Several Simple Examples of Partnership Exchange Tax Issues

Transcription

1 Several Simple Examples of Partnership Exchange Tax Issues Terence Floyd Cuff Loeb & Loeb LLP Los Angeles, California Copyright, 2013, Terence Floyd Cuff. All rights reserved. Terry Cuff is of counsel at the Los Angeles office of Loeb & Loeb, LLP. He undertook his undergraduate work at the University of California, Santa Cruz. This work emphasized American history, economics, computer science, mathematics, grooving with the redwoods, and walking softly in the forest to avoid stepping on banana slugs. Lacking better purpose in life and not being independently wealthy, Mr. Cuff attended and graduated from the University of Southern California School of Law and the New York University School of Law. Mr. Cuff s early practice in law was concentrated in tax problems of the entertainment industry, principally film and music. Unlike Mr. Cuff, his early clients were all talented, successful, popular, and well-known. Mr. Cuff s practice later shifted to corporate tax problems, tax problems of real estate investment trusts, and tax problems related to the early cable television industry. Mr. Cuff s hair has turned grey, his eyesight has dimmed, his weight has increased substantially, his tennis game has slowed down, and his practice now spans the spectrum of real estate and partnership tax and tax problems of real estate investment trusts. He spends too much of his time in airports, on airplanes, and in hotels in transit. He has become a gourmet of rubber chicken. Mr. Cuff writes and lectures about a wide variety of partnership and real estate tax problems. He recently has particularly focused most of his writing and lecturing on problems involved in drafting partnership and LLC agreements, problems of Section 1031 exchanges, and problems of structuring and presenting Excel spreadsheets in the real estate, finance, and tax areas. He has spent extensive time writing and lecturing about techniques that lawyers use to undermine the planned economics of partnerships and LLC s. When he was younger and in better physical condition, from 1969 through 1974, Mr. Cuff served with the United States Marine Corps and the Marine Corps Reserve. Mr. Cuff served as a combat engineer officer with the First Engineer Battalion and Seventh Engineer Battalion, First Marine Division. Mr. Cuff served as an antiaircraft missile defense officer (HAWK) with the 4th Light

2 Anti-Aircraft Missile Battalion. In the Marine Corps, Mr. Cuff learned to break things, to shoot things, to blow things up, and to shoot things down. Mr. Cuff seeks to apply these skills to his legal work. Outside of his day job, Mr. Cuff devotes much of his time to exploring the military and naval history of the American Revolution. Having become old and infirm, Mr. Cuff s limits other extracurricular activities to running around the tennis courts chasing a yellow tennis ball at the Live Oaks Tennis Club in South Pasadena, taking photographs of things that move and things that stand still, and trying to make Excel spreadsheets do things that they apparently do not want to do (particularly with VBA programming techniques). Mr. Cuff is interested in VBA programming both in Excel and in Word. Mr. Cuff is especially interested in standards for structuring and presenting Excel spreadsheets in tax and financial practice. Finally, Mr. Cuff is addicted to the adventures of Perry Mason and Marshal Dillon, from which he derives professional and spiritual guidance. Table of Contents 1. Basic Partnership Exchange Mechanics Boot in a Partnership Exchange Exchanges of LLC Interests Simple Exchange By LLC Simple Deferred Exchange By LLC Sale of Partnership Interest Midway Through Exchange Terminating Sale of Partnership Interest Midway Through Exchange Redemption of Partner Midway Through Exchange Allocation of Gain from an Exchange Combined Exchange and Installment Sale Distribution of Tenancy-in-Common Interests Partnership Exchanges, Then Distributes One Replacement Property to a Partner Exchange by a Single Member LLC Exchange and Contribution to Partnership

3 15. Signing Identification Notice and Agreements for Partnership Exchange Tenancies-in-Common Exchange of Apartment Building Owned in Tenancy-in-Common Exchange of Hotel Owned as Tenancy-in-Common Exchange of Farm Owned as Tenancy-in-Common Exchange and Partnership Between Husband and Wife Exchange and Partnership Division Exchange and Partnership Merger Exchange and Relief of Liabilities Exchange and At Risk Nonrecognition Exchanges of Section 704(c) Property Receipt of All Interests in Partnership Equivalent to Acquisition of Real Property Basic Partnership Exchange Mechanics. Example 1. A partnership owns investment real estate. The partnership wants to exchange real estate under Section What are the basic considerations for a partnership undertaking a Section 1031 exchange? The partnership rather than its partners are treated as the taxpayer for purposes of qualification under Section The partnership must qualify as holding the relinquished property and the replacement property for a qualifying purpose. The partnership must demonstrate that the partnership holds the relinquished property for productive use in a trade or business or for investment. The partnership must demonstrate that the partnership holds the replacement property for productive use in a trade or business or for investment. The partnership must undertake an exchange. The partnership must transfer its relinquished property and receive its replacement property. Receipt of replacement property by its partners is unlikely to qualify as an exchange by the partnership. The partnership must satisfy all of the requirements of Section 1031 at the partnership level. 3

4 The boot gain is recognized at the partnership level if book gain is recognized. The gain is allocated under the partnership agreement. Allocations in the partnership agreement will be respected if those allocations have substantial economic effect. The partnership must meet the requirements of Treasury Regulations Section (k)-1 if the exchange is a nonsimultaneous exchange. The partnership must undertake the identification of replacement property. The Treasury Regulations are not specific about who must sign the identification notice, but presumably whomever can sign for the partnership for normal agreements can sign the identification. The partnership must enter into the exchange agreement with the intermediary. 2. Boot in a Partnership Exchange. Example 2. The partnership receives $100,000 taxable boot in an exchange. Gain on the exchange is recognized at the partnership level. Gain is allocated under the partnership agreement if its allocations have substantial economic effect. Each partner then reports his distribute share of gain on his personal return. If the transaction is audited, the audit will be a partnership proceeding under the TEFRA audit rules unless the small partnership rules apply. Gain is recognized at partnership level. Income is allocated to partners under partnership agreement. 3. Exchanges of LLC Interests. Example 3. An LLC, ABC, owns real property with a fair market value of $1,000,000, an adjusted tax basis of $100,000, subject to nonrecourse liabilities of $300,000. ABC has held this property for use in its trade or business since 1982, before the introduction of the at risk rules. ABC has three members, A, B, and C, each of whom owns a 33-1/3% interest in ABC. The tax basis of each member s interest in ABC is equal to the sum of his tax capital account and his share of partnership liabilities (which, in turn, is equal to the product of his percentage interest in the partnership and the amount of partnership liabilities). The balance sheet of ABC is set forth below: 4

5 AB FMV Assets Real Property $100,000 $1,000,000 Total Assets $100,000 $1,000,000 Liabilities and Capital Nonrecourse Liabilities $300,000 $ 300,000 Capital A ($ 66,667) $ 233,333 Capital B ($ 66,667) $ 233,333 Capital C ($ 66,667) $ 233,333 Total Liabilities & Capital $100,000 $1,000,000 A, B and C each exchange their LLC interests in ABC for three separate interests in a second LLC as replacement property. What are the tax effects of the transaction? The first step is to establish that an LLC is treated as a partnership for federal income tax purposes. There does not appear to be material doubt than an interest in an LLC should be treated as an interest in a partnership for all tax purposes. Authority applying to a partnership should apply equally to an LLC. This is confirmed in the check-the-box regulations. There is no material question about most LLC s being taxed as tax partnerships. An exception is made for single member LLC s and certain community property LLC s owned solely by husbands and wives. The rules of Section 1031 (as in effect prior to 1984) did not explicitly say anything about exchanges involving LLC s, member interests, partnerships or partnership interests. For federal income tax purposes, an LLC should be treated as a partnership unless the LLC is treated as an association (or a tax partnership). 1 This Section will assume that the LLC is not classified as an association. Some taxpayers sought to exchange a partnership interest for another partnership interest in the absence of clear guidance. 2 No reported cases consider exchanges of interests in LLC s, but LLC s should be treated as partnerships for this purpose. The interesting distinction may be that in some 1 Rev. Rul , C.B See, e.g., Pappas v. Commissioner, 78 T.C (1982); Long v. Commissioner, 77 T.C (1981); Gulfstream Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979); Estate of Meyer v. Commissioner, 58 T.C. 311 (1972), nonacq., C.B. 3, aff d per curiam, 503 F.2d 556 (9th Cir. 1974); Miller v. United States, U.S. Tax. Cas (S.D. Ind. 1963). See, generally, Halpern, Partnership Swapping From Miller to Meyer to Gulfstream, 4 Journal of Real Estate Taxation 359 (1979); Boyd & Heller, Like-Kind Exchanges of Partnership Interests: A Comprehensive Analysis, 3 REVIEW OF TAXATION OF INDIVIDUALS 87 (1979); Chromow, Tax-Free Exchanges of Partnership Interests: Gulfstream Land and Rev. Rul Impose Constraints, 57 TAXES 130 (1979); Kanter, IRS Ruling Regarding Swap of Partnership Interests, 4 JOURNAL OF PARTNERSHIP TAXATION 130 (1980); Banoff, New Opportunities Now Exist for General and Limited Partnership Conversions, 52 JOURNAL OF TAXATION 130 (1980); Banoff, Partnership Interest Conversions: Planning Possibilities, 2 JOURNAL OF PARTNERSHIP TAXATION 203 (1984); Banoff, Intrapartnership Interest Swaps Covered by Section 1031 Says New Ruling, 71 JOURNAL OF TAXATION 48 (1989). But see Rev. Rul , C.B

6 cases it may (or may not) be significant whether a partner owns a limited partner interest or a general partner interest, while it is not clear whether the holder of an interest in an LLC should be treated as a general partner or a limited partner. We shall revisit this issue later in this article. Section 1031(a)(1) provides generally that: No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like-kind which is to be held either for productive use in a trade or business or for investment. The requirement that the relinquished property (the property given up by the taxpayer) and the replacement property (the property received by the taxpayer in the exchange) must be held for these specific uses is often referred to as the qualified use requirement. Section 1031 provided (prior to 1984) that a taxpayer could not exchange these types of property: Stock in trade or other property held primarily for sale. Stocks, bonds, or notes. Other securities or evidences of indebtedness or interest. Certificates of trust or beneficial interest. Choses in action. 3 Section 1031 is not expressly limited to real property or even to tangible property. 4 Taxpayers sought to undertake exchanges of partnership interests, particularly where both the exchange partnership and the replacement partnership held real property. 5 Whether a taxpayer could exchange a partnership interest in one partnership for a partnership interest in another partnership under Section 1031 was bitterly contested in the courts between taxpayers and the government. 6 The rule seemed to develop that it was possible to trade a general 3 I.R.C. 1031(a)(2). 4 Rev. Rul , C.B. 291 (baseball player contracts); Rev. Rul , C.B. 181 (broadcast rights and other TV station assets), modified by Rev. Rul , I.R.B See, e.g., Gulfstream Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979); Estate of Meyer v. Commissioner, 58 T.C. 311 (1972), nonacq., C.B. 3, aff d per curiam, 503 F.2d 556 (9th Cir. 1974); Miller v. United States, U.S. Tax. Cas (S.D. Ind. 1963); Long v. Commissioner, 77 T.C (1981); Pappas v. Commissioner, 78 T.C (1982). 6 See, generally, Halpern, Partnership Swapping From Miller to Meyer to Gulfstream, 6 JOURNAL OF REAL ESTATE TAXATION 359 (1979); Boyd & Heller, Like-Kind Exchanges of Partnership Interests: A Comprehensive Analysis, 3 REVIEW OF TAXATION OF INDIVIDUALS 87 (1979); Chromow, Tax-Free Exchanges of Partnership Interests: Gulfstream Land and Rev. Rul Impose Constraints, 57 TAXES 130 (1979); Kanter, IRS Ruling Regarding Swap of Partnership Interests, 4 JOURNAL OF PARTNERSHIP TAXATION 130 (1980); Banoff, New Opportunities Now Exist for General and Limited Partnership Conversions, 52 JOURNAL OF TAXATION 130 (1980); Banoff, Partnership Interest Conversions: Planning Possibilities, 2 JOURNAL OF PARTNERSHIP TAXATION 203 (1984); Banoff, Intrapartnership Interest Swaps Covered by Section 1031 Says New Ruling, 71 JOURNAL OF TAXATION 48 (1989); Biblin, Can a Like-Kind Exchange Be Combined With Another Tax-Free Transfer in Shifting Assets?, 78 JOURNAL OF TAXATION 22 6

7 partnership interest for another general partnership interest under Section 1031, but that a general partnership interest could not be exchanged for a limited partnership interest. 7 The cases seemed to look to a similarity of the underlying assets, so that it was necessary that each partnership generally own like-kind assets. 8 None of these cases dealt with exchanges of interests in LLC s. We likely will never know whether it was possible to exchange interests in LLC s under Section 1031 before The Internal Revenue Service was disappointed by its losses in the courts. It was concerned by the possibility that a taxpayer might avoid the boot rules in exchanges of partnership interests. A typical partnership would contain recognition property. A partnership might contain significant amounts of cash, although the principal asset of the partnership was real estate. A taxpayer might seek to escape the boot recognition rules through exchanging for an interest in a partnership laden with cash. 9 The Internal Revenue Code was amended in 1984 by the addition of Section 1031(a)(2)(D), which states in pertinent part that: This subsection [Section 1031(a)] shall not apply to any exchange of.... (D) interests in a partnership..... Section 1031(a)(2)(D) clarifies that it is not possible to exchange a partnership interest or LLC interest for another partnership interest or LLC interest under Section The exclusion similarly clarifies the law that a partnership interest or LLC interest cannot be exchanged without recognition of gain for an interest in real property. The described transaction is fully taxable to A, B and C. 4. Simple Exchange By LLC. Example 4. The facts are the same as in Example 3, except that ABC enters into a simultaneous exchange agreement and transfers its real property as relinquished property and receives as replacement property like-kind real property with a fair market value of $1,000,000 subject to liabilities of $400,000 and cash of $100,000. ABC holds the replacement property for investment purposes. What are the tax effects of the transaction? (1993). But see Rev. Rul , C.B See, e.g., Gulfstream Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979); Estate of Meyer v. Commissioner, 58 T.C. 311 (1972), nonacq., C.B. 3, aff d per curiam, 503 F.2d 556 (9th Cir. 1974); Miller v. United States, U.S. Tax. Cas (S.D. Ind. 1963); Pappas v. Commissioner, 78 T.C (1982); Long v. Commissioner, 77 T.C (1981). 7 Estate of Meyer v. Commissioner, 58 T.C. 311 (1972), nonacq., C.B. 3, aff d per curiam, 503 F.2d 556 (9th Cir. 1974). 8 See, e.g., Gulfstream Land & Development Corp. v. Commissioner, 71 T.C. 587 (1979). 9 See Long v. Commissioner, 77 T.C (1981). 7

8 This is a comparatively simple simultaneous exchange. The LLC is the taxpayer for purposes of analyzing the exchange, even though the LLC is not subject to federal income tax itself. The LLC transfers the relinquished property. Tax-exempt entity LLC should receive the replacement property. Whether there would be a good exchange if the LLC transferred the relinquished property and its members received the replacement property is questionable. The qualified use necessary to satisfy the investment purposes of Section 1031 is analyzed at the LLC level. The LLC must show that it held the relinquished property and that it will hold the replacement property either for investment or for use in its trade or business. This qualified use will be satisfied by the LLC regardless of the individual circumstances of its members. For example, a member of the LLC could be a dealer in real property; nevertheless, if the LLC satisfies the requisite qualified use with respect to both the relinquished and replacement properties, the LLC should qualify for the benefits of Section The exchange will not be fragmented depending on the individual circumstances or intents of the different members, so that it would be a good exchange as to some and a disqualified transaction as to others. Gain or loss is computed at the LLC level. In this case, the $100,000 in cash received by the LLC will constitute boot which is taxable. The taxable gain should be allocable to the members of the LLC in accordance with the governing operating agreement. The results should not be affected by the admission or withdrawal of partners from the LLC during the pendancy of the exchan+ge. A taxtermination of the LLC during the pendancy of the exchange easily could disrupt the exchange. A different taxpayer then would begin the exchange from the taxpayer who completes the exchange. 5. Simple Deferred Exchange By LLC. Example 5. The facts are the same as in Example 3, except that ABC enters into a purchase and sale agreement with an unrelated buyer. Soon thereafter, ABC enters into a deferred exchange agreement with a qualified intermediary and transfers its real property as relinquished property to the qualified intermediary. ABC designates like-kind replacement real property with a fair market value of $1,000,000 subject to liabilities of $300,000 within the 45-day designation period. The qualified intermediary acquires this replacement property and transfers it to ABC within the 180-day exchange period. ABC holds the replacement property for investment purposes. What are the tax effects of the transaction? As with other taxpayers, the LLC must: 8