I was approached by a new client last year to help him transition his successful small business to his children. What started out as a business succession plan quickly ballooned into a business reorganization. This was necessary because the business owner failed to honor the legal business structure that had been set up for the business.
A typical small business success story
Originally, the business operated as a sole proprietorship. The business had substantial real estate holdings, which were all owned by the business owner in his personal name. The business operated under an assumed name.
As a sole proprietorship, the profits and losses of the business were subject to self-employment taxes. So, for every dollar in taxable income, the owner was paying income taxes and the full amount of Social Security and Medicare taxes. This created an effective tax rate for the business of 45% of taxable income.
To reduce his effective tax rate, his tax preparer suggested that he organize the sole proprietorship as an S Corporation. The S Corporation profits would flow to the personal income tax return of the business owner. These profits would not be subject to self-employment taxes. The business owner must pay himself a reasonable salary, which is subject to Social Security and Medicare taxes. So the S Corporation would create a tax savings by not having self-employment taxes on the net income of the business after the salary of the owner.
Be careful what you ask for
On the initial tax return of the S Corporation, the tax preparer reported a transfer of all the assets of the sole proprietorship to the corporation. This transfer included all the real estate of the sole proprietorship. This was a huge missed opportunity for the business.
First, having the real estate outside of the operating entity would create a situation where the business owner could rent the real estate to his business. Rents from the business would generally not be subject to self-employment taxes. By retaining personal ownership of the real estate, the business owner would have created an income stream for himself other than salary and distributions.
Second, it is usually a good idea not to hold real estate in a corporation. Generally, we recommend holding the real estate personally or in a partnership rather than a corporation. This is due to differences in how the transfer of real estate out of the entity is treated.
Third, separating the real estate from the business operations can provide additional liability protection. This assumes that the real estate is held in some type of limited liability entity, such as a single or multi-member Limited Liability Company.
What we had here was a failure to communicate
Somewhere along the way, a miscommunication occurred between the business owner and his tax preparer. While the tax preparer was reporting the real estate as being owned by the new S Corporation, the business owner continued to own the real estate personally.
In the years after the S Corporation formation, new land and buildings were personally acquired by the business owner for use in his business. These personal acquisitions were also reported as acquisitions of the S Corporation. What’s worse, the bank loaned the money for the acquisitions in the name of the S Corporation, knowing that the real estate was owned individually and not by the corporation.
For 15 years, the tax preparer reported these assets on an S Corporation tax return. The S Corporation depreciated the property and reported the depreciation as a business expense. Since the statute of limitations for filing amended returns had long expired on most of these tax returns, there was no way to correct the reporting error.
In analyzing this situation, we decided that the simplest solution was to operate under the premise that the transactions reported on the S Corporation return were correct. Since we wanted the two sons to have the benefits of separate entities for the real estate and the business operations, a new LLC was formed for the business operations. The current S Corporation will continue to be owned by Dad, who will receive rent from the new LLC as a steady stream of retirement income.
So, what can you learn from this?
Throughout the entire process of sorting out the ownership of the business real estate and analyzing the business returns, I never once found where an attorney was consulted in the decision to form an S Corporation.
Any time you are considering a change in your legal organization for tax reasons, be sure to consult with an attorney. Any legal restructuring should give consideration to liability protection, and a good corporate attorney is your first line of defense. In the above situation, a rental agreement between the landlord and the renter would also need to be drafted by your attorney.
Second, be sure that all your advisers are on the same page. Had the tax preparer and an attorney been in communication with each other, the reporting and the actual legal ownership would have agreed.
Finally, be sure that you are absolutely clear on the organizational structure of your small business. You have paid your advisers for their professional guidance. Follow the plan.