Strategies for retailers and real estate professionals in today’s market - by Bernie Kennedy

It’s no secret that retail is currently under assault for numerous reasons–from changing formats to online purchasing. “Rightsizing” operations and individual locations is a hot topic in retail circles. Closing stores and reducing store size creates concomitant challenges for real estate professionals, including developers who rely on major credit tenants as anchors and brokers who have to hustle for new tenants.

Over the coming months, this column will address the many and varying issues that face retailers and real estate professionals alike and consider various strategies for tackling those issues.

Consider, first, the small family-owned retailer who owns and operates a handful of locations and is facing a downturn in business. This business operator might gradually find that the value of the real estate equals or exceeds the value of the retail business itself. In this situation, a sale of the business is unlikely to unlock the true value of the real estate as would occur if those assets were sold separately.

One strategy to address this problem is to separate the real estate assets from the overall business assets and distribute those assets directly to the shareholders, but this solution often creates an even larger problem – taxes.

Under our tax system, any distribution of assets to shareholders creates a double taxation event: First, at the corporate level, and secondly, at the shareholder level. For example, if the corporation purchased real estate assets for $5 million, which are now valued at $20 million, distributing those assets to the shareholders would create a taxable event at the corporate level on the $15 million gain in value (at corporate rates) and a second taxable event for the shareholders on the $20 million value of the distribution (at dividend rates). Assuming a 35% federal corporate rate and a 20% federal dividend rate, the tax effect of the transaction would result in sharing $9.25 million with Uncle Sam before the state takes its share.

One companion strategy, a Section 355 transaction, moves appreciated real estate out of corporation ownership directly to the shareholders without incurring corporate or individual taxation at the federal level, assuming various legal tests are met. The full details are complex and beyond the treatment of this article, and one should always consult with a tax expert when considering such a strategy.

How it works

In its most basic form, a “spinoff” plan would include three steps: 

(1) The parent corporation forms a subsidiary; 

(2) The parent corp. contributes real estate assets to the subsidiary; and 

(3) The parent corp. distributes the stock of the subsidiary to the shareholders. 

The net result, assuming certain other statutory and non-statutory legal tests are met, is that the original shareholders end up owning the stock of both corporations without the double taxation inherent in a straight distribution of assets.

Legal Requirements of a Section 355 Transaction

One test requires a “valid business purpose” for the transaction apart from the tax savings, defined by the treasury regulations as a “real and substantial non-federal tax purpose germane to the business of the distributing corporation.” One IRS-accepted purpose is the preparation for an acquisition of one portion of the parent corporation (e.g.: The retail business) by an entity that might not be interested in acquiring the other portion (e.g.: The real estate).

Another test requires that both the parent and subsidiary be engaged, both before and after the transaction, in “active businesses.” This requirement has been interpreted to mean that the activity must have been conducted for the 5-year period prior to the distribution to qualify. It should be noted that the Treasury Regulations provide that the ownership and operation of real property used in a trade or business does not constitute an active business unless the owner performs significant services with respect to the operation and management of the property. Merely leasing real property, improved or vacant, under a lease that requires little or no activity on the part of the owner, will probably be insufficient.

Additional technical tests must be met to qualify a transaction as a Section 355 transaction, and again consulting a tax expert is critical, but passing the “valid business purpose” and “active business” tests, is a promising start.

If you are going to separate your retail and real estate assets, and want to obtain the favorable tax treatment Section 355 offers, be prepared to enter the real estate business in earnest, not just for show. But the history of retail and real estate, especially in New York, is replete with stories of families who started as retailers and became real estate moguls. Not such a bad result.

Bernie Kennedy is a co-managing member (partner) at Bond, Schoeneck & King, Garden City, N.Y.