If you own the real estate for your bar, restaurant, or nightclub, you have likely been advised by your lawyer or accountant to place it into a separate LLC. There are many legal and tax advantages to separating your real estate from your operational entity. In The Best Tax Classification for Your Restaurant, we explain each tax entity type (LLC taxed as partnership, LLC taxed as schedule C, LLC taxed as S-corporation, Corporation, Partnership, and S-corporation) and the ideal option for your restaurant(s) based on your goals. In this article, we will explain why the real estate for your bar, restaurant, or nightclub should be structured as a single-member LLC (if a single owner) or LLC partnership (for multiple owners) for tax purposes.
No Ownership Restrictions
An S-corporation is typically a favorable tax entity classification for a restaurant, bar, nightclub, or other small businesses because its taxable income/profit is not subject to self-employment tax (15.3%). However, S-corporations have many restrictions, such as the inability to provide multiple classes of stock and multi-tier distribution models, foreign shareholders, and more, as discussed here. Real estate rental income is not subject to self-employment tax, thus making the self-employment tax benefit irrelevant. Therefore, putting real estate into an S-corporation subjects the owners to all the ownership restrictions for S-corporations for no benefit.
Tax-Free Contribution of Appreciated Property
If a shareholder in a C-corporation or S-corporation contributes appreciated real estate in exchange for stock in the C-corporation or S-corporation, they could be [depending on a variety of factors] taxed on the difference between their tax basis in the real estate and the value of the shares received. Partners in a partnership are not taxed on the contribution of appreciated real estate to the partnership upon contribution, regardless of their ownership percentage afterward. However, the shareholders in a C-corporation or S-corporation might be taxed in the same situation, depending on the circumstances.
No Double Taxation
Finally, income in a C-corporation is subject to double taxation, as discussed in The Best Tax Classification for Your Restaurant. The corporation pays a tax on its taxable profits and gains, and the shareholders pay tax on the same income when the profits are distributed to the shareholders. Therefore, rental income and the gain on the sale of real estate will be double-taxed under a C-corporation.
Tax Upon Distribution
Double taxation is also triggered in a C-corporation if the property is not sold but distributed to its shareholders. If the corporation wants to dissolve and/or distribute its real estate to shareholders, the distribution is treated as a sale, triggering a taxable gain to the corporation. In addition, the shareholder will have to recognize dividend income on the FMV of the property distributed. This is a terrible tax outcome.
If the property is distributed to shareholders in an S-corporation, the distribution is treated as a sale, triggering a taxable gain for the shareholders. Although the gain is not subject to double taxation, it is still a taxable gain that would have been deferred in a partnership until the property is sold.
A partnership can easily distribute real estate held by the partnership to the partners tax-free if they decide to liquidate the partnership. The gain is only taxed at the partner level if the property is sold. Distributing the real estate to partners tax-free is important in case partners want to hold the real estate as tenants in common instead of through an LLC for personal purposes. For example, you can’t 1031 exchange (a tax-free like-kind exchange of real estate) a partnership interest that holds real estate, so you would need the partnership to do the 1031 exchange, requiring you to get the entire partnership on board the 1031 exchange at the partnership level. On the other hand, you could distribute the real estate to the partners tax-free and have them own the real estate as tenants in common, thus allowing each partner to decide whether they want to 1031 exchange their share or cash out.
Increased Depreciation Deductions
Buyers of partnership interests can receive a stepped-up basis for their portion of the real estate purchased, which entitles them to higher depreciation deductions. A timely section 754 election must be made for this to take effect. This usually applies when one of the partners sells or transfers their interest for a higher value than what they paid. For example, assume partners A and B form an LLC to buy a commercial building for $3.9m. They would depreciate this building over 39 years, or $100,000 annually. Therefore, after 10 years, each partner’s basis in the building is $1,450,000 ($3,900,000 minus $1m in depreciation x 50%). If Partner A sells their partnership interest to Partner C after 10 years for $3m (assuming the property is worth $6m), Partner C would step into Partner A’s shoes and start receiving 50% of the $100k depreciation per year that Partner A was receiving. That’s unfair to Partner C because Partner C is paying more for their share of the building than Partner A. Therefore, the partnership can make a sec 754 election allowing Partner C to depreciate the $3,000,000 they paid over the remaining life of the assets, 29 Years (39 years -10 years). This increases Partner C’s share of depreciation deductions to $103,448 instead of $50,000. This election and/or benefit is only available to entities taxed as partnerships or single-owner LLCs who report their real estate income directly on their personal returns.
Next Steps
If you own the real estate for your restaurant, you may want to consider putting that property into a separate LLC and elect to be taxed as a partnership if there are multiple partners or report the income on your personal returns through Schedule E if you don’t have partners. Putting your real estate in a C-corporation or S-corporation can have problematic and detrimental tax consequences, as we outlined above. Feel free to contact us to learn more about how The Fork CPAs can help you strategically set up the accounting and taxes for your restaurant, bar, and nightclub.
