Why Owning Real Estate in a Corporation's Name is Not a Good Idea
Owning real estate in a corporation's name is not a good idea from both a tax and liability standpoint.
A regular C corporation is not a pass-through entity. Corporate taxable income is initially taxed at the entity level (the corporation pays taxes).
If the corporation distributes its earnings to it's shareholders as a dividend, the recipients of the dividend must include it in their individual income tax return where it is subject to income taxes a second time at the personal level.
If an asset that appreciates in value is held inside a corporation and the asset is subsequently sold by the corporation at the higher value, the gain will be taxed at the corporate level at corporate income tax rates..
If the corporation subsequently distributes income to its shareholders, for example as a dividend, the recipients will income in their individual income tax return where it will be subjected to income taxes a second time.
- You own property in your C corporation.
- The C corporation sells the property and realizes a gain of $10,000.
- The corporation's income tax rate is 15 percent.
- Corporate income tax is: $1,500 (15 percent x $10,000).
- The C corporation pays you a dividend of $8,500 (the gain of $10,000 minus the $1,500 in taxes).
- Your personal tax rate is also 15 percent.
- Your personal income tax is $1,275 (15 percent x $8,500).
- Total Tax Paid: $2,775 ($1,500 + $1,275)
- That's almost 28 percent of the $10,000 gain ($2,775/$10,000)
Now assume the same facts, except, you're organized as an LLC (a pass-through entity). Assume your personal tax bracket is 15 percent.
- Your tax is $1,500 (15 percent x $10,000 gain)
- The LLC entity is not subject to tax since it is pass-through entity.
- You save $1,275 by being organized as an LLC rather than a C corporation.
If the corporation was in a higher tax bracket than 15%, it would have paid taxes at its higher marginal tax rate. For individuals, however, dividends received from domestic corporations are taxed at the lower capital gain rates. Therefore, by being organized as an LLC (a pass-through entity) if your tax bracket was higher than 15% the dividend would have been taxed at the lower capital gain rate.
If you own real estate inside a corporation and the corporation is sued, property owned by the corporation could be lost.
For example, if you own an office building and someone slips on the lobby floor because your maintenance worker failed to mop up a spill from a broken bottle, the corporation could be sued.
If the corporation does not carry sufficient insurance to pay the claim, the judgment creditor may end up owning the corporate stock. By controlling the stock, the creditor can sell the building.
If the claim was for $2 million and your insurance covered only $1 million and your corporate-owned building is worth $500,000, the building could end up being sold to satisfy the claim.
Your personal assets would be protected since the lawsuit was against the corporation. But, you lose the building.
The Charging Order
What if you're a member of a multi-member LLC (or partnership) and one of the other members (or partners) gets sued personally and ends up with a judgment against him making that member (or partner) a debtor-LLC member (or debtor-partner). Are the non-debtor LLC members (or partners) insulated from the judgment-creditor? Are the LLC's (or partnership's) assets at risk?
The idea behind a charging order is to protect non-debtor LLC members (or non-debtor partners) in a multi-member LLC (or partnership) from claims against a debtor-member (or debtor-partner) and to protect the assets of the business entity so it may continue to operate unimpeded.
In other words, the collection efforts of the judgment creditor are limited because of the charging order mechanism. A charging order only gives a judgment creditor the right to attach a debtor LLC member's INTEREST in LLC (or partnership) distributions and not the LLCs (or partnership's) assets.
This means the business's assets remain out of the reach of the creditor. allowing it to continue operating without disruption and with its assets in tact. A judgment creditor may not vote his charging interest or participate in the management of the business either. These restrictions preclude a judgment creditor from voting for an LLC distribution, which would allow the creditor to get his hands on some money.
Partnership statutes and limited liability company statutes in most jurisdictions provide for charging orders. In most states, partnership and LLC statutes are based on the Uniform Act, such as the Revised Uniform Partnership Act of 1994 (“RUPA”), the Uniform Limited Partnership Act of 2001 (“ULPA”) or the Uniform Limited Liability Company Act of 1996 (“ULLCA”), or the earlier versions of these acts.
The advent of the charging order dates back to around 1914 in the United States. It was designed to protect non-debtor partners from claims against a debtor partner.
At that time, a creditor was able to obtain a writ of execution from the court directly against the partnership's assets. This led to the seizure of business's assets by the sheriff. This was possible because at that time the partnership itself was not treated as a juridical person, but simply as an aggregate of its partners.
The seizure of partnership assets was usually carried out by the sheriff, who would go to the partnership’s place of business and shut it down, causing a major disruption of business and financial loss to the non-debtor partners.
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- Return to the Tax Basics for Startups Table of Contents to find related links.