It’s generally not a good idea for a closely held C corporation to own assets with high appreciation potential. A classic example is real estate. If your corporation owns property, it’s likely the appreciation will be hit with double taxation when the real estate is sold and you take the resulting cash out of the company.

The reason is because the capital gains of C corporations are not taxed at preferential rates. When a C corp sells an asset, it is taxed at its regular corporate rate, which is usually 34 percent. What’s worse, capital gains may be taxed once at the corporate level and again when paid out to shareholders as dividends

Solution: Keep the ownership of valuable real estate assets in the hands of one of the owners and lease them to your C corporation. Or form a LLC, S corporation or partnership (family or traditional) to own the assets and then lease them to the C corporation.

What can you gain from this transaction?

  • On the C corporation’s side, the lease payments are deductible business expenses.
  • The payments are taxable income to you, but you can claim offsetting deductions for depreciation, amortization, and mortgage interest expenses.
  • The leasing arrangement is a way to get additional cash out of your C corporation without double taxation. Plus, double taxation is avoided on appreciation in the value of the real estate.
  • Owning the real estate outside the corporation generally means protection from exposure to liabilities from the corporation’s business.

It’s not necessary for business assets to appreciate in absolute terms in order for double taxation to occur. For instance, the results in the preceding example would be roughly the same if the entire $500,000 gain was caused by depreciation. Depreciation lowers the tax basis of the property, so a tax gain results whenever the sale price exceeds the depreciated basis.

Even if the business real estate is already inside your C corporation, you may be able to get it out before too much tax damage has been done. If the property was recently acquired, its market value may still be roughly equal to its tax basis. If so, you can buy the property from the corporation and lease it back with little or no harm done. Then, any future appreciation escapes double taxation. The lease payments come out free of double taxation as well.

You may also be able to use this leasing strategy for valuable intangible business assets such as patents, customer lists and copyrights. Such intangibles are likely to appreciate. So it’s best to keep them out of the corporation and in your hands if possible.

Best bet: Make sure lease payments from the C corporation to you (or to a entity controlled by you) are based on fair market rental rates for similar assets. Otherwise, the IRS can argue that any excess lease payments are just disguised dividends. In that case, you could wind right back in the double taxation trap.

For example, let’s say your C corporation business needs a new building. For liability reasons, you decide to set up a new single-member LLC (owned solely by you) to buy the property and lease it to the corporation. After 10 years, the property is sold for a $500,000 gain. The entire gain will be taxed on your personal tax return. Part of your profit will be taxed at no more than 25 percent (the amount of gain equal to your depreciation deductions). The balance will be taxed at no more than 15 percent under current law. Say, you pay a total of $110,000 to the U.S. Treasury for capital gains tax. There’s no federal income tax at the LLC level, so your after-tax profit is a healthy $400,000 ($500,000 minus $100,000).

Now let’s see what happens if your C corporation buys the very same property. The $500,000 gain will probably be taxed at the 34 percent corporate rate. The firm pays the $170,000 tax and distributes $330,000 to you, which will be a dividend taxed at 15 percent under current law. That’s another $149,500 lost to the government. So your after-tax cash is $280,500 ($500,000 minus $170,000 minus $49,500).

Compare that $280,500 figure with the $400,000 you would receive under the leasing alternative. That’s a 42.6 percent increase in after-tax return. Which would you rather have in your pocket?