THE ROLE OF DELAWARE STATUTORY TRUSTS AND DELAWARE LIMITED LIABILITY COMPANIES LIKE-KIND EXCHANGE TRANSACTIONS

Transcription

1 THE ROLE OF DELAWARE STATUTORY TRUSTS AND DELAWARE LIMITED LIABILITY COMPANIES IN LIKE-KIND EXCHANGE TRANSACTIONS presented to The American Bar Association s Section of Real Property, Trust & Estate Law Chicago August 2, 2009 by NORMAN M. POWELL, ESQUIRE YOUNG CONAWAY STARGATT & TAYLOR, LLP P.O. Box 391 The Brandywine Building 1000 West Street, 17 th Floor Wilmington, DE Phone: npowell@ycst.com

2 I. THE 1031 LIKE-KIND EXCHANGE. A. No gain or loss is recognized if property used in a trade or business or held for investment is exchanged for other property of like-kind that will be used in a trade or business or held for investment. IRC 1031(a)(1). B. Does not apply to any exchange of stocks, bonds, or notes, other securities or evidences of indebtedness or interest, interests in a partnership, or certificates of trust or beneficial interests. IRC 1031(a)(2). 1. Whether an organization is an entity for federal tax purposes is a matter of federal tax law and does not depend upon state law. 2. Business entity is any entity recognized for federal income tax purposes ( including a disregarded, single-member entity) that is not properly classified as a trust under Reg a. A business entity with two or more owners is classified as either a corporation or a partnership. b. A business entity with one owner is either classified as a corporation or disregarded. c. Absent election otherwise, a business entity not classified as a corporation will be (i) (ii) classified as a partnership if it has 2 or more owners, or disregarded if it has 1 owner. 3. A Trust is an arrangement whereby trustees take title to property for the purpose of protecting and conserving it for beneficiaries. Reg (4)(a). 4. The law recognizes and distinguishes business and commercial trusts, which are not simply arrangements to protect or conserve property for beneficiaries, but actually carry on a profit-making business. Reg (4)(b). a. An Investment Trust will not be classified as a trust if there is a power under the trust agreement to vary the investment. b. An Investment Trust with a single class of ownership interests, representing undivided beneficial interests in the 2

3 assets of the trust, will be classified as a trust if there is no power to vary the investment. C. The Tenant -In-Common or TIC Structure. II. REV. RUL The TIC market allows owners of property to acquire replacement property when they sell their relinquished property. 2. A sponsor will obtain financing, acquire property or other assets, and sell TIC interests to taxpayers who need replacement property. 3. The TIC structure works because the TIC interests are viewed as interests in the underlying property and not as interests in a partnership. Rev. Proc a. Lenders typically require that the owners of TIC interests be bankruptcy-remote entities usually single-member Delaware LLCs. b. Because single member LLCs are disregarded for federal income tax purposes, ownership of a single-member LLC is treated as direct ownership of the LLC s property. 4. Thus, the TIC market works, but it s complicated because lenders have to deal with multiple owners (the various single-member LLCs comprising the TIC). 5. Closing and loan administration would be streamlined and presumably less costly if title could be vested in a single bankruptcy-remote entity. 6. Hence the interest in DSTs and Rev. Rul A. Rev. Rul Involved a trust that owned real estate leased to tenants. 2. IRS concluded the DST was an entity and could not be disregarded for federal income tax purposes. 3. That left the question whether it would be treated as a business entity or as a trust. a. IRS concluded the DST wasn t an agent of its beneficial owners. 3

4 b. IRS concluded the DST was fundamentally different than an Illinois land trust and thus was a separate legal entity for tax purposes (beneficial owners of the DST have limited personal liability while the beneficiary of an Illinois land trust does not; the beneficial owners of the DST have no right to manage or control the trust s property while the beneficiary of an Illinois land trust retains such right). c. Because the trustee s powers were severely limited and included none of the powers that would indicate an intent to carry on a profit-making business, the DST was classified as a trust under Rev (c)(1). B. Impact of Rev. Rul Clarified that an interest in a grantor trust will be treated as an interest in the underlying assets of the trust. 2. Thus, an interest in a grantor trust can be replacement property. 3. The key issue is whether the DST will be treated as a grantor trust or as a business entity. 4. If the trustee has the power (regardless of whether exercised) to do any of the following seven (7) things, the DST will be treated as a business entity: a. dispose of the property and acquire new property. b. renegotiate the lease. c. enter into leases with other tenants (except when existing tenant is bankrupt or insolvent). d. renegotiate the financing or obligation used to purchase the property. e. refinance the financing or obligation used to purchase the property. f. invest cash received to profit from market fluctuations. g. make more than minor, non-structural modifications not required by law. 5. Likewise, if the trustee can vary the investment of the trust (e.g., by buying additional property or funds from the beneficiaries), the DST will be classified as a business entity. 4

5 III. A FEW THOUGHTS ON SPECIAL PURPOSE ENTITIES. A. A major concern is whether the special purpose entity ( SPE ) itself will file for bankruptcy for reasons unrelated to the credit-worthiness of the relevant asset. 1. To minimize this risk, parties restrict the ability of the SPE to voluntarily commence bankruptcy proceedings. a. The law governing the SPE must permit responsibility for making the determination to be vested in an appropriate decision-maker, such as a trustee, director, or other manager designated in the governing agreement. b. The law governing the SPE must permit the duties (including fiduciary duties) of such designated person to the SPE and its beneficial owners to be restricted by the governing agreement. c. The law governing the SPE should provide that in acting under the governing agreement the decision-maker will not be liable to the SPE or any beneficial owner for relying in good faith on the governing agreement. 2. Thus, parties should include in the SPE s governing agreement provisions that restrict the fiduciary duties and related liabilities of the designated decision-maker regarding matters related to initiating a bankruptcy filing for the SPE. B. Certain alternative entity SPEs provide an important advantage over a corporate SPE. 1. A corporation generally does not offer as much contractual flexibility regarding the fiduciary duties and liabilities of its directors/managers. a. The increased risk of incurring fiduciary liability to a stockholder/ originator may create an incentive for a director or other fiduciary of a corporate SPE to vote in favor of bankruptcy. C. A major concern in every structured financing is whether creditors of the owners or managers of the SPE will be able to reach the assets of the 5

6 SPE to satisfy their claims in a bankruptcy proceeding involving the owners or managers. An SPE can help minimize this risk in several ways. 1. Less risk of SPE consolidation. a. The SPE should be a legal entity separate and distinct from its owners and managers. b. These features can help parties maintain separateness between the SPE and its owners and managers, and thereby reduce the likelihood that a bankruptcy court will consolidate the assets and liabilities of the SPE with those of the owners and managers. 2. More protection for SPE assets. a. The law under which the SPE is formed should provide that no creditor of a beneficial owner of the SPE has any right to obtain possession of or exercise any legal or equitable remedies with respect to the property of the SPE. b. A beneficial owner of an SPE should have no interest in specific property. c. These statutory protections can help shield SPE assets from the beneficial owner s creditors in bankruptcy. 3. Less risk of SPE termination. a. The law under which the SPE is formed should provide that the SPE may not be terminated or revoked by a beneficial owner or other person except in accordance with the terms of its governing agreement. b. The SPE should have perpetual existence and not be terminated or dissolved by the dissolution, termination or bankruptcy of a beneficial owner. c. Therefore, a carefully drafted governing agreement can significantly reduce the risk that a bankrupt beneficial owner or its trustee in bankruptcy will be able to terminate the SPE prematurely and reach its assets. IV. FEATURES TO LOOK FOR IN A SPECIAL PURPOSE ENTITY. A. The Delaware statutory trust and the Delaware limited liability company have emerged as the preferred SPEs. 6

7 B. Features of the Delaware statutory trust ( DST ): 1. The DST is easy to form and maintain. a. Parties may form a DST by filing a short-form certificate of trust with the Delaware Secretary of State. (i) (ii) Certificate states the name of the trust. Certificate states the name and address of the Delaware trustee. b. No annual fees or filings are required. 2. Limited liability for SPE owners and managers. a. Beneficial owners of a DST are entitled to the same liability protections that Delaware law provides to stockholders of a Delaware corporation. b. Trustees and other managers of the statutory trust are not personally liable to third parties for acts, omissions or obligations of the statutory trust. 3. Contractual flexibility. a. The policy of the DST Act is to give maximum effect to the principle of freedom of contract and to the enforceability of trust agreements. b. A trustee s fiduciary duties to the beneficial owners or the statutory trust, may be restricted or expanded in the trust agreement. 4. Flexible tax treatment. a. A DST may be structured as a corporation, a partnership or a grantor trust for federal and Delaware income tax purposes. b. A DST can qualify as a FASIT (financial asset securitization investment trust), a REMIC (real estate mortgage investment conduit), a REIT (real estate investment trust) or a RIC (registered investment company). 5. Bankruptcy remoteness. a. Minimizing the risk in a beneficial owner s bankruptcy. 7

8 (i) (ii) (iii) A DST is a legal entity separate and distinct from its owners and managers. This separateness lessens the likelihood that a bankruptcy court will consolidate the assets and liabilities of the SPE with those of the owner. More protection for SPE assets. (A) A creditor of a beneficial owner of a DST has no right to obtain possession of or exercise any legal or equitable remedies with respect to the property of the DST. (B) Beneficial owner generally has no interest in specific property of the DST. (iv) Less risk of SPE termination. (A) A DST may not be terminated or revoked by a beneficial owner or other person except in accordance with the terms of its trust agreement. (B) A DST has perpetual existence and will not be terminated or dissolved by the dissolution, termination or bankruptcy of a beneficial owner unless the terms of the trust agreement provide otherwise. b. Minimizing the risk of the SPE s bankruptcy. (i) (ii) Parties sometimes seek to restrict the ability of the SPE to voluntarily commence bankruptcy proceedings. The contractual flexibility provided by the DST Act facilitates this. (A) Permits designation of an independent trustee responsible for making the determination to seek bankruptcy protection. (B) Permits contractual limitation of fiduciary duties the independent trustee might otherwise owe to the beneficial owner or the DST itself. 8

9 C. Selected statutory provisions relating to DST bankruptcy remoteness (a) - A DST is a separate legal entity (e.g., like a corporation, LLC or limited partnership) (c) - Beneficial interest in DST is personal property (e.g., like stock or LLC/LP interests) (c) - Beneficial owner has no interest in specific DST property (subject to the terms of the trust agreement) (b) - Creditors of beneficial owner have no right to possess property of DST or to exercise any legal or equitable remedies with respect to property of DST (a) - DST cannot be terminated or revoked by a beneficial owner or any other person (except in accordance with the terms of the trust agreement) (b) - Bankruptcy, dissolution, termination, incapacity or death of beneficial owner does not terminate or dissolve DST (subject to the terms of the trust agreement) Management structure/rules are created by trust agreement rather than imposed by statute (creates greater likelihood of compliance and therefore should make separation of assets from originator easier to achieve) (b) & (c); 3806(c) & (d) - Decision-maker flexibility re: DST bankruptcy (especially fiduciary duties of decision-maker). D. Features of the Delaware limited liability company ( LLC ). 1. Entity status -- LLCs are separate legal persons that exist independently of their members and that may act in their own name. See 6 Del. C (b). 2. Continuity of life -- unless its certificate of formation provides otherwise, an LLC's duration may be indefinite. See 6 Del. C (a)(1). 3. Limited liability of members -- LLC members as such generally have limited liability for the obligations of their LLCs. See 6 Del. C Management structure -- unless an LLC's operating agreement provides otherwise, the management of an LLC is vested in its members. See 6 Del. C

10 5. Decision-making formalities -- unless the operating agreement provides otherwise, the members and managers of an LLC are not required to comply with decision-making formalities (including, for example, formalities concerning meetings and the recording of votes) as a condition for the validity of their decisions. See 6 Del. C , Fiduciary duties and liabilities of non-manager members -- the operating agreement of an LLC may expand or restrict the duties (including fiduciary duties) and liabilities relating thereto that a non-manager member may have, at law or in equity, to the LLC or another member or manager. See 6 Del. C (c). 7. Fiduciary duties and liabilities of managers -- the operating agreement of an LLC may expand or restrict the duties (including fiduciary duties) and liabilities relating thereto that a manager may have, at law or in equity, to the LLC or another manager or member. See 6 Del. C (c). E. Statutory rules specifically applicable to single-member LLCs. 1. The very fact that single-member LLCs have only a single member gives rise to issues not relevant to multi-member LLCs. 2. Consider the means by which the owner of a single-member LLC may alter the default rules of the Act as applicable to that owner. a. LLC acts in most U.S. jurisdictions provide that members may not alter statutory default rules except through oral or written operating agreements. (i) (ii) The term "operating agreement" arguably implies an understanding among two or more members and thus may be interpreted to imply that owners of single-member LLCs may not alter statutory default rules. However, Delaware defines a limited liability company agreement as an agreement of the member or members, see 6 Del C (7) (emphasis added), and specifically provides that the operating agreement of a single-member LLC shall not be unenforceable by reason of there being only one person who is a party to the operating agreement, see id. NMP/ / /2 10