Property, such as real estate, can increase in value while someone owns it. S corporations, like other taxpayers, can recover the after-tax money put into the property tax free through depreciation deductions or capital gains calculation. Typically when an S corporation distributes property, it must recognize gain or loss on the distribution. Under certain circumstances, an S corporation can distribute appreciated real estate into a limited liability company, or LLC, tax free.
Section 721 Contributions
Although substantial limitations apply to LLCs owning interests in S corporations, S corporations are free to own membership shares of LLCs. Section 721 of the tax code allows members to make tax-free contributions to LLCs in most circumstances. As with other provisions for tax-free contributions, the LLC assumes the S corporation’s basis in the real estate to defer recognizing gain. Several restrictions apply to prevent abusively disguising sales as contributions.
Read More: How to Add Capital Contributions to an LLC
Disguised Sales Circumstances
The tax code includes a few provisions designed to catch tax-free contributions to LLCs that are used to disguise a sale or exchange. When an S corporation contributes appreciated real estate to an LLC, it can lose the tax-free treatment under Section 721 if certain events take place following the contribution. If the LLC distributes the real estate to another member of the LLC within seven years, the S corporation will have taxable gain at the time of the distribution. Likewise, if the S corporation receives other property from the LLC as a liquidation of its interest within seven years, it loses the tax-free treatment of its contribution. Distributions of money or property from an LLC to the S corporation within two years of the real estate contribution are presumed to be related -- and taxable -- exchanges.
An S corporation’s contribution of appreciated real estate only qualifies for tax-free treatment if it has or receives a membership interest in the LLC. When an S corporation receives a membership interest in exchange for the contribution, it must exchange directly with the LLC. Should it contribute the property to another member, tax law recognizes the transaction as a taxable sale. Both the S corporation and the LLC member might have to recognize gain on the deal.
Offset by Losses
Distributions that don’t qualify as tax-free contributions require the S corporation to recognize gain to the extent that the real estate’s fair value exceeds the corporation’s tax basis. Shareholders are only required to pay capital gains tax on their portion of the S corporation’s net capital gain. If an S corporation has investments that make sense to sell at a loss, selling them in the same year the corporation distributes real estate could negate the gain on the property.
Sean Butner has been writing news articles, blog entries and feature pieces since 2005. His articles have appeared on the cover of "The Richland Sandstorm" and "The Palimpsest Files." He is completing graduate coursework in accounting through Texas A&M University-Commerce. He currently advises families on their insurance and financial planning needs.