Entity Planning When Selling a Farm or Ranch: Corporations and the 1031 Exchange
Some folks have incorporated their farm or ranch operation, holding the assets -- including the land -- in a C corporation or an S corporation. While there can be certain advantages to operating a ranch or farm in a corporation, there may be a steep price to pay when it comes time to sell the farm or ranch. The issue relates to how these corporate entities are taxed, and the fact that farm and ranch real estate has often appreciated significantly in value over generations.
Let’s first understand the two basic types of corporate entities, C corporations and S corporations. A C corporation -- or regular corporation -- is a separate taxable entity that pays tax on its profits at the corporate level. An S corporation is generally not a separate taxable entity and is commonly referred to as a “flow-through” entity, whereby the business profits and losses pass through the corporation to the shareholders who report them on their individual tax returns.
Owning appreciated real estate such as farm or ranch land inside either corporate structure is generally a bad idea -- but a C corporation is even more problematic than an S corporation, as we’ll discuss below.
A C Corp Means Paying Double Tax
When an individual, partnership, limited liability company (LLC) or S corporation sells appreciated real estate, any gain flows from the entity to the individual and tax is assessed at the individual level. Generally, there is no tax paid by the entity. But when a C corporation sells appreciated real estate, it is a separate taxable entity and pays tax on its profits, so it will owe tax on the sale. Then, when the after-tax sale proceeds are distributed to the shareholders as dividends, the shareholders will pay another tax on the dividend income. Effectively, the income from the sale of a farm or ranch is being taxed twice -- once at the corporate level and once at the individual level.
At the corporate level, passage of the Tax Cuts and Jobs Act of 2018 lowered the corporate income tax rate from 35% to 21% -- so that hit isn't as bad as it once was. But a state level tax may also apply at the corporate level, so it's possible that the combined federal and state tax paid by the corporation will total 25% - 30%.
Then, when the net sale proceeds are distributed to the shareholders, they are taxed as dividends. Assuming these dividends are “qualified” dividends for tax purposes, they will be taxed at the applicable capital gains tax rate, which may be as high as 23.8% (including the Medicare surtax of 3.8% for taxpayers exceeding a certain income level). Again, a state tax rate may also apply to the dividends.
When combining both the federal corporate and individual taxes, and possibly state taxes at both the corporate and individual levels, the total combined tax rate can be more than 50%. Ouch!
Avoiding Double Taxation
So what should be done in this situation?
Some might suggest structuring the sale as a stock sale as opposed to an asset sale, where the individual shareholders would sell their stock in the corporation rather than the corporation selling its assets. This would eliminate the corporate level taxes, as only the individuals would be taxed -- but many buyers may balk at this approach. By purchasing the stock of a corporation, a buyer does not receive a step-up in basis in the assets of the company and potential depreciation deductions may be significantly reduced. Also, by purchasing stock they may inherit assets with low tax basis and embedded gains, as well as assuming any contingent liabilities that may be associated with the corporation. Thus, if a buyer considers purchasing the corporate stock, they may use this as leverage to negotiate a discounted purchase price on the ranch.
Another solution to consider is converting the C corporation to an S corporation. As explained above, an S corporation can sell appreciated real estate and generally not owe tax on the sale. Instead, the gain is passed through to the shareholders, who will be subject to tax on their individual tax returns.
To take advantage of this, the conversion to an S corporation must occur at least 5 years prior to the sale. If the sale occurs within 5 years of conversion, the corporation will have to pay a 21% tax on the “built-in gain”, which is the difference between the corporate assets’ fair market value and the tax basis at the date of conversion. This is one of the few instances where an S corporation may be subject to tax. The shareholders would then have to pay tax on the gain passed through to them from the S corporation -- and would therefore still incur double taxation. But, after 5 years, the built-in gains tax expires and the threat of double taxation is eliminated.
A solution for selling within 5 years of conversion would be for the selling corporation to complete a 1031 exchange, and thus pay no tax at all. As long as no taxable (i.e., non-1031 exchange) sale has occurred within the 5-year holding period, no tax will be paid by either the corporation or the individual shareholders. We have had clients use this strategy successfully.
The election to convert from a C corporation to an S corporation must be filed with the IRS no more than two months and 15 days after the beginning of the tax year the election is to take effect.
Accommodating Shareholders with Differing Goals
For all the reasons stated above, using the 1031 exchange to defer tax is an excellent strategy for anyone selling appreciated real estate held in a corporation. But what happens when some shareholders want to complete a 1031 exchange and others want to cash out and go their separate way?
They can’t do both.
According to exchange rules, corporate stock does not qualify for 1031 exchange treatment, so the individual shareholders may not perform an exchange. The corporation is the entity that must complete the exchange.
A solution for this may be to structure a corporate stock redemption, where the corporation buys back the stock from the shareholders who wish to cash out and go their separate way. For example, let’s assume XYZ Corporation owns a high-value ranch and the decision has been made to sell because the five family-member shareholders wish to retire. Since XYZ is a C corporation and the corporation’s tax basis in the ranch assets is low, there will be a large tax at the corporate level upon the sale, and further taxes assessed to the individual shareholders upon distribution of the ranch sale net proceeds. Because of the excessive taxes in the event of a sale, several shareholders wish to perform a 1031 exchange into commercial real estate that will generate monthly rental income they may use for their retirement.
Further, after speaking with their CPA they decide to elect to be taxed as an S corporation to prepare in the event that 5 years or more from now they may choose to sell the commercial real estate in a taxable transaction. After this 5-year holding period, they could sell, distribute the net sales proceeds to the shareholders and be subject to only one level of tax as opposed to two.
However, not all of the shareholders want to do a 1031 exchange. A couple of them would rather take their cash now, regardless of how much tax they have to pay, and go their separate way. In this situation, the corporation could buy back the stock of the shareholders who wish to cash out. The other shareholders could remain in the corporation and complete their 1031 exchange.
The shareholders who choose to sell their stock back to the corporation will be treated as if they had sold their stock or received a dividend. This treatment will depend on a number of factors that are beyond the scope of this article. But the bottom line is this: they will only pay one level of capital gains tax at the individual level. Those choosing to remain shareholders would, of course, defer all tax because the corporation completed a 1031 exchange.
To go further, if the stock sales took place after the 1031 exchange into commercial real estate was completed, the corporation could have a funding mechanism for buying back those stock shares: the cash flow from the commercial real estate. This may enable the corporation to redeem those shares without borrowing money or depleting corporate cash reserves.
This is a complex scenario, and it is strongly advised that anyone considering strategies to avoid the double taxation of a C corporation asset sale seek appropriate guidance from tax professionals. That said, the use of a 1031 exchange and conversion to S corporation status can be useful strategies for those C corporations wishing to avoid double taxation on the sale of appreciated farm or ranch land.
We’ve provided the information in this Straight Talk guide for general educational purposes. It is not intended as specific tax or legal advice. Please consult a professional for specific advice regarding your particular situation.
© 2018 Jack Sauther & Diana Sauther