Llc Real Estate Investment Tax Schedule
Llc Real Estate Investment Tax Schedule document sample
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Removing Real Estate from Corporations (An Advanced Workshop and Interactive Discussion) AICPA NATIONAL TAX EDUCATION PROGRAM IUPIU INDIANAPOLIS, INDIANA JULY 24, 2002 BRIAN T. WHITLOCK, CPA, JD, LLM Blackman Kallick Bartelstein, LLP 300 S. Riverside Plaza Chicago, IL 60606 Phone: (312) 980-2941 Fax: (312) 207-1066 e-mail: firstname.lastname@example.org Removing Real Estate from Corporations (An Advanced Workshop and Interactive Discussion) Real Estate is an asset that most businesses acquire at some point. Our preference is generally to hold it outside of the regular corporation, but all too frequently we come across clients whose corporation balance sheet includes land and buildings. The reasons for originally holding the real estate in the corporation seemed valid at the time it was acquired, but now? The value of the real estate is increasing. The shareholders would like to remove the real estate at the least possible cost. This advanced interactive discussion will give you the opportunity to work with other practitioners and experts as we identify and analyze numerous theoretical and practical solutions for removing real estate from a corporation with the least Corporate Income Tax, Individual Income Tax, and Gift and Estate (Transfer) Tax exposure. Participation will be flexible, but come prepared to learn. You have the opportunity exchange your ideas and explore new strategies with others. You will have the opportunity work through the calculations and the theories to see the potential traps and solutions as they unfold. You WILL learn practical solutions that you can employ to save your clients tens of thousands of dollars. Overview – Putting the Issues in Perspective Your client is holding real estate inside of a Corporation. It is a common scenario. The real estate might be vacant land, investment property, rental property, or it may serve as the corporation’s place of business. The real estate may have been put inside the corporation to avoid a perceived threat of legal liability, to capture an interest deduction, to avoid the accumulated earnings tax, or merely because it was expedient (i.e., the company had an established credit relationship with the bank. Regardless of the reason it was acquired, once the real estate was inside of the corporation, it gave rise to numerous tax and family considerations. If the real estate is held inside the corporation, it cannot be used by the family to generate passive income for the benefit of senior family members. Real estate generally appreciates in value. Inside the corporation that value benefits only the members of the family that are active in the business, or shareholders in the business. From a tax perspective, there are three potential tax traps for appreciated real estate: Corporate Income Taxes Accumulations of investment assets may be subject to Accumulated Earnings Penalty Tax under Internal Revenue Code (IRC) Sections 531-537. Passive assets and the passive income that they generate may trigger Personal Holding Company Taxation under IRC Sections 541-547. Sales and exchanges of appreciated real estate can be subject to corporate level income taxes. Inside of C Corporations gains are taxed at ordinary rates not the typical 20% capital gains rates. Distributions of appreciated assets can trigger corporate income taxes under IRC Section 336. Individual Income Taxes Transfers of appreciated assets to corporation can be subject to taxation under IRC Section 351. Gain (loss) is recognized upon the receipt of property distributions from a corporation IRC Section 301. Gift and Estate (Transfer) Tax Holding real estate inside of corporations creates large monolithic entities that are difficult to share with junior family members that have diverse financial goals. Holding real estate inside of corporations restricts the family’s ability to transfer wealth equitably. Holding investment real estate inside of corporations may limit the estate’s access to deductions under IRC Section 2057 and tax deferral under IRC Section 6166 Holding appreciated assets inside of a corporation restricts estate liquidity. This discussion will attempt to advance numerous solutions. Some solutions will be better suited to avoid or reduce corporate income tax; other may be better suited to avoid or reduce individual income taxation or the transfer tax. There is no “Silver Bullet;” rather as creative CPA tax practitioners it is our challenge to mix, match, and create comprehensive solutions to our clients tax challenges – That’s why we get paid the Big Bucks!” Sale of Assets / Liquidation of a C Corporation Facts The sole shareholder of ABC Inc. is interested in retiring. ABC owns a building with a FMV of $500,000 and zero adjusted basis, and land with a FMV of $100,000 and a $50,000 basis. A buyer is interested in purchasing the real estate and not the stock of the corporation. Strategy ABC Inc. sells the assets and liquidates the corporation; ABC distributes the proceeds to the sole shareholders in exchange for their stock. Tax Consequences if ABC is a C Corporation. ABC Inc. - will recognize a $550,000 gain on the sale of the land and building. ABC will pay tax at regular corporate rates (as high as 35%) on the recapture of depreciation as well as the capital gain. ABC will distribute the proceeds, less the corporate tax of $192,500 and miscellaneous liabilities, to the shareholder. The Shareholder - will recognize capital gains equal to the proceeds received in liquidation, less his/her basis in the stock. The shareholder will pay tax at the reduced individual capital gains rates (generally 20%). Common Strategies for Deferring or Reducing the Corporate in a Sale Seller Makes Payments of Current and/or Accrued Deferred Compensation ABC can also pay compensation and/or a bonus to its key employee for negotiating a successful sale of its business assets. Obviously, in order for compensation to be deductible, it must be reasonable. If the Seller can anticipate a sale of its business by more than one year, then the Seller may be able to accrue a larger amount of compensation deduction as an inducement to the key employees to stay. Seller controlled Gain Deferral – Like Kind Exchange IRC Section 1031 allows taxpayers selling real estate to defer the income tax on the sale of real estate, if the Seller engages in a like kind exchange. The Seller must follow specific rules laid out in the Regulations under Section 1.1031 regarding the handling of the proceeds and the identification and acquisition of the replacement property. Seller controlled Deferral of Gain – Private Installment Sale The gain on installment sales is generally reported over the term of the installment note. Where the installment note is to a related party Section 453(e) requires that the real estate be retained for at least two years by the installment buyer. After two years the real estate may be resold without triggering a gain in the installment note. Note can stay in corporation until shareholders death. Annual interest and capital gain in corporation can be offset by operation expenses and benefits inside the corporation. WARNING: Transfer of note will accelerate remaining gain on uncollected balance of note. Allocation of Purchase Price Buyers of entrepreneurial businesses generally wish to acquire assets rather than the shareholder’s equity interest. The purchaser will generally wish to deduct its purchase price in the form of depreciation or business expenses. Proceeds may be allocated towards the purchase of the following assets: Inventory will be recovered in the first business cycle (generally less than 1 year) Real estate will be recoverable through depreciation deductions over 39 years Equipment, furniture, etc. may recoverable over 5 – 7 years Goodwill over 15 years (IRC Section 197) Land is not depreciable. Purchaser Makes Payments direct to Equity Seller under Covenant Not to Compete A portion of the proceeds may be paid directly by the purchaser to the seller and not pass through the corporation. Payments under a Covenant Not to Compete are generally deductible by the corporation as paid. Payments received by the individual are taxable as ordinary income. Purchaser Makes Payments direct to Equity Seller for Personal Goodwill In Martin Ice Cream Company v. Commissioner, 110 TC 189 (March 17, 1998), the Tax Court held that the customer relationships were the property of the Shareholder who personally developed the business relationships and contacts. The Shareholder never signed an employment agreement with the company and he never transferred the relationships to the corporation. The relationships were the property of the Shareholder, not the corporation. Since the payments never pass-through the corporation, they are not subject to corporate taxation. The payments received by the individual qualify as the sale of an asset and thus qualify for capital gain treatment. Strategies for Reducing or Avoiding Tax by Removing Assets Distributions in Liquidation – Asset Management Tools A corporate level tax will generally be due upon the distribution of an asset from a corporation under IRC Section 336. The tax will be assessed on the difference between the fair market value and the adjusted basis. Absent a sale to a third party, the fair market value will be determined by an appraisal. “Fire Sale” (Get low and go) - The lower the appraisal the lower the corporate tax. Timing the Transfer The lower the differential between the appraised value and the adjusted basis, the lower the corporate tax. Additions and improvements rarely add to the market value in the same measure as they add to basis. Example: ABC Inc., currently owns a building and land with a basis of $100,000 (accumulated depreciation $100,000) and $50,000, respectively. The fair market value (FMV) of the building and land are $500,000 and $100,000, respectively. In order to accommodate its ever growing business, ABC decided to expand its building at a cost of $500,000. ABC also spent an additional $100,000 on land improvements. Due to the nature of the additions, the building's FMV increased by only $150,000, and the land's FMV increased only marginally. The gain differential shrunk from $550,000 to $100,000. Transferring the real estate after the improvements are complete will reduce the corporate tax. Asset Compression If the corporation contributes the real estate to Family Limited Partnership or Limited Liability Company, in exchange for a restricted equity interest, then a business appraiser may be able to discount the value of the equity interest for lack of marketability and/or lack of control. Asset Fractionalizations: Vertical and Horizontal Divisions The ownership of real estate can be divided both vertically and horizontally. Vertical divisions include: tenancies in common, and partnerships. (For Example: the corporation could sell and undivided interest in the real estate prior to liquidation). Horizontal divisions include: leasehold interests, life estates and remainder interests, and land only sale and leasebacks. Asset Compression: Family Limited Partnership Rollout The Facts ABC Inc., a C Corporation, owns a building with a FMV of $500,000 and zero adjusted basis, and land with a FMV of $100,000 and a $50,000 basis. The land and building will likely continue to appreciate over the years. The Strategy ABC Inc. contributes the land, building, and improvements to a Family Limited Partnership in exchange for limited partnership interests at lowest reasonable appraised values. The shareholder contributes cash and property at highest reasonable appraised values to the Family Limited Partnership in exchange for a general partnership interest. Tax Consequences The contribution of property to the Family Limited Partnership will be a nontaxable transfer under Section 721 of the Code. ABC will recognize a gain on the sale or distribution of the limited partnership interest. The gain will be equal to the discounted value of the limited partnership interest, less its basis. The basis of the limited partnership interest is that of the property contributed to the partnership for said interest. CAUTION: The transfer of the limited partnership interest should not be near the time of the formation of the limited partnership. In Pope & Talbot, Inc., 104 T.C. No 29 (1995), the Court ruled that the distribution of the partnership interest triggered gain under Section 311 based upon the value of the property without valuation discounts. The anti-abuse rules in Treasury Regulation Section 1.701-2 may also enable the IRS to challenge the partnership. Vertical Division: Sale of Land - Retention of Building The Facts ABC Inc., a C Corporation, owns a building with a FMV of $500,000 and zero adjusted basis, and land with a FMV of $100,000 and a $50,000 basis. ABC has no plans to move its operations. The land and building will likely continue to appreciate over the years. The Strategy ABC Inc. sells the land, on which its building stands, to a Family Limited Partnership created by the sole shareholder of ABC. The land will be subject to a 40-year lease with ABC. At the end of the 40 years the Family Limited Partnership need not renew its land lease with ABC. Consequently, the land and anything on it (building and improvements) will belong to the Family Limited Partnership. Tax Consequences ABC Inc. will recognize a gain on the sale of the land (($100,000-$50,000)*.35 = $17,500 tax). It will also deduct rent payments paid to the Family Limited Partnership. Vertical Division: Split Interest Purchase of Real Estate The Ultimate Section 1031 Exchange The Facts ABC Inc., a C corporation, is selling its existing business real estate and is considering the purchase of new land valued at $200,000 and constructing a building valued at $2,000,000 to be used in operations. They would like to avoid purchasing the replacement real estate inside the corporation, since this will trap an appreciating asset inside the corporation. The Strategy Instead of purchasing the entire interest, the corporation and the shareholder could each purchase a split interest in the land. ABC would purchase a 40-year term interest, and the 100% shareholder would purchase the remainder interest in the land. Richard Hansen Land, Inc., 65 TCM 2869, TC Memo 1993- 248. Split interest purchases and sales have been used in intra-family transactions prior to the 1990 enactment of IRC Section 2702. If the shareholders buy the remainder in proportions equal to the shareholdings, Section 2702 should not apply. Tax Consequences ABC Inc. - The cost of the term interest in the land would make up most of the cost ($169,050). ABC could amortize this amount, but it would not be deductible under IRC Section 167(e)(3)(B). The amortization would flow to Schedule M-1. ABC would depreciate and deduct the building cost. At the end of 40 years, the land and building would pass to the shareholder without any tax consequences to ABC. Shareholder – The cost of the remainder interest would be nominal ($30,950). This amount would not be deductible. At the end of 40 years, the land and building would pass without any tax consequences to Shareholder. Vertical Division: Charitable Lead Trust Created by Corporation The Facts ABC, Inc. owns a Building with a FMV of $500,000 and a zero adjusted basis; the building sits on land with a FMV of $100,000 and a $50,000 basis. Phase 1: Fractionalizing the Value into Functional Parts. ABC, Inc. transfers the land and building to a Nonqualified Nonrandom Charitable Lead Trust (CLT). In a CLT, a qualified charity receives 100% of the income interest for a term of years while the donor retains the remainder interest. At the end of the term, the remainder interest in the trust will be returned to ABC, the donor. Tax Consequences ABC's contribution to the CLT will not be tax deductible. If the CLT is a non-Grantor Trust then there are no income tax consequences to the donor. The trust will collect the rental income and the trust will pay the entire amount to qualified charities, thus ABC will avoid the charitable limitation imposed on C Corporations equal to 10% of income. The split interest trust will not be subject to the excise taxes on transactions with private foundations if the payment is not a structured as an annuity (CLAT). Phase 2: Transferring the Remainder The shareholder will create a Generation Skipping Trust (GST) for the benefit of his descendants. The shareholder will fund the trust with a gift equal to the value of the remainder interest of the CLT. The GST trust will then purchase the remainder interest in the CLT from ABC. Tax Consequences The value of the income interest will be determined under IRC Section 7520. As a result, the income interest will be greater as the AFR (interest rate) is higher and the term is longer. Therefore, ABC will recognize a sale a capital gain on the sale of the remainder interest. Any appreciation of the property will be free from both the shareholder's and his spouse's estate for estate tax purposes. Strategies for Reducing or Avoiding Tax by Removing Assets Tax-free Divisions – Equity Management Tools Spin-offs and Split-ups Section 355 of the Internal Revenue Code allows corporations to reorganize (i.e., divide into two separate corporations) income tax free. The key requirements of a tax-free division of a corporation under Section 355 are: (1) Both of the new corporations must be engaged in the active conduct of a trade or business; (2) such trade or business must have been actively conducted for a period of five years prior to the division; and (3) the transaction must not be used principally as a device for the distribution of earnings and profits. FLP Spin-off Similar to the compression technique, the corporation contributes the real estate to Family Limited Partnership or Limited Liability Company, in exchange for an equity interest in the new entity. The FLP hold the real estate for a long period and operate it as rental property paying a management fee back to the corporation as general partner. The corporation elects “S” Corporation status. (See S discussion). REIT Spin-offs The separate active trade or business requirement can be difficult to support where the real estate is a single purpose manufacturing facility that is used solely by the business. A new alternative may be available as a result of Rev. Rul. 2001-29, 2001-26 IRB 1348. In this ruling a C Corporation contributed its appreciated real estate to a new corporation that elected to be taxed as a REIT (Real Estate Investment Trust). According to the Ruling a REIT can meet the active trade or business requirement of Section 355(b). After the spin off, the REIT rents the real estate back to the C Corporation, which provides the REIT with substantial cash flow. The REIT can then function as a pass through entity by distributing as dividends all of its capital gains and at least 90 percent of its taxable income. IRC Section 857. A REIT must not be closely held after the first year to which the REIT election applies. Section 856(a)(6). An entity is considered to be closely held if at any time during the last half of its taxable year, more than 50% of the value of its outstanding stock is held by 5 or few shareholders. In addition, a REIT must have 100 or more unrelated shareholders after the first year to which the REIT election applies. Section 856(a)(5). The original shareholders of the C Corporation who receive the REIT shares should be eligible for capital gains treatment. NOTE: IRS Notice 88-19, 1988-1 C.B. 486 describes regulations under IRC Section 337 that the IRS intends to promulgate that would require REITs to either track for 10 years (similar to S Corporations) or recognize built-in gains at the time the C Corporation transfers assets to a REIT in a carryover basis transaction. Presumably the rules of Section 1374 would apply. Strategies for Reducing or Avoiding Tax when Holding Assets Getting to S S Corporations are not subject to corporate income tax on gains. Exception: Built In Gains (BIG) recognized within 10 years of a C Corporation with retained earnings conversion to S may be subject to tax under IRC Section 1374. Absent taxation under Section 1374, the gain recognized on the sale of a capital asset will be taxable to the S Corporation shareholders pro-rata. The gain in the hands of the shareholders will carry the same treatment as if the shareholder had individually sold its pro-rata share of the underlying assets. Thus, the gain will be eligible for the applicable capital gains rates of 8, 10, 18, 20, 25, and 28%. Once taxed, the gain will add to the shareholder Accumulated Adjustments Accounts (AAA) pro- rata. The S Corporation shareholder’s stock basis is increased (decreased) by changes in AAA. As a result, no additional income or capital gains tax (attributable to the disposition of the appreciated real estate) will be due from the shareholder upon the subsequent liquidation of the S corporation. The “BIG” Myth “All Built in Gains recognized with 10 years of conversion to S are taxable.” --- NOT TRUE!!!!!!!!!!!!!! 1) Post election gains (appreciation) are not taxable under Section 1374. PLANNING POINT: Get an appraisal of each asset that is likely to be sold within a ten-year period. The BIG on that asset will be limited to the differential between FMV and the adjusted basis on the date of election – not the date of sale. 2) Only net unrealized BIG is taxable – The net unrealized BIG is unrealized gains minus unrealized deductions (e.g., Section 481 adjustments; losses not allowed under Sections 382, 383 or 384; Section 467 accruals; Section 267 accruals to shareholders and related parties; nonqualified deferred compensation plans). The limitations under Section 1374(c) are often overlooked by tax practitioners. First, Section 1374(c)(1) excludes corporations that were always S Corporations. Secondly, “the total cap on net recognized built-in gains in the corporation’s net unrealized built in gain.” Eustice and Kuntz, Federal Income Taxation of S Corporations (Warren, Gorham & Lamont, 3rd Edition, 2001). Let’s follow the statute. Section 1374(c)(2) reads as follows “The amount of net recognized built in gain taken into account under this section for any taxable year shall not exceed the excess (if any) of – (A) the net unrealized built-in gain, over (B) the net recognized built-in gain for prior taxable years beginning in the recognition period.” Section 1374(d)(1) defines the term “net unrealized built-in gain” as “(A) the fair market value of the assets of the S Corporation as of the beginning of its 1st taxable year for which an election under section 1362(a) is in effect, exceeds (B) the aggregate adjusted bases of such assets at such time.” Section 1374(d)(5)(C) provides: “The amount of the net unrealized built-in gain shall be properly adjusted for amounts which would be treated as recognized built-in gains or losses under this paragraph if such amounts were properly taken into account (or allowable as a deduction) during the recognition period.” As early as 1986, the Infernal Revenue Service announced that it would adopt an “anti-stuffing rule” that would apply if shareholders contribute depreciated property to the corporation before the election is made. IRS Announcement 86-128, 1986-51 IRB 22. Treas. Reg. Section 1374-9 in fact applies where a corporation acquires an asset before or during the recognition period with a “principal purpose” to avoid the tax. Avoiding the Section 1375 Passive Income Tax and Termination - Section 1362(c)(3) Section 1375 of the Infernal Revenue Code imposes a tax whenever “passive investment income” of an S Corporation with old C Corporation accumulated earnings and profits exceeds 25% of the S Corporation’s gross receipts. Section 1362(c)(3) acts to terminate the corporation’s S election where the “passive investment income” in excess of 25% of the S Corporation’s gross receipts three consecutive years. Passive Investment Income is generally defined to include gross receipts derived from “royalties, rents, dividends, interest, annuities, and sales or exchanges of stock or securities” (at an actual gain). IRC Section 1362(d)(3)(C). Passive Investment Income Planning Solutions: 1) Pay out all C Corporation Earnings and Profits The Section 1362 termination clause only take effect when the S Corporation has prior C Corporation retained earnings and profits “at the close of each of third consecutive years”. If all of the E & P is paid out as a dividend before the end of the third year, taxable to the shareholders, then the Corporation may operate freely as an S Corporation with unlimited passive income. The dividends may be spread out over the periods in order to minimize the tax impact. The Section 1375 tax is calculated on the excess net passive income. The code limits the amount to the corporation taxable income without regard to the amortization of organizational expenses under Section 248 and without regard to deductions for net operating losses under Section 172. 2) Create 75% or more active income to counteract and override passive investment income concerns. a) Provide significant services or incur significant costs in the rental business. Treas. Reg. Sec. 1.1362-2(c)(5)(ii)(B)(2). A score of Revenue Rulings b) Provide management services to another entity (i.e., FLP, LLC, or S Corporation) Good for relatively small amount; c) Create Joint Venture with Tenant. See White Ferry, Inc. v. Comm., TC Memo 1993-639. d) Invest in a partnership. Partnership gross receipts retain the same character. Partner is allowed to include pro-rata share of gross receipts. PLR 8706052 provided two examples: one partnership that operated a hotel, the other leased retail and office space. 3) Merge C Corporation or Personal Holding Company with an active business and elect S for the combined entity. a) Wait 10 years before you dispose of BIG; or b) Offset BIG with deductions and other BILs in order to zero out your NET BIG Remember that the test for Built In Gains (BIG) is generally a one time only test. If on the date of the election to S Corporation status there is no Net BIG then the there is no tax imposed under Section 1374 at any time throughout the entire 10 year period. Third Party Intermediary Vendors A number of venture capital firms have arisen in the last few years that make a business of leveraging off of other people money. In the course of presenting these materials over the last 4 years I have come across two such companies: MidCoast Investments, Inc. Fortrend International, LLC 1926 10th Avenue North, Suite 400 750 Lexington Avenue Lake Worth, FL 33461 39th Floor New York, NY 10022 Each of these companies looks for the acquisition of C Corporations that are in the process of negotiating a sale of their assets to unrelated third parties. These companies acquire the stock of the C Corporation after the sale has been negotiated but before the company has been liquidated. The intermediary pays the shareholders an amount that is greater than the after tax liquidated value of the company. The proceeds in the hands of the shareholder are taxed as a capital gain. The intermediaries then use the cash generated from the sale of the assets to purchase “bank and credit card company receivables” at pennies on the dollar. The intermediary changes the core business and the method of accounting for the C Corporation and acts as a collection business, deferring the C Corporation’s tax payment on the sale of the assets and thus playing the float on the tax dollars. Lifetime Sale of Assets / Liquidation of an S Corporation Facts The sole shareholder of ABC Inc. is interested in retiring. ABC owns a building with a FMV of $500,000 and zero adjusted basis, and land with a FMV of $100,000 and a $50,000 basis. A buyer is interested in purchasing the real estate and not the stock of the corporation. Strategy ABC Inc. sells the assets and liquidates the corporation; ABC distributes the proceeds to the sole shareholders in exchange for their stock. Tax Consequences if ABC is an S Corporation. ABC Inc. - will not pay any Federal Income tax on the sale of the assets, if the Built in Gain rules do not apply. The Shareholder – will pay Federal Income tax. The $550,000 gain recognized by ABC will flow through the corporation to the shareholder's income tax return, if ABC is an S Corporation. The gain will be taxed at the shareholder's individual capital gain rates: 25% on recapture of depreciation and 20% on the true appreciation (approximately - $115,000), instead of the Corporate tax rates, which are significantly higher ($192,500). The S Corporation income (AAA) will add to the shareholders’ basis and thus avoid a second level of tax upon liquidation and distribution of the corporation's assets to the shareholders. Post Mortem of Sale and Liquidation of S Corporation The Facts All the shares in ABC Inc., an S Corporation, were owned by the shareholder. Upon his death the stock of the S Corporation received a step-up in basis. The date of death value of the stock is $1,000,000. ABC owns a building with a $500,000 FMV and an adjusted basis of zero, and land with a FMV of $100,000 and a basis of $50,000. The Strategy ABC distributes the land and building and liquidates in the year the shareholder's stock receives a step- up in basis. Tax Consequences following Death of Sole Shareholder In a partnership, the entity could make an IRC Section 754 election a set-up the basis of the assets inside the partnership to reflect the increase in basis in the hands of the partner under IRC Section 1014. This would avoid the capital gain to the extent of the raised basis. Although S Corporations are taxed like partnerships, significant differences continue to exist. Specifically, S Corporations are not permitted to make an election similar to IRC Section 754. Nonetheless, a similar result is possible if the S Corporation carefully handles the sale and subsequent liquidation. Here are the steps to follow: 1. The stock receives a “step-up” in basis equal to its fair market value at the shareholder's date of death ($1,000,000). 2. The Corporation realizes a $550,000 gain on the sale of the building and land. 3. The gain flows down to the shareholder and will be shown on his annual tax return and increases the basis of the S Corporation stock to $1,550,000 (the "adjusted basis"). 4. At liquidation, the building, land, and other assets distributed would be $550,000 less than the adjusted basis of the stock. Therefore, the estate would recognize a $550,000 capital loss on his income tax return. 5. The capital loss netted against the capital gain would result in a zero capital gain to the estate for income tax purposes, as long as it occurs in the same calendar year. The Partial Redemption (AAA Bailout) The Facts ABC Inc., an S Corporation, currently owns a building and land with an adjusted basis of $600,000. The fair market value (FMV) of the building and land are $750,000. The Strategy ABC redeems a portion of shareholder equity in exchange for the building and land. The redemption should be structured so that it will not be “substantially disproportionate.” IRC Section 301 and 302. The redemption will be treated like a dividend. Tax Consequences of the AAA Bailout ABC Inc. - Under IRC Section 311, distributions of appreciated property to a shareholder will be treated as a sale. Therefore, the distribution of the building and land will result in a $150,000 capital gain ($750,000-$600,000), $100,000 of which is recapture depreciation. Since ABC Inc. is an S Corporation the capital gain will flow through to the shareholder and be reported on his 1040 and taxed at 25%. Shareholder - Under IRC Section 1368, shareholders are not taxed on dividends unless their Accumulated Adjustment Account (AAA) is less than the amount of the dividend. The AAA account is the sum of the earnings in an S Corporation that are taxed, but not distributed to the shareholder. Any amount in excess of the shareholder's AAA account is treated as a gain from a sale or exchange of property. In the present situation, the shareholder's AAA account equals $1,151,000. The dividend equals the FMV of the land and building distributed, $750,000. Consequently, the dividend will not be taxable and the shareholder's AAA account will be reduced by $750,000 to $401,000. Rev. Rul. 95-14, 1995-1 C.B. 169.