Owning Your Business Building Through a Separate LLC: Lease Terms, Taxes, and Traps

Owner-operators frequently buy the space where their business operates. Whether to hold it personally, in the operating company, or in a separate entity is a classic structuring decision. The separate property LLC is a common answer. It is also easy to get wrong if rent, documents, and taxes are treated casually.

The basic structure

Two entities:

The operating company (LLC, S-corp, or other) runs the business, employs staff, and signs customer contracts.
The property LLC owns the real estate and leases it to the operating company under a written lease.

Both entities may be owned by the same individual or group. Often the ownership percentages are identical, but they can differ, and different ownership creates additional considerations for rent fairness.

Why owners do this

Liability separation. A claim against the operating company (from employees, customers, or contract disputes) would generally not reach the building owned by a different entity, and a claim tied to the building (such as a premises injury) would generally not reach the operating company's assets, provided the entities are separate in practice and insurance is in place. See liability protection limits of an LLC.
Keeping real estate out of an S-corp, which is often disadvantageous for tax reasons. See real estate in an LLC or personal name.
Flexibility on sale. A buyer of the operating business can lease the building, or the building can be sold separately. The owner keeps the real estate asset and rental income after selling the operation, if desired.
Retirement income. Rent from the property can become income after the business is sold.
Financing. Lenders can underwrite the property separately from the operating business, though they typically require guarantees.
Estate planning. The property can be transferred to heirs separately from the business.

The lease is the backbone

A written lease between the entities, signed by authorized persons for each, should address:

Parties and premises.
Term and renewal options.
Rent: at or near market rate, with escalations. Support with a broker opinion of value, comparable listings, or an appraisal. Below-market rent may distort tax results, and above-market rent can look like a disguised distribution or compensation.
Expense responsibilities: triple net, modified gross, or gross. Who pays taxes, insurance, maintenance, and capital repairs.
Insurance requirements, with each entity insured appropriately and additional insured status as required.
Use restrictions.
Default, remedies, and termination.
Assignment and subletting, important if the operating business is sold.
Subordination and non-disturbance provisions if there is a mortgage.
Security deposit, if any.

The rent must actually be paid on time and recorded. See intercompany charges and agreements.

Tax reporting

Property LLC. If it is a single-member LLC owned by an individual (disregarded), rental income and expenses are reported on Schedule E of the owner's return. If it has multiple members, it files Form 1065. Rent paid by the operating company is deductible to the operating company as a business expense.

Depreciation. The building (not land) is depreciated over 39 years for nonresidential property, and cost segregation can accelerate parts of it. See Section 179 and depreciation basics. Depreciation reduces taxable income while owned and creates recapture on sale. Land is not depreciable.

Self-rental rule. Rental income from property rented to a business in which the taxpayer materially participates is recharacterized as nonpassive income. That prevents using passive losses from other activities to offset that rental income, but also means that rental losses (if any) from the self-rented property are not passive in the same way. The rule affects how income and losses are treated for passive loss purposes. Ask your tax adviser how it applies to your situation.

Self-employment tax. Rental income from real property is generally not subject to self-employment tax, so rent paid by an operating company to the owner does not bear SE tax, unlike operating profit. That is not an excuse to set rent at an unreasonable amount. Rent must be supportable.

QBI deduction. Rental real estate leased to a commonly controlled trade or business can be treated as a trade or business for purposes of the QBI deduction, and the IRS has provided a safe harbor for rental real estate enterprises, with specific requirements. See QBI deduction.

Related-party rules. Losses and certain deductions between related parties can be restricted in some cases, especially when entities use different accounting methods.

State and local. Some states tax commercial rent or treat rents differently. Property taxes and assessments vary by jurisdiction and may reassess on a transfer.

Financing

Purchase in the property LLC when possible, so no later transfer is needed.
Mortgage lenders commonly require guarantees from the owner and sometimes the operating company. The guarantee by the operating company links the entities' risks, so understand the consequences.
SBA loans for owner-occupied commercial real estate may have specific structures, often requiring both entities as borrower and guarantor. Ask a lender.
Existing mortgage and transfers: review the due-on-sale clause before moving property from personal name or from the operating company into a new LLC.

Moving property out of the operating company

If the operating company (particularly an S-corp or C-corp) already owns the building, moving it to a separate entity can trigger tax on appreciation, transfer taxes, and lender consent requirements. In an S-corp, a distribution of the property to shareholders is treated like a sale at fair market value for gain recognition, passing through to owners. A sale to a new entity at fair market value also triggers gain. Get tax advice before transferring. Options may include leaving the property in place and planning around it, or using a structure that avoids immediate tax (in limited cases).

Exit planning

When selling the operating business, decide whether the buyer will purchase the building, lease it, or acquire an option. A long-term lease at market rent can support the sale price. The lease terms, assignment rights, and renewal options should protect both parties. If the building is sold, gain treatment includes depreciation recapture at up to 25 percent for real property, and consider a 1031 exchange to defer. See selling a business: tax basics.

Governance and operations

Separate bank accounts for each entity.
Separate books, with intercompany balances reconciled.
Separate insurance policies with correct named insureds.
Written operating agreements for both entities.
Consistent signature blocks.
Annual review of rent against market.
Proper registration and annual reports for each entity. See annual reports and franchise taxes.

Common mistakes

No written lease, or a lease that the entities do not follow.
Rent that bears no relation to market.
Not paying rent.
Keeping real estate inside the S-corp for convenience.
Transferring mortgaged property without lender review.
Ignoring self-rental and passive loss rules.
Failing to insure each entity properly.
Mixing bank accounts.
Not planning for a sale.
Overlooking state taxes on commercial rent.

For help structuring and documenting a property and operating company arrangement, AE Tax Advisors can assist, and a discovery call is a good first step. See also holding company basics.