Business owners frequently ask us, “Should I put real estate or equipment used in my business in a separate entity?” There can be good reasons for doing so, including:
1. Protecting the equity in real estate or equipment assets from potential creditor claims or other liabilities arising in the operating business.
2. Segregating these assets as a potential source of retirement income should the operating business be sold and the assets rented to new owners or others.
3. Offering estate planning alternatives by creating two vehicles for wealth transfer – the operating business entity separate from the entity owning these assets.
These are all legitimate reasons for segregating appropriate assets from an operating business entity. However, there are some tax considerations to keep in mind if you are planning to pursue this path.
The best time to segregate assets is typically at the time of acquisition, since potential tax costs may arise from doing so at a later time. These taxes could involve real estate transfer taxes or income taxes on the gain arising from any difference between fair market value and tax basis of the assets to be transferred to a separate entity.
Attention should also be given to Federal “passive loss” provisions in evaluating economic transactions that will arise between the entity owning the assets and the operating business that will use them. The arrangements generally involve some form of lease arrangement.
Rental activities are, by default, treated as “passive” under Federal tax rules. These tax rules can yield unappealing income tax consequences. Where a lease arrangement results in a loss to the lessor entity, the loss will often be limited in its deductibility to the amount, if any, of positive income produced from other passive sources. Where lease arrangements yield a profit, a twist in passive activity rules recharacterizes such profit to nonpassive income when rental activity is to a related business in which the lessor entity’s owners materially participate. These provisions can have a particularly harsh impact where lease arrangements involve equipment qualifying for bonus or other accelerated tax depreciation writeoffs. Real estate tax depreciation writeoffs are at a more conservative pace; therefore, the potential impact of passive loss issues may be lower but should not be overlooked.
We recommend modeling out future taxable income consequences and evaluating each scenario before pulling the trigger on an asset segregation plan. In many cases, some tweaking of structure and lease terms can provide an effective means to accomplish your goals while avoiding unanticipated adverse tax issues.