Section 1031 and Proximate and Midstream Business Transactions

Transcription

1 Brooklyn Law School From the SelectedWorks of Bradley T. Borden November 5, 2003 Section 1031 and Proximate and Midstream Business Transactions Brad Borden Available at:

2 Midstream Business Transactions 1 SECTION 1031 AND PROXIMATE AND MIDSTREAM BUSINESS TRANSACTIONS * 19 TAX MGMT. REAL ESTATE J. 307 (November 5, 2003) Bradley T. Borden, CPA, LL.M. ** TABLE OF CONTENTS I. INTRODUCTION... 2 II. THE HOLDING AND USE REQUIREMENTS... 3 A. The Holding Requirement... 3 B. Mixed-Person Transactions... 4 C. The Use Requirement... 5 III. PROXIMATE DISTRIBUTIONS AND CONTRIBUTIONS... 7 A. Proximate Distributions Distribution Followed by Exchange Exchange Followed by Distribution...10 B. Proximate Contributions Contribution Followed by Exchange Exchange Followed by Contribution...12 C. JCT Simplification Recommendation IV. PROXIMATE AND MIDSTREAM BUSINESS RESTRUCTURINGS. 14 A. Partnership Terminations Midstream Actual Terminations Exchange Followed by Actual Termination Midstream Technical Terminations Exchange Followed by Technical Terminations...21 B. Conversions and S Elections C. Corporate Restructurings Tax-Free Corporate Acquisitions Midstream and Proximate Type B Reorganizations Proximate Type A and Type C Reorganizations Midstream Type A and Type C Reorganizations Taxable Corporate Acquisitions Proximate and Midstream Taxable Stock Swaps Proximate and Midstream Taxable Asset Acquisitions...29 * A version of this article was originally published in the December 2001 and January 2002 issues of the Real Estate Tax Digest, Copyright 2003 Bradley T. Borden. All rights reserved. ** CPA, L.L.M., Oppenheimer, Blend, Harrison and Tate, Inc., San Antonio, Texas.

3 2 Bradley T. Borden 8. Proximate and Midstream Taxable Mergers and Consolidations Corporate Divisions...32 a. Asset-Distribution Division b. Stock-Distribution Divisions c. Asset-Contribution-Stock-Distribution Divisions D. Partnership Mergers and Divisions Partnership Mergers Partnership Divisions Midstream Mergers and Divisions Proximate Mergers and Divisions...40 IV. SPECIAL ISSUES RELATED TO REVERSE EXCHANGES V. EXAMPLES OF 1031 EXCHANGES AND PROXIMATE AND MIDSTREAM TRANSACTIONS IX. CONCLUSION I. INTRODUCTION A single exchange can defer millions of dollars of taxable gain. While property owners zealously guard against harm or loss to property, at times they neglect to properly plan to take advantage of the nonrecognition provisions in Worse than failing to structure a 1031 exchange when possible is expending resources to plan an exchange, only to have it fail because the effect of other tax laws was not considered. The confluence of 1031 with other areas of tax law creates complex issues that must be addressed in many exchanges. In particular, there are numerous situations in which 1031 transactions overlap partnership and corporate transactions. 2 If the partnership and corporate tax laws are not considered along with 1031 in such transactions, millions of tax dollars could be lost when the 1031 exchange is busted. It is not uncommon for 1031 exchanges to be affected by partnership or corporate transactions. For example, anytime a 1031 exchange occurs in close proximity to a partnership or corporate transaction, there is a possibility that the Court Holding doctrine or the 1031 holding and use requirements could cause the exchange to fail to qualify for 1031 treatment. Also, a midstream partnership or corporate transaction (i.e., a transaction that occurs while an intended 1031 exchange is pending) could create a mixed-person transaction that cannot satisfy the exchange requirement. 1. Unless otherwise indicated, references to sections in this article are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder. 2. For purposes of this article, the term partnership and corporate transactions refers generally to contributions, distributions, terminations, conversions, mergers, divisions.

4 Midstream Business Transactions 3 Many proximate and midstream business transactions involve taxpayers acquiring or disposing of undivided interests in property. When such interests are involved, the taxpayers must be comfortable that the interest is an interest in the underlying property, not a partnership interest, which is disqualified from 1031 nonrecognition treatment. 3 While this issue must be considered anytime an undivided interest is involved in a proximate or midstream business transaction, it is not the subject of this outline. Instead, this article focuses on the holding and use requirements of 1031(a). II. THE HOLDING AND USE REQUIREMENTS For several years, practitioners, the courts, and the IRS have struggled with issues related to the exchangor s use of both relinquished property and replacement property. Section 1031(a)(1) specifically provides that 1031 treatment will apply to an exchange only if the relinquished property and the replacement property are held by the exchangor for productive use in a trade or business or for investment. Thus, to qualify for 1031 treatment, property must satisfy two requirements: (1) it must be held by the person seeking 1031 treatment (the holding requirement ) and (2) such person must hold such property for the productive use in a trade or business or for investment (the use requirement ) 4. This test is applied at the time of the exchange. 5 A. The Holding Requirement In the partnership context, some transactions fail to qualify for 1031 treatment because the intended exchangor never holds the property. This occurs most frequently when there is a sham transaction and the form of a transaction is not recognized by the courts. Such a transaction was at issue in Chase v. Commissioner 6. In that case, a partnership owned an apartment complex. The partnership received an offer on the apartment complex and decided to sell it. Before the sale of the apartment complex closed, the partnership deeded an interest in the complex to one of its partners. The deed for such transfer was not recorded. The final sales contract provided that the portion of the sales proceeds equal the value of the partner s interest in the deeded property would be transferred to an escrow agent pursuant to an exchange agreement. The exchange agreement was entered 3. See 1031(a)(2()(D). 4. See Neal T. Baker Enterprises, Inc. v. Commissioner, 76 T.C.M. (CCH) 301 (1998). 5. See Cottle v. Commissioner, 89 T.C. 467, (1987) and Neal T. Baker Enterprises, Inc. v. Commissioner, 76 T.C.M. (CCH) 301 (1998) T.C. 874 (1989).

5 4 Bradley T. Borden into by the escrow agent and the partner. The partner used the proceeds held in escrow to acquire property intended as replacement property for the interest in the partnership property. The court held that although a deed was transferred to the partner, the partner never held an interest in the apartment complex individually. Thus, the transaction did not qualify for 1031 treatment. In holding in this manner, the court found that the expenses of operating the apartment complex were paid with funds that were in the partnership s bank account. The partner did not pay any of the expenses from the date he received the deed to the interest in the apartment complex until the date the sale closed. The rent paid by the tenants of the apartment complex continued to be paid to the partnership. Finally, the partner s relationship with respect to the apartment complex was in all respects unchanged after the deed was transferred to him. At no time did the partner act as owner of the apartment complex except in the capacity of limited partner. All parties to the sale indicated that the partnership was the owner of the property. The partner did not negotiate in an individual capacity concerning the terms for the disposition of the apartment complex. These factors all indicated that the partnership, not the partner, held the apartment complex at the time of the sale. In other cases with slightly different facts, courts have come to similar conclusions. For example, in Commissioner v. Court Holding Co., 7 a corporation negotiated the sale of its sole asset, a piece of real estate. The parties to the transaction orally agreed on terms and conditions of sale and met to reduce the agreement to writing. Before executing the documents the corporation was informed by its tax attorney that selling the building in the corporation s name would result in the imposition of greater tax than if the shareholders were to sell the property. Thus, the corporation liquidated, distributing the deed to the property to the shareholders who subsequently transferred the deed to the buyers. The Supreme Court held that although the form of the transaction was a sale by the individual shareholders, the transaction was in substance a sale by the corporation. These two cases show how courts can look at the substance of the transactions to determine who holds property for tax purposes. As was shown in Chase, failure to account for this issue can result in a mixed-person transaction that does not qualify for 1031 treatment. B. Mixed-Person Transactions U.S. 331 (1945).

6 Midstream Business Transactions 5 A mixed-person transaction is an intended exchange in which one person transfers property and another person receives replacement property. For example, a mixed-person transaction includes a transaction in which an individual transfers property as the first leg of an intended exchange, joins a partnership, and causes the partnership to receive property as the second leg of the intended exchange. Such a transaction does not qualify for 1031 treatment because no reciprocal transfer of property occurs. 8 This issue often arises in the partnership area. In TAM , the IRS ruled that a transaction in which a partnership transferred property and directed that the intended replacement property be directly deeded to the partnership did not satisfy the exchange requirement in 1031(a)(1). 9 The same result should obtain if an individual transfers property and directs that intended replacement property be received by a partnership of which the individual is a partner. There is one exception to this rule. A person may transfer property and establish a single-member limited liability company that is disregarded for federal tax purposes to acquire the replacement property. The IRS has privately ruled that such a transaction does not create a mixed-person transaction and that it may satisfy the 1031(a)(1) exchange requirement. 10 C. The Use Requirement Section 1031(a)(1) requires that both relinquished property and the replacement property be held by the exchangor for productive use in a trade or business or for investment, but it does not define this requirement. 1031(a)(2)(A), however, specifically excludes stock in trade or other property held primarily for sale from qualifying for 1031 treatment. This concept differs from the more narrow concept found in 1221(a)(1) which excludes property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business from the definition of capital asset. Thus, for purposes of 1031, a taxpayer who acquires property with the intent to sell such property is deemed to hold such property primarily for sale even if selling the property is not part of the taxpayer s ordinary course of business. 11 Regals Realty v. Commissioner 12 is often cited in cases addressing 1031 s use requirement. In that case, a corporation acquired property intended to be replacement property. Less than two weeks after the 8. See 1031(a)(1); Regs (d). 9. See also Demirjian v. Commissioner, 457 F.2d 1 (3d Cir. 1972) ( 1033 does not apply to a transaction in which a partnership disposes of condemned property and the partners of such partnership use the condemnation proceeds to acquire intended replacement property). 10. PLR See Black v. Commissioner, 35 T.C. 90 (1960) F.2d 931 (2nd Cir. 1942).

7 6 Bradley T. Borden corporation acquired the deed to the intended replacement property, the corporation s board of directors adopted resolutions to liquidate the corporation by distributing its cash to the shareholders and selling the newly-acquired property. The court held that this immediate decision to sell the property shows that the corporation acquired the property to resell it and disallowed like-kind exchange treatment to the transaction. In another case, the Tax Court held that a transaction in which a taxpayer acquired two residential properties in exchange for farmland did not qualify for like-kind exchange treatment. 13 In that case, the taxpayer allowed her two adult children to move into the residences immediately after she acquired them and transferred the deeds to the residences to the children seven months after the transaction. During the time the children lived in the residences before receiving the deeds, they made improvements to the property and paid no rent for the use of the houses. The court held that the evidence was sufficient to establish that the taxpayer did not intend to hold such property for productive use in a trade or business or for investment. Likewise, in Lindsley v. Commissioner, 14 the Tax Court held that property acquired with the intent to donate it to a charity was not held for investment. In that case, the taxpayer had expressed an intent to transfer the intended replacement property to a charity before the exchange occurred. Based on this intent, the court was able to determine that the taxpayer acquired the property with an intent to transfer it, not hold it for productive use in a trade or business for investment. These cases show that a taxpayer must intend to hold property for productive use in a trade or business or for investment at the time the exchange takes place. There is no requirement that the property be held for a certain period of time to satisfy this requirement. In Wagensen v. Commissioner, 15 the taxpayer gave replacement property to members of his family just nine months after he acquired it. Despite this immediate transfer, the court found that the taxpayer acquired the replacement property to use in his ranching business - the purpose for which he held the relinquished property. One fact the court relied on in its holding was that the taxpayer did not speak with his accountant about making the gift until the replacement property was received. Thus, although the taxpayer transferred the property shortly after acquiring it, all the evidence showed that the taxpayer intended to hold the property for the productive use in his trade or business at the time the property was acquired. Neal T. Baker v. Commissioner 16 lies on the other end of the spectrum. In that case, the taxpayer held property for 11 years before 13. Click v. Commissioner, 78 T.C. 225 (1982) T.C.M. (CCH) 540 (1983) T.C. 653 (1980) T.C.M. (CCH) 301 (1998).

8 Midstream Business Transactions 7 transferring it in an exchange. The court considered several factors to hold that the taxpayer held the property for sale at the time the exchange occurred. First, the taxpayer was a developer. Second, the taxpayer reported the property on its books in its work-in-progress account with other development property. Third, it made efforts to make its final map ready to be recorded. Finally, it took steps to lock in lower city development fees. Although the taxpayer made no improvements to the property and held it for 11 years, based on the factors listed, the court found that the taxpayer held the property primarily for sale and, thus, did not satisfy the use requirement. Therefore, 1031 treatment was denied. III. PROXIMATE DISTRIBUTIONS AND CONTRIBUTIONS The above cases support the principle that the use requirement is determined at the time of the exchange regardless of the amount of time the taxpayer has held such property. The intended use of replacement and relinquished properties is important in the business context when an exchange occurs in close proximity to a distribution from or contribution to a separate tax entity. A. Proximate Distributions A proximate distribution is (1) a distribution of exchange property by a partnership to a partner shortly after the partnership receives it, or (2) a distribution of property by partnership to a partner who then transfers it in exchange for other property. Since the use requirement provides that an exchangor cannot acquire replacement property with the intent either to liquidate it or to use it for personal pursuits, 17 some practitioners worry that a distribution may disqualify the exchange from 1031 treatment. Practitioners have discussed this issue for many years, and yet many still believe that there are no clear answers for the proper treatment of proximate distributions. 18 A review of case law and rulings helps one understand the issue and provides a basis for structuring certain transactions, but leaves some questions unanswered. 1. Distribution Followed by Exchange Bolker v. Commissioner, 19 involved a corporation and its sole shareholder. In that case, the corporation liquidated, 20 following which the 17. See Regals Realty Co. v. Commissioner, 127 F.2d 933 (2d Cir. 1942) (intent to sell disqualifies the exchange); Click v. Commissioner, 78 T.C. 225 (1982) (intent to give as gift disqualifies the exchange). 18. See, e.g., Biblin, Can a Like-Kind Exchange be Combined with Another Tax-Free Transfer in Shifting Assets?, 78 J. TAX N 22 (1993); Levine, Attorney Urges IRS to End Confusion of Like-Kind Rules and Partnerships, 97 TNT (1997); Raby and Raby, Undivided Fractional Interests and Section 1031 Exchanges, 2001 TNT (2001) F.2d 1039 (9th Cir. 1985).

9 8 Bradley T. Borden shareholder transferred the distributed property in exchange for other property of a like kind. On the day of the distribution, the shareholder entered into a contract to transfer the distributed property in exchange for other like-kind investment property, but the exchange did not occur for another three months. In holding that the shareholder held the distributed property for investment and not for the intent to transfer it, the court noted that although the liquidation was planned before any intention to the transfer the property arose, the shareholder intended to use the distributed property in a tax-free exchange at the time he acquired it. The court s decision in favor of the taxpayer turned on the rationale that a taxpayer could satisfy the use requirement even though the relinquished property was acquired for the purpose of being exchanged. The court stated that although a taxpayer s intended use of the property is measured at the time it is acquired, the taxpayer is not required to intend to keep the property indefinitely in order to satisfy the use requirement. The court held if a taxpayer owns property which he does not intend to liquidate or to use for personal pursuits, he is holding that property for productive use in a trade or business or for investment with the meaning of 1031(a). 21 Finally, the court concluded that the intent to exchange property for like-kind property satisfies the holding [and use] requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits. 22 Thus, based on the Bolker decision, if a taxpayer acquires property in a tax-free transaction with the intent to exchange it for like-kind property, the taxpayer holds such property for investment under 1031(a). Rev. Rul represents the IRS s position on this issue as of In that ruling, the taxpayer was the sole shareholder of a corporation that owned a shopping center. Pursuant to a prearranged plan, the corporation liquidated, distributing the shopping center to the shareholder who immediately exchanged it for other like-kind property. The IRS s summary ruling provided that the corporation s productive use of the shopping center could not be attributed to the shareholder. Thus, the shareholder did not hold the shopping center for productive use in a trade or business or for investment and could not qualify for 1031(a) treatment. The only apparent distinction between Rev. Rul and the Bolker decision is that the distribution and exchange in the revenue ruling were part of a single plan. This distinction appears to be immaterial in light of the rationale used by the court in Bolker. The Bolker court likely would have held that the holding and use requirements are satisfied even though the property is received in a liquidating distribution as part of a plan to 20. The liquidation occurred under former Section 333, so it was tax-free. See Bolker v. Commissioner, 81 T.C. 782 (1983). 21. Bolker, 760 F.2d Iid. (emphasis in original) C.B. 305.

10 Midstream Business Transactions 9 exchange the property. If a distribution is made as part of a prearranged plan to exchange the distributed property, care must be taken to ensure the transaction does not violate the Court Holding doctrine and cause a mixedperson transaction. Otherwise, if a taxpayer acquires property with the intent to exchange it for other like-kind property, it should be deemed to be held for investment under the Bolker decision. Miles H. Mason 24 is a Tax Court memorandum decision that involved a liquidating distribution from a partnership followed by an exchange. The question considered in that case was not whether the exchange of property received in a liquidating distribution from a partnership satisfies the use requirement. Rather, the question was whether the partnership actually liquidated prior to the exchange or whether the partners exchanged partnership interests instead of qualified 1031(a) property. There is no indication in the text of the case why the use requirement was not at issue. One has to wonder, however, if the IRS realized it would have been fruitless, based on the Bolker decision, to raise the issue. The parties involved in the transaction each owned a 50% interest in two partnerships. The two partnerships owned real estate. The partners entered into an agreement to liquidate the partnerships and then exchange interests in the distributed real property. The IRS argued that the assets of the partnerships were not distributed prior to the exchange, so partnership interests, not property interests were exchanged. The court, however, after careful examination of the purchase and sale contracts, found that the parties did intend for the properties to be distributed from the partnerships and that they had personally entered into the agreement to exchange distributed real property, not interests in partnerships. The Mason case is important in two respects. First, it demonstrates that a carefully planned and documented distribution followed by an exchange can satisfy the requirements of Second, it shows that courts will examine the substance of transactions that occur proximately to 1031 exchanges to determine what property is actually exchanged. While Rev. Rul is still somewhat troubling with respect to distributions followed by exchanges, taxpayers can take comfort that in Bolker the court did not accept the IRS s position, and in Mason, the IRS did not raise the use requirement issue. Thus, there is a basis for allowing 1031 treatment to apply exchanges proximately following distributions of relinquished property. Such distributions must be carefully analyzed, however, to ensure that the partners do not receive undivided fractional interests that are treated as partnership interests. Bolker and Mason each considered an exchange following a tax-free distribution. A liquidating distribution to an individual is taxable to the shareholder under 331 and is taxable to the corporation under 336. Likewise, nonliquidating distributions of appreciated property are taxable T.C.M. (CCH) 1134 (1988).

11 10 Bradley T. Borden to the corporation under 311(b) and possibly the individual under 301(c). Under Bolker, it should not matter if intended relinquished property is acquired in a tax-free transaction. The focus should be on the purpose for holding the property at the time of the exchange. The court in Bolker very clearly provided that property held to be exchanged for property of a like kind satisfies the use requirement. Furthermore, an exchange following a proximate taxable acquisition should not cause concern to the IRS because the basis of property so transferred should reflect the fair market value of the property. Thus, there should be little, if any, gain to defer. Outside the context of the holding and use requirement, a taxpayer may be concerned that the IRS will attempt to classify an undivided interest received in a distribution as the ownership of an interest in an entity. This concern is amplified by the IRS s statement in Rev. Proc that it generally will not issue an advanced ruling that a tenancy-in-common arrangement is not a partnership or corporation if the property was held by a partnership or corporation immediately before the formation of the tenancy-in-common arrangement. This statement demonstrates that the IRS looks disfavorably on such transactions. 2. Exchange Followed by Distribution The analysis of exchanges followed by liquidations is slightly different from the analysis of liquidations followed by exchanges. The reason for this difference is that the focus turns to the intended use of replacement property if the exchange precedes the liquidation. The authority on this issue is scant but illuminating. Maloney v. Commissioner 26 addresses the issue in the corporate context. In Maloney, a corporation distributed replacement property to its shareholders shortly after acquiring it in a 1031 exchange. The distribution was governed by old 333 which provided for tax-free corporate liquidations. In examining the corporation s intent for acquiring the replacement property, the court noted that the exchange reflect[ed] both continuity of ownership and of investment intent. It then provided a detailed analysis of the corporation s intent. As part of its analysis, the court quoted Bolker extensively reiterating that a like-kind exchange may be preceded by a tax-free acquisition of property at the front end, or succeeded by a tax-free transfer of property at the back end. It also emphasized that the intent to liquidate is akin to an intent to sell or gift property only in the sense that the term liquidate means the property owner receives cash, marketable securities, or other property not of the same kind. The court then stated that a liquidation under old 333 is not a cashing out liquidation, so the corporation s intent to distribute C.B. 733, T.C. 89 (1989).

12 Midstream Business Transactions 11 the replacement property in complete liquidation of the corporation satisfies the use requirement. In the trust context, the IRS has ruled that property received in an exchange before an anticipated distribution of the replacement property to the trust beneficiaries can be held by the trust for investment purposes. 27 In that ruling, the trustee transferred farmland held in trust in exchange for other farmland and rental property. At the time of the exchange, the trust was scheduled to terminate within a few months after the replacement property was to be received. Nonetheless, the IRS held that the trustee acquired the replacement property in trust to be held for investment. Although Maloney and PLR do not address the holding and use requirement in the partnership context, the principles should apply to partnership liquidations. Maloney was decided based on old 333 which allowed tax-free liquidations of corporations to individual shareholders. The IRS did not discuss whether the distribution in PLR would be tax-free. Since the distribution of property from a trust, however, may be a taxable transaction, 28 the IRS may not require a subsequent tax-fee distribution. Since all property that qualifies for 1031 treatment can be distributed tax-free from a partnership, 29 the Maloney analysis should apply in the partnership context. Thus, taxpayers should feel relatively comfortable exchanging property in a partnership and then distributing the replacement property to its partners. Property received in an exchange followed by a taxable corporate distribution would likely fail to satisfy the use requirement if such distribution was planned at the time the property is received. A taxable corporate distribution is treated as a sale of distributed property under 336(a) and as a sale of appreciated property under 311(b). Thus, if such a distribution is planned at the time an exchange is consummated, the exchange should fail to satisfy the use requirement under Regals Realty. B. Proximate Contributions A proximate contribution is either (1) a transaction in which a partner or shareholder exchanges property and shortly thereafter contributes the received property to a partnership or to a corporation, or (2) a transaction in which a partner or shareholder contributes property to a partnership or to a corporation, after which the partnership or corporation transfers such property as part of an exchange. The same use requirement issues discussed in the proximate distribution context arise with respect to a proximate contribution. A look at case law and rulings in this area provides limited guidance and leaves some questions unanswered. 27. PLR See See 731(a)(1) and (2).

13 12 Bradley T. Borden 1. Contribution Followed by Exchange There appear to be no cases or rulings that address whether an exchange following a contribution to a partnership or to a corporation may qualify for 1031 treatment. The issue is whether the partnership or corporation, after holding the property for a short period of time, intended to hold such property for productive use in a trade or business or for investment. The Bolker rationale leads to the conclusion that an exchange following a contribution does satisfy the holding and use requirements. If a partnership or corporation acquires property with the intent to transfer it in exchange for other like-kind property, the Bolker decision suggests that the entity holds such property for investment. Thus, the partnership or corporation, as the tax reporting entity, should satisfy the holding and use requirements. One must be careful in such situations, however, not to violate the Court Holding doctrine. This can only be done if the partnership or corporation, as the case may be, is deemed to transfer the contributed property. 2. Exchange Followed by Contribution The Ninth Circuit and the IRS have examined whether a tax-free contribution following an exchange satisfies the holding and use requirements. They reached different conclusions on distinguishable facts. In Rev. Rul the IRS held that an exchange did not satisfy the holding and use requirement where the replacement property was immediately transferred to a wholly-owned corporation in a 351 tax-free contribution. The IRS s summary ruling simply stated that the shareholder acquired the replacement property to transfer it to the corporation and not to hold it for productive use in a trade or business or for investment. The lack of analysis makes the ruling difficult to compare with other, more detailed, analyses of this issue. The Ninth Circuit, in Magneson v. Commissioner, 31 held that an exchange followed by a transfer of the replacement property to a general partnership in exchange for a general partnership interest satisfies the holding and use requirements. The court relied on two main principles in finding for the taxpayer. First, the court stated that [t]he central purpose of both 721 and 1031(a)... is to provide for nonrecognition of gain on a transfer of property in which the differences between the property parted with and the property acquired are more formal than substantial, and the new property is substantially a continuation in the old investment still C.B F.2d 1490 (9th Cir. 1985).

14 Midstream Business Transactions 13 unliquidated. 32 Thus, the court relied on the policy behind both 721 and 1031 and the substance of the transaction. Second, the court noted that a general partner s ownership interest in property of a general partnership is similar to a tenancy-in-common interest. This principle is weakened if the partnership is a limited partnership and the contributing partner receives a limited partnership interest. Nonetheless, the court [D]ecline[d] to read into 1031(a) the requirement that the taxpayer continue to hold the acquired property in the exact form of ownership in which it was acquired. So long as, as in this case, the taxpayers continue to own the property and to hold it for investment, a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under 1031(a). 33 The Magneson decision is consistent with the other decisions discussed above. As the Maloney court stated, an exchange followed by a tax-free transfer of the replacement property should qualify for 1031 treatment. Contributions to a partnership or corporation are tax-free exchanges. 34 Thus, an exchange followed by a contribution of the replacement property to a partnership or corporation should qualify for 1031 treatment. Several members of the Tax of the American Bar Association ( Tax Section members ) believe the law supports this conclusion, 35 although there are practitioners who question the conclusion. 36 Contributions in exchanges for interests other than general partnership interests satisfy the policy issue in Magneson, but are less analogous to the continued ownership. Thus, there is reason for greater concern in situations involving such contributions. C. JCT Simplification Recommendation In its 2001 report on tax simplification, the Joint Committee on Taxation staff observed that there is significant uncertainty as to whether a 32. Id. at Id. at See 351(a), 721(a). 35. Wilkins, ABA Tax Section Members Report on Like-Kind Exchange Issues Involving Partnerships, 2001 TNT (March 1, 2001) ( Wilkins article ). 36. Cuff, 1031 Exchanges Involving Partnerships and LLC s: Some Observations on the ABA Report, 28 J OF REAL EST. TAX N 203 (Spring 2001) ( Cuff article ).

15 14 Bradley T. Borden taxpayer satisfies the holding requirement when property involved in a like-kind exchange is received shortly before, or transferred shortly after, the exchange by the taxpayer (e.g., distribution of property from a partnership followed by the taxpayer s exchange of such property for likekind property or taxpayer s contribution of property received in an exchange to a corporation immediately after the exchange). 37 Based on this conclusion, the Joint Committee staff made the following recommendation: [F]or purposes of determining whether property satisfies the holding requirement under 1031 like-kind exchange rules, a taxpayer s holding period and use of property should include the holding period of and use of property by the transferor, in the case of property: (1) contributed to a corporation or partnership in a transaction described in 351 or 721; (2) acquired by a corporation in connection with a transaction qualifying as a reorganization under 368; (3) distributed by a partnership to a partner; or (4) distributed by a corporation in a transaction to which 332 applies. In addition, the Joint Committee staff recommends that property whose use changes should not qualify for like-kind exchange treatment unless it is held for productive use in a trade or business or investment for a specified period of time. The recommendation that the use of a transferor be attributed to the transferee in certain tax-free transfers obtains the same result, in a different manner, as the decisions in Bolker, Maloney, and Magneson. Thus, the rule would standardize current case law and would provide solace to individuals who do not enjoy deriving the law from court decisions. The second recommendation, that property must be held for a period of time to satisfy the use requirement, would add complexity to the current law. This rule would eliminate some property from the 1031 regime, but would not eliminate the holding and use tests, as such tests would still have to be applied to all property at the time of exchange. Thus, this area most likely will retain some uncertainty for years to come. IV. PROXIMATE AND MIDSTREAM BUSINESS RESTRUCTURINGS All of the issues discussed thus far must be considered when proximate and midstream business restructurings occur. For various reasons, taxpayers often restructure a business in close proximity to 37. Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, JCS-3-01 (Volume II), VI.A.2 (April 2001).

16 Midstream Business Transactions There are numerous restructurings that may occur in proximity to an intended 1031 exchange. For example, a partnership may be terminated, an entity may convert to a different legal or tax form, an entity may make an election to be taxed under the provision of Subchapter S, a corporation may be involved in a reorganization, partnership, or any combination of these may occur. Such restructurings may occur before or after an intended 1031 exchange (a proximate restructuring ) or while an intended 1031 exchange is pending (a midstream restructuring ). Both proximate and midstream restructurings occur with great frequency, but there is little or no direct authority guiding taxpayers and practitioners in such transactions. As the discussion below reveals, serious consequences may result if the issues related to such transactions are not considered when exchanges are structured. A. Partnership Terminations Section 708(a) provides generally that for purposes of Subchapter K, an existing partnership shall be considered as continuing if it is not terminated. This provision is significant in the 1031 context because a midstream partnership termination probably invokes the mixed-person rules. On the other hand, if a partnership does not terminate, it shall be considered as continuing; in which case, the mixed-person rules should not be invoked. In addition, a proximate termination raises the holding and use requirement issues. These issues must be carefully considered any time an intended 1031 exchange occurs in a partnership. There are four ways a partnership can terminate. First, a partnership terminates if no part of any business, financial operations, or venture of the partnership continues to be carried on by any of its partners in a partnership. 38 Thus, if one partner acquires all of the interests in a partnership and becomes the sole owner of the business enterprise, the partnership will terminate at the time only one person carries on the business. 39 This is an actual termination. Second, a partnership terminates if within a 12-month period there is a sale or exchange of 50%t or more of the total interest in partnership capital or profits. 40 Thus, if one or more partners owning at least 50% of a partnership sell such interest during a 12- month period, the partnership will terminate. Such a termination is known as a technical termination. If this is a midstream termination, an outstanding property transaction could fail to qualify for 1031 treatment because of the mixed-person rules. Third, as discussed in greater detail (b)(1)(A). 39. See Regs (b)(1) (b)(1)(B).

17 16 Bradley T. Borden below, a partnership that is involved in a merger may terminate. Fourth, a division also may terminate a partnership. 1. Midstream Actual Terminations In an actual termination, the remaining owner is deemed to receive a liquidating distribution of the assets attributable to the owner s prior interest in the partnership, and to acquire the assets attributable to the transferee partner s interest in the same manner that the remaining owner acquires such transferee s partnership interest. 41 Thus, if a two-member partnership terminates because one partner dies, transferring all of the interests to the surviving partner under a will, the surviving partner will be deemed to receive the assets attributable to the deceased partner s interest by bequest. If one partner, in a two-member partnership, buys the other partner s entire interest, the acquiring partner will be deemed to purchase the partnership assets attributable to the transferee partner s interest in the partnership. Since an actual termination results in a single person holding what were formerly partnership assets, a midstream actual termination should destroy an intended 1031 exchange because of the mixed-person rules. 42 Assuming the exchange is destroyed, the only question remaining is how the broken exchange should be treated. Assume that A and B are the only members of a partnership that owns raw land with a basis of $100,000 to the partnership (the partnership acquired the property several years ago, immediately after A and B formed the partnership). A and B each have a basis in their respective partnership interests of $50,000. The partnership sells the raw land as the first leg of an intended 1031 exchange. The $2 million proceeds from the sale of the raw land are received and held by an intermediary. The exchange agreement is drafted in such a manner that it satisfies all of the requirements in Regs. 1031(k)-1(g)(4) and -1(g)(6). The partnership identifies suitable replacement property within the identification period, but before the partnership receives the replacement property, the partners have a falling out and A buys B s interest in the partnership for $1 million. This creates an interesting scenario. At first blush, it would appear that B should recognize $950,000 gain on the sale of her partnership interest. 43 The analysis, however, is not that simple. Since the partnership transferred the intended relinquished property and A will acquire the intended replacement property, the transaction most likely fails to qualify for 1031 treatment under the mixed-person rules. Since, 1031(a)(1) does not apply, the partnership 41. See Edwin E. McCauslen v. Commissioner, 45 T.C. 588 (1966); Rev. Rul , C.B Under an aggregate theory, however, one may argue that the portion of the exchange assets attributable to the remaining owner should qualify for 1031 treatment. 43. See 741.

18 Midstream Business Transactions 17 will recognize gain or loss on the exchange of the raw land, unless some other provision exempts the gain or loss. 44 Assuming no other provision exempts the gain, the partnership will be required to recognize the gain on the sale or exchange of the raw land. The timing and amount of such gain requires additional analysis. When the partnership transferred the raw land, it received either (1) a promise from the intermediary to transfer replacement property, or (2) the proceeds from the sale of the raw land. One may be inclined to argue that since the proceeds from the sale of the raw land were received by an intermediary in exchange for a promise by the intermediary to acquire and transfer replacement property to the partnership, the consideration received is an obligation, not the actual sale proceeds. If that were the case, the installment sale rules may apply to the transaction. 45 This scenario will be considered shortly. First, this article considers whether the partnership actually or constructively received the sale proceeds. Regs (k)-1(g)(4)(i) provides that the qualified intermediary is not considered the agent of the taxpayer for purposes of 1031(a). This safe harbor does not apply outside the 1031(a) context. The exchange agreement in this example was carefully drafted to include all of the requirements necessary to establish the intermediary as a safe harbor. Since the transaction fails to satisfy the requirements in 1031(a)(1), however, and since an intermediary is a qualified intermediary only for the purposes of 1031(a), the safe harbor does not apply. 46 Thus, one must look to state law to determine whether the intermediary is the agent of the partnership or if the partnership otherwise is in constructive receipt of the money held by the intermediary. Assume that the intermediary is the agent of the partnership under state law. If this is the case, then the partnership was in constructive receipt of the sale proceeds at the time the intermediary received such proceeds. 47 Being deemed to have received the sale proceeds at the time the raw land was transferred, the partnership must recognize $1.9 million of gain on the transfer of the raw land. That amount would be allocated evenly between A and B, 48 so that each would recognize $950,000 of capital gain 49 on the disposition. 50 The outside basis of each would also be increased to $ 1 million. 51 Each partner would be liable for $190,000 of tax on the properties disposition. 52 Because of the outside basis increase, when B received $1 million on the sale of her interest, she would recognize no gain. 44. See 1001(c). 45. See See Regs (k)-1(f)(2). 47. See Regs (a) and (k)-1(f)(2). 48. See 704(b) (assuming the partnership agreement does not require special allocations). 49. See 702(b). 50. See 702(a)(2). 51. See 705(a)(1). 52. Assuming the gain is taxed at 20%.

19 18 Bradley T. Borden If the intermediary was not the agent of the partnership and the partnership was not otherwise deemed to be in constructive receipt of the sale proceeds, and the installment sale rules applied, the dissolution upon the sale of B s interest would have a slightly different outcome. B would recognize capital gain of $950,000 on the sale of her interest under 741 and incur a $190,000 tax liability. 53 A would be deemed to acquire 50% of the intermediary s obligation for $1 million and to receive 50% as a liquidating distribution with a basis in such liquidated interest of $50, If the intermediary acquires and transfers property worth $2 million to A and the installment sale rules apply, 55 A will recognize a gain of $950,000 on the receipt of such property. 56 Thus, in this scenario, the tax consequences to the members of the terminated partnership are similar regardless of the manner of accounting for the sales proceeds. A, however, may be able to defer some gain to a subsequent year if the transfer of the raw land and the receipt of the other land straddle two years and the partnership is not deemed to be in constructive receipt of the sales proceeds. 57 Since the sale of the raw land produced the same character of gain as the sale of the partnership interest, 58 and since B s outside basis was equal to the basis of the raw land attributable to B, losing 1031 treatment did not impact the tax consequences under this fact pattern. If, however, B s outside basis differed from the inside basis of assets attributable to B, or if the character of gain recognized by the partnership would differ from the character of gain recognized on the disposition of a partnership interest, 59 losing 1031 treatment could have a significant tax impact. For example, if the partnership had transferred 1231 property, such as an airplane, any amount of recapture on the disposition of the airplane would have created ordinary income. 60 Thus, practitioners must carefully consider the impact a midstream termination could have on the parties. 2. Exchange Followed by Actual Termination The rules that apply in determining a taxpayer s intent to hold replacement property should apply to property received in an exchange prior to an actual termination. If the parties planned to terminate the 53. Assuming the gain is taxed at 20%. 54. See 732(a). 55. The installment sale rules would apply only if the exchange agreement provides that the intermediary s obligation will be satisfied in a subsequent year. See 453(b). Regs (k)- 1(j) will not help defer gain because it applies only if the money is kept in a safe harbor. 56. See 453(c). 57. See id. 58. See 41,1221, and Section 741 provides the sale of a partnership interest shall be treated as the sale of a capital asset except to the extent any partnership unrealized receivables or inventory are allocated to the selling partner. 60. See 1245(a).

20 Midstream Business Transactions 19 partnership after an exchange, the partnership arguably did not hold the replacement property, to the extent deemed sold, for productive use in a trade or business or for investment, since a portion of the property would be deemed held for resale. If a partner s unexpected death is the cause of the termination, however, then the partnership could argue that the property was acquired to be held for productive use in its trade or business or for investment. The question becomes one that is answered by a facts and circumstances analysis, and planners should be mindful of this potentially destructive result when considering a partnership termination where an intended 1031 exchange occurs in close proximity. 3. Midstream Technical Terminations Having established the results of an actual termination, this article considers the results a technical termination will have on an intended 1031 exchange. If a technical termination occurs, the transaction is treated as a contribution of the terminating partnership s assets to a new partnership in exchange for interests in the new partnership, following which the terminating partnership, in a liquidating distribution, distributes the interests in the new partnership to the acquiring partner and the remaining partners. 61 There appears to be no guidance on how a technical termination affects proximate or midstream intended 1031 exchanges. In their report on like-kind exchange issues involving partnerships, the ABA Tax Section members concluded that technical terminations should not affect midstream exchanges. 62 The support for this conclusion is that technical terminations are disregarded under 704(b), 704(c), and 737; that the holding period and the character of the terminated partnership s assets in the hands of the new partnership are determined under the general rules for contributions of property to a partnership; and that there is no policy reason why a like-kind exchange that straddles a technical termination should fail to be governed by 1031 simply because a new partnership completes the exchange. 63 The conclusion on this issue requires greater scrutiny. 64 It is true that there may be policy reasons for not disturbing the 1031 exchange treatment of an exchange straddling technical termination of a partnership, but the policy reasons for causing the intended 1031 exchange to fail may be more compelling. Arguments on both sides should be considered. For the most part, property attributes of a terminating partnership are carried over to the new partnership. 65 Based on this, some may argue that the same 61. See Regs (b)(4). 62. See Wilkins article, cited in note 35 above. 63. See id. 64. See Cuff article, cited in note 36 above. 65. See Regs (b)(2)(iv) (a technical termination does not affect the partners capital accounts); Regs (a)(3)(i) (a technical termination does not create 704(c) property); Regs (a) (a technical termination does not affect the 737 rules); Regs (g)(2) (no