Trapped Rental Assets In An S Corporation

By Jason Watson, CPA
Posted Saturday, August 3, 2024

As the only shareholder of an S Corp, you might think that everything the business owns you also personally own. Not true. The relationship you have with your S Corp is not a marriage where mine is mine and yours is mine too.

Part 1

If you want to move assets out of an S corporation or convert them to personal use, you will trigger a taxable event. A potentially big one. When assets are distributed to the S Corp shareholders, they are distributed at fair market value. Cash is easy. An automobile is generally not a big deal. But real estate can kick your butt.

We recently had a consultation with an S Corp owner whose business owned a hotel building. On the advice of an inexperienced CPA he revoked his S corporation election. This triggered a distribution of business assets at fair market value. The basis in the hotel building was $400,000 and the fair market value was $2,000,000. This sparked a $320,000 capital gain tax event reported on his K-1. Capital gains is a success tax, right? But when you don’t actually get the cash from the transaction, this tax could be impossible to pay. Keep appreciating assets out of an S corporation people (or at least have eyes wide open on the risk)!

Sole proprietors and garden-variety LLCs enjoy a bit more flexibility under certain circumstances when distributing property or assets out of the business.

Part 2

Assets within your S Corp can also be problematic upon death. If you own an asset at the time of death, the asset is re-valued and your heirs get a step-up in basis (cost). So, when they sell the asset their gain is lower. For example, you buy a painting for $5,000 and when you die, the painting is valued at $20,000. If your heirs sell the painting for $22,000, they will only realize a $2,000 taxable gain.

If the asset is sitting in the S Corp upon your death, the S corporation’s stock value might get a step-up in basis through an appraisal. However, it might prove harder to demonstrate than the increased value of one particular asset. Look at it another way. S Corps don’t die, and therefore assets within the business don’t get a step-up in basis upon a shareholder’s death.

We’ll acquiesce. This trapped asset problem is super rare yet so many owners love to have personal stuff owned by the S Corp.