what would happen if the shareholder died.
After the death of the shareholder of the S Corporation, the shares would pass in accordance with the shareholder’s Will passing control of the corporation (and the real estate owned by it) to the persons specified therein. The danger is in what happens next.
The shares of stock are passed on with an increase in the value of those shares to the beneficiaries to the date of death value. However, the increase at the date of death is not equal to the value of the property owned by the corporation at the time of death. If the corporation sells the property after death, there will be a very large capital gain which will be recognized by the corporation. This will then be passed along to the shareholders of the corporation on their personal returns.
If the same property was owned by a partnership or LLC at the time of death, there would be no capital gain on the same sale since the real property would have been passed along to the new members of the partnership or LLC at the date of death value.
The only solution to avoid paying the capital gain on the sale of the property for the shareholders is to liquidate the S corporation in the same taxable year as the sale of the property. This liquidation will cause the shares to be liquidated and a capital loss will result. This capital loss should offset the gain and result in the same effect as if the property was owned by an LLC or partnership. However, if the liquidation is not done within the same taxable year as the sale of the property, the capital loss will only be able to be used at $3,000.00 per year going forward.
An even worse situation can result if the S corporation decides to distribute or transfer the property out of the corporation. In this case, even if the property is held by the shareholders and not sold, a capital gain on the property is to be recognized at the same value as if it were sold at the fair market value.
Great care must be taken when dealing with S corporations that own real property so as to avoid making costly mistakes. An experienced real property attorney and/or accountant should be consulted whenever dealing with these issues.