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The selection of the appropriate business entity requires an analysis of many factors by the planning professional. Liability avoidance is usually a paramount consideration, but close behind in importance are the federal and state tax impacts that can be expected from the selection of certain types of entities over others. This analytical process is really no different in the real estate context than in most others, although the likely involvement of institutional investors sometimes puts special pressures on the tax planning concerns.

A detailed exposition of all of the liability, control and tax issues, among others, that drive the choice of entity in real estate deals is beyond the scope of this article. However, attached to this article is a truly plenary and excellent article that wades through all of those issues, and then some, in a comprehensive and cogent fashion. For those desiring a deeper and broader understanding of the many issues that must be thought through when advising clients on entity selection, we highly commend this article to your reading.

B. TAX PLANING - THE AGE OF FLEXIBILITY

We live and work in a planning environment somewhat like the famed “Alice’s Restaurant,” where “you can have anything you want.” The flexibility of the “check-the-box Regulations,”[1] when combined with various state law conversion statutes and the laissez-faire enforcement posture of the State Comptroller’s office, yield a canvas upon which we can paint almost any entity picture we desire. We can form state law partnerships, general, limited or limited liability, and elect to have them taxed as corporations. We can take a corporation, convert it to a partnership, and then elect whether such “partnership” will be taxed as a “C corporation”[2], an S corporation[3] or a partnership (such latter treatment usually being a disastrous accident as opposed to a conscious, educated choice inasmuch as it would result in a deemed liquidation of the corporation, generating deemed sales of both the assets of the corporation and of the stock owned by the shareholders). Finally, we can access the extraordinary flexibility of limited liability companies (LLC’s), which can be taxed as C corporations, S corporations, partnerships or entities that are completely disregarded for federal tax purposes.

C. TEXAS FRANCHISE TAX ISSUES

The Texas franchise tax often is the determinative issue in entity selection for businesses that will have nexus with the State of Texas. Such businesses will be subject to such tax, but only if they are operated in the form of a corporation or an LLC. Partnerships are completely exempt from the franchise tax (as such tax exists on the date this article was sent to the publisher). For entities that are subject to the franchise tax, generally the amount of the tax is equal to 4.5% of the taxable income of the entity, multiplied by a fraction the numerator of which is the Texas gross receipts received by the entity during the tax period and the denominator of which is all of the gross receipts that are received by such entity during such period. [NOTE: AS THIS IS BEING DRAFTED, THE TEXAS LEGISLATURE IS CONSIDERING ALTERING THE TEXAS FRANCHISE TAX.]

D. THE BIAS FOR PARTNERSHIPS

By and large, sophisticated practitioners in Texas have recommended the partnership form for most businesses, and especially for real estate businesses, since the “4.5% of taxable income” component of the Texas franchise tax was added in 1991. For federal tax purposes, the “flow-through” nature of partnership taxation avoids the ghastly spectra of double taxation of both operating profits and disposition gains that one faces if stuck with the C corporation structure. Even the S corporation structure is less desirable than the partnership form of business due to the limitations imposed on the number and type of persons/entities that may own stock in an S corporation, the complexity of the provisions of Subchapter S of the Code, and the fact that shareholders may not include in their basis - against which losses may be deducted-debts of the S corporation, whereas partners may so include the debt incurred by a partnership, subject to many complex rules.

Most importantly, though, the present provisions of the Texas franchise tax not only discourage the use of corporations but also eliminate the usage of LLC’s as the prime vehicle for holding real estate. Although LLC’s that have more than one owner are, absent an election to the contrary, taxed as partnerships for federal income tax purposes, they are still subject to the Texas franchise tax. This anomaly of Texas law means that deals done via LLCs in most of the country are usually done in partnership form in Texas, and practitioners all over the country have become familiar with this aberration.

And when we say “partnerships” are used primarily in Texas, we mean to say limited partnerships under the Texas version of the Revised Uniform Limited Partnership Act. General partnerships have the unpleasant aspect of unlimited joint and several liability for its owners, and limited liability partnerships—which are merely general partnerships that have filed as registered limited liability partnerships under the applicable provisions of Texas law[4]--do not provide a complete liability shield for their owners, as does a correctly structured limited partnership.

The normal form taken by this type of vehicle is as follows - an entity, either a corporation (C or S) or an LLC, is formed by the organizer of the venture to serve as the general partner of the limited partnership. Remember that a limited partnership must have at least one “general partner” which is liable without limit for the liabilities of the limited partnership and which also manages the limited partnership. That general partner entity will traditionally have only nominal assets, other than its interest in the limited partnership. It then forms the limited partnership, with the equity owners of the venture becoming the limited partners thereof. Generally, the general partner entity will own one percent or less of the ownership interests in the partnership, with the limited partners owning the remaining 99+% of such interests. It matters not that the same persons who are the limited partners may also own the general partner entity, or even that the same individual may be the sole limited partner and the sole owner of the general partner entity. Either way, those owners are protected from the debts and liabilities of the limited partnership, which owns and operates the real estate project. Further, they have the benefits of partnership taxation for federal tax purposes and have eliminated almost all of the Texas franchise tax on the profits of the venture. Only that portion (1% or less) of such profits which are allocated to the general partner entity (which we assumed would be an LLC or corporation) will be subject to such tax.

E. WHITHER THE FRANCHISE TAX?

We can’t imagine that we have told you anything you didn’t already know about the applicable tax issues and the preferred structure. The question that the organizers of this program wanted us to answer - we think - is this: Under the new franchise tax legislation, what is the best structure for owning, operating and selling real estate?

You see our problem - the legislature hasn’t finished its work on this issue, so we can’t - at the time we turned this article in - tell you much about new planning techniques. If some new legislation is passed prior to our presentation in July, we’ll share it and our planning thoughts with you then. If not, then there are still some things you can do when faced with an existing structure that was not selected with franchise tax minimization in mind. We will devote the remainder of this article to a discussion of some of those techniques.

F. FRANCHISE TAX PLANNING - AN OVERVIEW

When faced with an entity other than a limited partnership structured as described above, the general objectives will be twofold: First, restructure so that the operating entity is a limited partnership. Second, do so in a fashion that causes the least dislocations for federal tax purposes.

The former objective may be achieved fairly easily, whether by converting the entity to a limited partnership or by creating subsidiary entities that then form a limited partnership. Where great mischief and damage can and has been done by unsophisticated practitioners is in failing to appropriately deal with the federal income tax issues that arise upon conversion.

The most appalling fact pattern that we have seen in this regard is an S corporation holding substantially appreciated property which the advisor simply converted to a limited partnership after contributing a portion of the stock of such S corporation to a single-member LLC which was then to serve a the general partner of the limited partnership. We’ll discuss below some of the dangers of this approach even when the appropriate elections are filed, but in this case the advisor DIDN’T EVEN ELECT TO HAVE THE LIMITED PARTNERSHIP TREATED AS A CORPORATION FOR FEDERAL TAX PURPOSES!! Truly unbelievable. It isn’t clear whether that advisor ever really understood what he had done, but it is undeniable that he simply effected a liquidation of that corporation, with the gain recognition impacts that we discussed above.

Assuming that such an advisory meltdown is not part of the practice approach that any of us would use, let’s explore the structures that can be used in various contexts.

G. EXISTING ENTITY - GENERAL PARTNERSHIP OR LIMITED LIABILITY PARTNERSHIP

In this case, the fix is fairly easy. There is no Texas franchise tax concern because both general partnerships and LLPs are presently exempt from that tax. The real concern here is liability protection. We would suggest that (1) the partners contribute 1% of their partnership interests to an LLC, and (2) the partnership then convert to a limited partnership having as its sole general partner the LLC and as its limited partners the pre-existing partners in the same pro rata ownership percentages.

PRACTICE TIP: When preparing to do any of the restructuring described herein, the biggest non-tax drafting issue will be the buy-sell provisions. Even if the parties have a well-drafted existing buy-sell and want to keep the basic terms thereof intact, it takes some sophistication to replicate the terms in a different type of entity AND to tie the buy-sells of the general partner entity and the limited partnership together in a way that works seamlessly. However, if the parties either do not have a buy-sell agreement or one or more of them want to take the occasion of the restructuring as an opportunity to change the substance of their agreement (or non-agreement), then those negotiations can produce delay, extra expense and acrimony and can ultimately transform your fairly simple and straightforward plan into a morass of accusations and recriminations among the parties and yourself. This one issue can lead to the biggest problem in accurately estimating the price of the restructuring and should be addressed up front in a way that eliminates transactional and billing surprises.

H. EXISTING ENTITY - C CORPORATION

Two basic approaches have surfaced in minimizing franchise tax for C corporations—the Delaware sandwich and what we will call the “straight conversion.”

1. The Delaware Sandwich

Where it is impractical for the corporation itself to convert to a new kind of entity, say in a situation where the corporation is publicly traded, then a structure known as the “Delaware sandwich” is widely used. This structure takes advantage of the part of the franchise tax formula whereby the tax obtained by multiplying taxable income by 4.5% is then multiplied by the gross receipts fraction, i. e., Texas gross receipts/all gross receipts. Here’s how it goes:

a. Corporation forms two wholly-owned LLCs, one in Texas and one in a low-tax/no-tax jurisdiction like Delaware or Nevada.

b. The Texas LLC, as the 1% general partner, and the Delaware LLC, as the 99% limited partner, form a Texas limited partnership.

c. Corporation transfers (a) 1% of its assets and liabilities to the Texas LLC, which transfers those same assets and liabilities to the limited partnership as its contribution to capital and (b) 99% of its assets and liabilities to the Delaware LLC, which transfers those same assets and liabilities to the limited partnership as its contribution to capital.

(1) Federal Tax Impact Nothing. The two LLC’s are disregarded under the “check-the-box Regulations” and the limited partnership, which is now deemed to be wholly-owned by the Corporation because the two LLC’s are disregarded, is similarly disregarded. No new federal tax returns need be filed.

(2) Franchise Tax Treatment At the limited partnership level, no franchise tax is imposed because the limited partnership is exempt from the Texas franchise tax. The 1% of income allocated to the Texas LLC will be subject to Texas franchise tax because, as the general partner of the limited partnership, the Texas LLC will be deemed to be doing business in Texas and thus subject to the franchise tax. (The same would be true if the general partner LLC were domiciled in another state.) The 99% of income allocated to the Delaware LLC, however, is not subject to Texas franchise tax because the activity of being a limited partner does not, in and of itself, constitute doing business in Texas. SO LONG AS THE DELAWARE LLC DOES NOT HAVE SUFFICIENT CONTACTS WITH THE STATE OF TEXAS TO GIVE IT NEXUS UNDER APPLICABLE TEXAS LAW, IT WILL NOT BE SUBJECT TO THE TEXAS FRANCHISE TAX.

When the two LLC’s repatriate the funds distributed to them up to the original C corporation, the 99% coming from the Delaware LLC will be deemed to be “out of state” gross receipts. Thus, although the Corporation is subject to the franchise tax and has taxable income equal to that of the entire enterprise, only the 1% received from the Texas LLC will be taxed due to the workings of the gross receipts fraction portion of the franchise tax.

2. PROBLEMS WITH THE “DELAWARE SANDWICH”:

a. Moving the Assets.

You actually have to move the assets, liabilities, bank loans, lease obligations, etc. through the LLC’s down to the limited partnership to give substance to this transaction for state purposes. That can be an extremely complex task, and possibly undoable if landlords, lenders and regulators do not cooperate. THIS ISSUE IS THE SECOND MOST LIKELY TO LEAD TO A MISCALCULATION OF POSSIBLE TRANSACTION COSTS.

b Nexus of the Delaware LLC.

It is critical that the Delaware LLC not operate in any fashion in the State of Texas, else it will be deemed as having sufficient nexus with Texas and will make this planning vehicle unsuccessful. It’s not that the actions of the LLC, e. g., electing its members and managers, exercising its powers as a limited partner, moving money from the Delaware LLC to the Corporation, and so on, must be done in Delaware—it’s just that they can’t be done in Texas. We literally will send clients over the Red River to accomplish certain tasks, and many clients simply do not have the discipline to keep from doing acts that would, upon close inspection, give the Delaware LLC nexus with Texas.

c The Target.

Several very large publicly traded corporations such as Dell and SBC have used this technique to avoid literally millions of dollars in Texas franchise tax, and it is this structure that the Legislature most talks about when it discusses eliminating the “loopholes” in the Texas franchise tax.

3. The “Straight Conversion”

For most privately held C corporations, the franchise minimization structure of choice is done in three simple steps:

a. Each shareholder contributes 1% of his stock in the Corporation to a newly formed LLC, which will ultimately function as the 1% general partner of the converted Corporation.

b. Convert the Corporation to a limited partnership, with the LLC becoming the 1% general partner and the shareholders in the aggregate becoming the 99% limited partners of the limited partnership.

c. Check the Box—Have the Corporation file a Form 8832 with the IRS in which it elects to be taxed as an “association taxable as a corporation.”

(1) Federal Tax Impact. This conversion is treated as a tax-free “mere change in form” reorganization under Code Section 368(a)(1)(F), which means quite simply that there is no gain or loss recognized by either the Corporation or its shareholders and that all of the assets continue with carryover bases and tacked holding periods. The LLC will file its own tax return, presumably as a partnership if there is more than one owner thereof.

(2) Franchise Tax Treatment. The business is now conducted in an entity exempt from Texas franchise tax. Except for any dividends paid to the LLC, it will have no franchise tax liability, and if dividends are paid, the LLC will receive only 1% thereof. Absent any dividends, 100% of the franchise tax has been eliminated.

Notice the simplicity and absence of problem issues inherent in the use of the “straight conversion.” The assets do not move, there are no nexus issues, and this structure has not drawn the level of political flak that has dogged the “Delaware sandwich” structure. The assets and liabilities of the Corporation are automatically owned and assumed by the limited partnership. Care should be given to any lease provisions, loan covenants, franchise terms and regulatory concessions that might describe this type of corporate restructuring as an event of default, but at this juncture in the history of these conversions, our experience is that most of such agreements do not capture this type of transaction within its definition of events of default.

Again, care must be given to the replication or creation of appropriate buy-sell provisions. Moreover, as a practical matter all of these restructuring approaches require some level of education of the client and its employees regarding the appropriate use of the limited partnership’s name on letterhead, contracts, etc.

PRACTICE TIP: The new limited partnership agreement will need to be stripped of “capital accounts” and income allocations inasmuch as it is intended to be taxed as a corporation. The draftsman must take great care not to allow his form partnership agreement to leave the office without careful revisions that take into account the “check-the-box” entity decision that has been made.

I. EXISTING ENTITY - S CORPORATION

Because all S corporations are privately held, the “straight conversion” is the structure many practitioners first attempted to use for S corporations. The “Delaware sandwich” was, and still is, available but the obvious drawbacks of that approach - specifically the necessity of actually moving the assets down through the LLCs and into the limited partnership - militated towards the use of the much simpler “straight conversion.” However, danger was lurking in that seemingly simple decision.

1. The “Second Class of Stock” Issue: Confusion at the Service

Many “straight conversions” of S corporations were done prior to the latter part of 1999. Its simplicity made it the restructuring approach of choice, especially for advisors who were less attuned to the nuances of Subchapter S and happy to jump on the bandwagon of an approach that could be replicated from some widely available forms. In fact, in late 1999 a practitioner in Central Texas received a favorable private letter ruling from the Service on a “straight conversion” of an S corporation.[5] Thus began the drama.

Subchapter S has many technical requirements, including limitations on the types and number of shareholders that are permissible, strictures on the amount of passive income that can be earned, and most importantly here, a prohibition on having more than one class of stock.[6] Code Section 1361(b)(1)(D) provides that an “S corporation” may not have more than one class of stock. Seasoned practitioners wondered, when analyzing the efficacy of the “straight conversion” technique, whether a general partnership interest and a limited partnership interest in a “partnership” that had elected to be taxed as a corporation could somehow be deemed to be two different classes of stock. Reasonable arguments could be marshaled on either side of the argument, and apparently they were; in the Service.

Sources inside the Service let it be known, immediately after the issuance of the favorable 1999 private letter ruling, that the matter was far from settled within the Service, and as evidence of the internal conflict on the issue the Service very quickly determined that it would no longer rule on the issue.[7] That ruling by the Service set off a flurry of “undoing” straight conversions of S corporations by taxpayers who passionately did not want to be the test case on this issue. The “straight conversion” is not now - and frankly never was by thoughtful practitioners - considered to be an appropriate approach to minimizing franchise tax liability.

2. Other Approaches We are aware of at least two other structures that are being utilized to minimize franchise tax for S corporations—one we recommend, and one we really don’t.

3. Simple Limited Partnership Subsidiary

The approach that we least prefer works like this:

a. S Corporation forms a Texas LLC, which will become the general partner of a limited partnership, contributing 1% of its assets and liabilities to such LLC.

b. LLC forms a limited partnership by contributing to it the 1% of the S Corporation’s assets and liabilities which were contributed to LLC, while S Corporation contributes the remaining 99% of its assets and liabilities to the limited partnership for a limited partner interest.

c. S Corporation redomiciles in a low-tax/no-tax state such as Delaware or Nevada and attempts to eliminate all contacts with Texas so as to avoid having nexus with the State of Texas.

The intent of this approach is to allow S Corporation to receive 99% of the income of the limited partnership as a limited partner, which does not, in and of itself, create nexus with Texas, and to itself become non-taxable by effectively leaving the state.

The problems with this structure are few, but significant:

(1) Once again, the assets of the S Corporation must actually be transferred to the limited partnership, with all of the problems accompanying such transfers that were described above.

(2) We have grave doubts about the ability to eliminate all of the S Corporation’s Texas contacts efficiently. The risk of failing to do so is that this entire endeavor would be fruitless in the attempt to minimize franchise tax.

4. Two-tier LLP/LP Structure

Our preferred approach to minimizing franchise taxes for S corporations goes like this:

a. Have the shareholders of the S corporation contribute their stock to a newly formed general partnership which makes the filing necessary to become a registered limited liability partnership (LLP).

b Have the LLP “check-the-box” to be treated as a corporation, make an election to be taxed as an S corporation, and make an election to have the original S corporation (all of the stock of which is now owned by the LLP) treated as a “qualified Subchapter S subsidiary” (a “QSUB”).

c Have the LLP contribute 1% of the stock of the original S corporation (now the QSUB) to an LLC wholly-owned by the LLP.

d Convert the QSUB to a limited partnership.

(1) Federal Tax Impact. The effect of steps 1 and 2 is to create a new S corporation (the LLP which has elected to be taxed as a corporation and has filed its own S election) which has a wholly-owned subsidiary. Code Section 1361(b)(3)(A) provides that a QSUB[8] is not treated as a separate corporation and that the assets, liabilities and items of income, deduction, gain, loss and credit of the QSUB are treated as the assets, liabilities and items of income, deduction, gain, loss and credit of the parent S corporation. Thus, the assets, liabilities and income of the original S corporation, now the QSUB, are all treated for federal tax purposes as being those of the LLP/new S corporation. Absent this QSUB election, the S election of the original S corporation would terminate because outside of the QSUB regime an entity such as the LLP would not be allowed as a shareholder of an S corporation.

The creation of the single-member LLC is a tax nothing, such LLC being disregarded for federal tax purposes. When the original S corporation is then converted to a limited partnership, it continues to be disregarded, not because is continues to be a QSUB but because it is now a non-corporate entity with one owner (remember, the LLC is disregarded) that has not elected to be treated as a corporation, and therefore is disregarded under the default characterization rules of the “check-the-box” Regulations.

(2) Franchise Tax Treatment. The operations of the venture are now conducted by a limited partnership which is exempt from the Texas franchise tax. The 1% of the income of that limited partnership that is allocated to the LLC will be subject to the franchise tax, inasmuch as the LLC is a taxable entity, but the 99% of such income that is allocated to the LLP will not be subject to franchise tax inasmuch as that entity is not a taxable entity. Thus, 99% of the franchise tax liability on the income of this business will have been eliminated.

PRACTICE TIP: Again, the capital account and income allocation provisions of the LLP will need to be removed, and the entire agreement amended appropriately, to take into account the reality that this entity has elected to be taxed as an S corporation.

II. SUMMARY

At this writing, the Texas franchise tax is under consideration by the Texas legislature. If no change in made in that tax, the preferred entity for real estate deal will continue to be a limited partnership with a corporation or LLC as its 1% general partner. If that tax is altered, a different structure may be indicated. As it stands, various techniques are available to convert entities that are subject to the franchise tax to ones that aren’t, but special care must be taken with the federal income tax implications of making any such conversions.

III. 1031 ISSUES

A. Revenue Procedure 2002-22 and Tenancy-in-Common Exchanges

As Popeye’s buddy Wimpy once said, “I will gladly pay you Tuesday for a hamburger today.” This line of thinking is common amongst real estate investors today. Real estate investors, like all investors, typically desire to enter into real estate deals, make money today, but defer the payment of taxes until well into the future. Internal Revenue Code (the “Code”) section 1031 helps real estate investors fulfill this desire.

As a general rule, gain from the sale or exchange of property must be recognized for federal income tax purposes.[9] The gain that must be recognized is the excess of the amount realized from the sale or exchange over the taxpayer’s adjusted basis in the property sold or exchanged.[10] Code section 1031(a)(1) provides an exception to the general rule for exchanges of “like kind” properties held for productive use in a trade or business or for investment. According to that section:

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.[11]

Thus “like kind” properties may be exchanged tax-free. However, the Code specifically precludes like kind exchange treatment for “interests in a partnership.”[12]

The inability to enter into a like kind exchange of partnership interests is animportant taxtrap for real estate advisors to be aware of. Due to the strict time-restraints imposed on deferred like kind exchanges[13] and the practical problems associated with finding and actually obtaining replacement property,[14] many real estate investors who cash out their investments with an eye toward locating suitable like kind exchange property in the near future end up acquiring tenancy-in-common (“TIC”) interests in order to avoid recognition of gain.

On the surface of such an exchange, no problems would seem to exist, for numerous authorities state that a fee simple interest in real property is of like kind to a TIC interest in real property.[15] However, severe problems will arise if the replacement TIC interest is recharacterized as a partnership interest, for partnership interests are ineligible for like kind exchange treatment. Fortunately for taxpayers, Revenue Procedure 2002-22[16] clarifies the conditions under which a fractional TIC interest in rental real property will be considered a true TIC interest and not a tax partnership interest.

1. Purpose of Revenue Procedure 2002-22

The stated purpose of Revenue Procedure 2002-22 is to specify the conditions under which the Service will consider a request for a ruling that an undivided fractional interest in rental real property (other than a mineral property) is not an interest in a business entity. Although the revenue procedure does not proclaim to be a safe harbor, stating that its guidelines “are not intended to be substantive rules and are not to be used for audit purposes,” commentators believe that the revenue procedure does in fact establish a safe harbor for advisors and auditing agents to rely on. According to one commentator, “[t]he inference that arrangements that fall within the guidelines are blessed by a safe harbor is substantially justified.”[17] Thus for all practical purposes, Revenue Procedure 2002-22 provides a useful safe harbor for taxpayers who purchase TIC interests in rental real properties.

2. Ruling Requests and Multiple Properties

Where multiple parcels of property owned by co-owners are leased to a single tenant pursuant to a single lease and any debt of one or more co-owners is secured by all of the parcels, the IRS will generally treat all of the parcels as a single property. These properties generally will not be considered for a ruling request unless:

a. each co-owner’s percentage interest in each parcel is identical to that co-owner’s percentage interest in every other parcel,

b. each co-owner’s percentage interests in the parcels cannot be separated and traded independently, and

c. the parcels are properly viewed as a single business unit.

The Service will generally treat contiguous parcels as comprising a single business unit and will generally treat noncontiguous parcels as comprising a single business unit provided there is a close connection between the business use of one parcel and the business use of another parcel. For example, an office building and noncontiguous parking garage may be treated as a single business unit under this rule.

3. Required Information

If a taxpayer intends to rely on Revenue Procedure 2002-22 merely as a safe harbor, no information need be submitted to the Service. For taxpayers submitting ruling requests, the Service requires the following information:

a. a complete statement of all facts relating to the co-ownership, including those relating to promoting, financing, and managing the property;

b. the name, taxpayer identification number, and percentage fractional interest in the property of each co-owner;

c. the name, taxpayer identification number, ownership of, and any relationship among, all persons involved in the acquisition, sale, lease and other use of the property, including the sponsor, lessee, manager, and lender;

d. a full description of the property;

e. a representation that each of the co-owners holds title to the property (including each of multiple parcels of property treated as a single property under this revenue procedure) as a tenant in common under local law;

f. all promotional documents relating to the sale of fractional interests in the property;

g. all lending agreements relating to the property;

h. all agreements among the co-owners relating to the property;

i. any lease agreement relating to the property;

j. any purchase and sale agreement relating to the property;

k. any property management or brokerage agreement relating to the property; and

l. any other agreement relating to the property not specified, including agreements relating to any debt secured by the property (such as guarantees or indemnity agreements) and any call and put options relating to the property.

4. Conditions for Obtaining Rulings

In order for the Service to consider a request for a ruling under Revenue Procedure 2002-22 (or in order to comply with the safe harbor), a taxpayer must fulfill the following conditions:

a. Tenancy in Common Ownership

Each co-owner must hold title to the property (either directly or through a disregarded entity) as a tenant in common under local law. Thus, title to the property as a whole may not be held by an entity recognized under local law.

b. Number of Co-Owners

The number of co-owners must be limited to no more than 35 persons.

c. No Treatment of Co-Ownership as an Entity

The co-ownership may not file a partnership or corporate tax return, conduct business under a common name, execute an agreement identifying any or all of the co-owners as partners, shareholders, or members of a business entity, or otherwise hold itself out as a partnership or other form of business entity. Likewise, the co-owners may not hold themselves out as partners, shareholders, or members of a business entity.

The fact that the co-owners may not conduct business under a common name seemingly prohibits them from doing business under a trade name. An “otherwise innocent ‘dba’ apparently violates this ruling guideline.”[18]

d. Co-Ownership Agreement

The co-owners may enter into a limited co-ownership agreement that may run with the land. For example, a co-ownership agreement may provide that a co-owner must offer the co-ownership interest for sale to the other co-owners at fair market value before exercising any right to partition. Or it may provide that certain actions on behalf of the co-ownership require the vote of co-owners holding more than 50 percent of the undivided interests in the property.

e. Voting

The co-owners must retain the right to approve the hiring of any manager, the sale or other disposition of the property, any leases of a portion or all of the property, or the creation or modification of a blanket lien. Any sale, lease, or re-lease of a portion or all of the property, any negotiation or renegotiation of indebtedness secured by a blanket lien, the hiring of any manager, or the negotiation of any management contract (or any extension or renewal of such contract) must be by unanimous approval of the co-owners. For all other actions on behalf of the co-ownership, the co-owners may agree to be bound by the vote of those holding more than 50 percent of the undivided interests in the property.

This revenue procedure approves of management arrangements, but only if they are sufficiently limited. Co-owners must be careful not to delegate certain rights and duties to a manager. In addition, co-owners must insure in their co-ownership agreement that certain decisions can be made only by unanimous consent.

f. Restrictions on Alienation

Each co-owner must have the rights to transfer, partition, and encumber the co-owner’s undivided interest in the property without the agreement or approval of any person. However, certain restrictions on the right to transfer, partition, or encumber interests in the property that are required by a lender and that are consistent with customary commercial lending practices are not prohibited. Moreover, the co-owners, the sponsor, or the lessee may have a right of first offer (the right to have the first opportunity to offer to purchase the co-ownership interest) with respect to any co-owner’s exercise of the right to transfer the co-ownership interest in the property. In addition, a co-owner may agree to offer the co-ownership interest for sale to the other co-owners, the sponsor, or the lessee at fair market value before exercising any right to partition.

Obviously, Revenue Procedure 2002-22 is strict regarding limitations on a co-owner’s right to transfer, partition, or encumber his undivided interest. Subject to limited exceptions, a co-ownership agreement generally cannot place restrictions on these rights. If it does, the co-ownership runs the risk of being treated as a partnership.

g. Sharing Proceeds and Liabilities upon Sale of Property

If the property is sold, any debt secured by a blanket lien must be satisfied and the remaining sales proceeds must be distributed to the co-owners.

h. Proportionate Sharing of Profits and Losses

Each co-owner must share in all revenues generated by the property and all costs associated with the property in proportion to the co-owner’s undivided interest in the property. Neither the other co-owners, nor the sponsor, nor the manager may advance funds to a co-owner to meet expenses associated with the co-ownership interest, unless the advance is recourse to the co-owner and is not for a period exceeding 31 days.

As noted by one commentator, “[s]pecial allocations of profits or losses are normally a sign of a partnership arrangement. This ruling guideline requires that profits and losses be shared by the venturers in accordance with percentage ownership interests.”[19]

i. Proportionate Sharing of Debt

The co-owners must share in any indebtedness secured by a blanket lien in proportion to their undivided interests.

j. Options

A co-owner may issue an option to purchase the co-owner’s undivided interest (call option), provided that the exercise price is fair market value. Fair market value equals the co-owner’s percentage interest in the property multiplied by the property’s fair market value as a whole. A co-owner may not acquire an option to sell the co-owner’s undivided interest (put option) to the sponsor, the lessee, another co-owner, or the lender, or any person related to such persons.

k. No Business Activities

The co-owner’s activities must be limited to those customarily performed in connection with the maintenance and repair of rental real property (“customary activities”).[20] Activities will be treated as customary activities for this purpose if the activities would not prevent an amount received by an organization described in Code section 511(a)(2) from qualifying as rent under Code section 512(b)(3)(A) and theregulations thereunder. In determining the co-owner’s activities, all activities of the co-owners, their agents, and any persons related to the co-owners with respect to the property will be taken into account, whether or not those activities are performed by the co-owners in their capacities as co-owners.

The purpose of this provision apparently is to prohibit rental real property co-ownerships from providing services for profit that are generally not associated with the maintenance and repair of rental real property. Co-owners must carefully limit their business activities, for “[t]oo much business activity by the tenants-in-common is one of the quickest ways for a tenancy arrangement to be recharacterized as a tax partnership.”[21]

An “organization described in § 511(a)(2)” refers to a tax-exempt organization. If a payment to a tax-exempt organization would qualify as rent under Code section 512(b)(3)(a), then the activity giving rise to that payment is a customary activity for purposes of Revenue Procedure 2002-22. Code section 512(b)(3)(A) states that, for purposes of determining whether the income of an exempt organization is unrelated business taxable income (“UBTI”), “all rents from real property . . . , and all rents from personal property . . . leased with such real property, if the rents attributable to such personal property are an incidental amount of the total rents” shall be excluded from UBTI.[22] Thus under the revenue procedure, provided income qualifies as true rent under Code section 512(b)(3)(A) and the accompanying regulations, the activities giving rise to the rent will constitute customary activities and will not cause a co-ownership to be recharacterized as a partnership.

l. Management and Brokerage Agreements

The co-owners may enter into management or brokerage agreements, which must be renewable no less frequently than annually, with an agent, who may be the sponsor or a co-owner, but who may not be a lessee. The management agreement may authorize the manager to maintain a common bank account for the collection and deposit of rents and to offset expenses associated with the property against any revenues before disbursing each co-owner’s share of net revenues. In all events, however, the manager must disburse to the co-owners their shares of net revenues within three months from the date of receipt of those revenues. The management agreement may also authorize the manager to prepare statements for the co-owners showing their shares of revenue and costs from the property. In addition, the management agreement may authorize the manager to obtain or modify insurance on the property, and to negotiate modifications of the terms of any lease or any indebtedness encumbering the property, subject to the approval of the co-owners. The determination of any fees paid by the co-ownership to the manager must not depend in whole or in part on the income or profits derived by any person from the property and may not exceed the fair market value of the manager’s services. Any fee paid by the co-ownership to a broker must be comparable to fees paid by unrelated parties to brokers for similar services.

m. Leasing Agreements

All leasing arrangements must be bona fide leases for federal tax purposes. Rents paid by a lessee must reflect the fair market value for the use of the property. The determination of the amount of the rent must not depend, in whole or in part, on the income or profits derived by any person from the property leased (other than an amount based on a fixed percentage or percentages of receipts or sales).

n. Loan Agreements

The lender with respect to any debt that encumbers the property or with respect to any debt incurred to acquire an undivided interest in the property may not be a related person to any co-owner, the sponsor, the manager, or any lessee of the property.

o. Payments to Sponsor

The amount of any payment to the sponsor for the acquisition of the co-ownership interest must reflect the fair market value of the acquired co-ownership interest and may not depend, in whole or in part, on the income or profits derived by any person from the property.

Provided the requirements listed above are satisfied, the Service will consider a taxpayer’s request for a ruling. Also, as pointed out earlier, satisfaction of the above requirements also satisfies the apparent safe harbor created under the revenue procedure.

b. What’s Your QUALIFIED INTERMEDIARY IQ?

During the past year, the Service has issued two important rulings clarifying the role of the qualified intermediary (“QI”) in deferred like kind exchanges. These two rulings are analyzed in turn below:

1. Private Letter Ruling 200236026[23]

A deferred like kind exchange is defined as “an exchange in which, pursuant to an agreement, the taxpayer transfers property held for productive use in a trade or business or for investment (the ‘relinquished property’) and subsequently receives property to be held either for productive use in a trade or business or for investment (the ‘replacement property.’”[24] Of critical importance in deferred like exchanges is the rule requiring a taxpayer to recognize gain or loss if he (or his agent) actually or constructively receives money or property which does not meet the requirements of Code section 1031(a) before the taxpayer actually receives like kind replacement property.

The Regulations provide four safe harbors, the use of any of which “will result in a determination that the taxpayer is not in actual or constructive receipt of money or other property for purposes of section 1031.”[25] One of the safe harbors protects taxpayers who use QIs to facilitate their deferred exchanges. Under the QI safe harbor, “the qualified intermediary is not considered the agent of the taxpayer for purposes of section 1031(a).”[26] In order for a person to qualify as a QI, the following conditions must be met:

a. First, there must be an agreement between the taxpayer and the QI that expressly limits the taxpayer’s rights to receive, pledge, borrow, or otherwise obtain the benefits of money or other property held by the QI.[27]

b. Second, the QI must not be the taxpayer or a disqualified person.[28]

c. Third, the taxpayer and the QI must enter into a written exchange agreement.[29] They must agree that the QI will: (1) acquire the relinquished property from the taxpayer, (2) transfer the relinquished property, (3) acquire replacement property, and (4) transfer the replacement property to the taxpayer.[30]

A QI is treated as acquiring and transferring the relinquished property if the QI enters into an agreement with a person other than the taxpayer for the transfer of the relinquished property to that person and, pursuant to that agreement, the relinquished property is transferred to that person.[31] A QI is treated as acquiring and transferring replacement property if the QI enters into an agreement with the owner of the replacement property for the transfer of that property and, pursuant to that agreement, the replacement property is transferred to the taxpayer.[32] A QI is treated as entering into an agreement if the rights of a party to the agreement are assigned to the QI and all parties to that agreement are notified in writing of the assignment on or before the date of the relevant transfer of the property.[33]

If a taxpayer follows the rules above, then a QI can be used to accomplish a forward like-kind exchange without the QI being considered an agent of the taxpayer.

Private Letter Ruling 200236026 is interesting because it discusses the use of a “virtual QI” in deferred exchanges. In the letter ruling, the taxpayer’s business required it to periodically dispose of certain assets and reinvest in like kind properties. To facilitate its deferred exchanges, the taxpayer used an on-line QI and electronic or wire transfers. The QI’s on-line system provided users with unique user names and passwords to access the system. All on-line methods of executing agreements, transmitting notices of assignment, and making replacement property identifications were done in accordance with the Electronic Signatures in Global and National Commerce Act.[34]

Through the on-line QI system, the taxpayer entered into an agreement with the QI that (1) restricted the use of the proceeds from the sale of relinquished property to the purchase of like-kind property, (2) restricted the taxpayer’s ability to receive the benefits of money or other property held by the QI, and (3) assigned to the QI the taxpayer’s rights to sell relinquished property under sale agreements and rights to purchase replacement property under purchase agreements. The taxpayer was then granted access to the QI’s website to access its process for engaging in deferred, multiple-batch like kind exchanges. Proceeds from the sale of relinquished properties were transferred to the QI’s bank and credited to the taxpayer’s account with the QI. Through the website, the taxpayer would then direct the QI to reinvest the proceeds in like kind replacement properties. In all cases the buyer of the relinquished properties and the seller of the replacement properties were notified of the assignment of the taxpayer’s rights through e-mails that contained wiring instructions.

The IRS upheld the taxpayer’s like kind exchanges, concluding that the on-line QI was qualified and that the taxpayer was not in constructive receipt of any of the proceeds from the sale of the relinquished properties until the taxpayer had actually received those proceeds. The fact that the letter ruling confirms the validity of on-line QI’s will be important to many businesses that take advantage of the simplicity of on-line exchanges.

2. Revenue Ruling 2002-83[35]

Code section 1031(f) provides special rules for like kind exchanges between “related persons.” According to that section, if a taxpayer engages in a tax-free like kind exchange with a related person and either the taxpayer or the related person disposes of the property received in the exchange within two years after the date of the last transfer that was part of such exchange, then the original exchange will cease to qualify for nonrecognition treatment. In that case, any gain or loss that was not recognized by the taxpayer on the original exchange must be recognized as of the date that the like kind property is disposed of by either the taxpayer or the related person.

Revenue Ruling 2002-83 adds to the related party rules by holding that the use of an unrelated QI by related taxpayers to complete an exchange and sale will be denied like kind exchange treatment. The facts of the ruling are as follows: A and B are related parties. A owns Property 1 with a fair market value of $150x and an adjusted basis of $50x. B owns Property 2 with a fair market value of $150x and an adjusted basis of $150x. C, an unrelated person, desires to acquire Property 1 from A.

To facilitate the transaction, A, B, C and a QI enter into a like kind exchange agreement. Pursuant to the agreement, A transfers Property 1 to QI and QI transfers Property 1 to C for $150x. Days later, QI pays the $150x proceeds to B for Property 2, and then transfers Property 2 to A. In the end, A holds replacement Property 2, C has purchased Property 1, and B has cashed out.

On the face of this transaction, the exchange would appear not to be an exchange between related persons because A and B never directly traded with each other; instead, both traded with the QI. However, as noted in the revenue ruling, under Code section 1031(f)(4), if an unrelated third party is used to circumvent the purposes of the related party rule in Code section 1031(f), the nonrecognition provisions of Code section 1031 do not apply to the transaction.[36] Revenue Ruling 2002-83 holds that the QI was used to circumvent the purposes of Code section 1031(f) and thus the exchange does not qualify for gain deferral.

Looking at the transaction from a different angle, A tried to do indirectly what he could not do directly. Had A and B exchanged properties directly, with B then immediately selling Property 1 to C, the related party rules would have precluded tax-free exchange treatment. So, rather than exchanging directly, A and B used a QI to attempt to indirectly accomplish their like-kind exchange. Revenue Ruling 2002-83 clearly prohibits parties from structuring exchange transactions to evade the related party rules of Code section 1031.

c. Water, Water, Everywhere, But Not a Drop to Exchange?

Code section 1031 applies to exchanges of “like kind” properties. As used in Code section 1031, “the words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality.”[37] For example, no gain or loss will be recognized by a taxpayer on the exchange of “city real estate for a ranch or farm” or on the exchange of “a leasehold of a fee with 30 years or more to run for real estate.”[38] In accordance with these principles the Service has previously ruled that where, under applicable state law, water rights are considered real property rights, the exchange of perpetual water rights for a fee interest in land constitutes a nontaxable like kind exchange under Code section 1031.[39]

Recently, a United States district court had occasion to consider a similar water rights issue. In Wiechens v. U.S.,[40] the taxpayer exchanged certain water rights with a term of 50 years for a fee simple interest in farm land and claimed like kind exchange treatment. The Service denied like kind exchange treatment, arguing that despite the fact that the water rights were interests in real property under state law, they were not of like kind to a fee simple interest in real estate. The district court agreed with the Service, holding that “an exchange of non-perpetual water rights, such as the [taxpayer’s], for a fee simple interest in land does not satisfy §1031.”[41]

The court relied on Revenue Ruling 55-749 in ruling the way it did. As previously mentioned, that ruling holds that perpetual water rights are of like kind to a fee interest in real property. In the case at hand, the water rights were limited to a duration of 50 years. Despite the taxpayer’s argument that water rights with a term of 50 years are analogous to a leasehold of a fee of 30 years (which is deemed by the Regulations to be of like kind to a fee interest in real property), the court held that the taxpayer’s water rights were sufficiently limited to be of like kind to farm land.

Practitioners whose clients seek to exchange water rights for real property should be wary of this decision. If a client seeks to exchange perpetual water rights, then there’s probably no problem, for all of the relevant authorities deem perpetual water rights to be of like kind to real property. But if the water rights are for a fixed term of years, even for 50 years or possibly more, there is a chance that a court might find that they are not of like kind to real property.

D. Revenue Ruling 2003-56[42]

In a deferred like kind exchange, a taxpayer transfers his relinquished property before he receives his replacement property. Because a taxpayer has 180 days from the date he gives up his relinquished property within which to receive his replacement property,[43] the deferred exchange often straddles two tax years. Revenue Ruling 2003-56 addresses the tax consequences of such an exchange in the context of a partnership.

In Revenue Ruling 2003-56, the Service analyzed two different situations. In Situation 1, P is a general partnership with two equal partners. P owns Property 1 that has a fair market value of $300x, an adjusted basis of $80x, and is subject to a liability of $100x. Pursuant to a deferred exchange agreement, P transfers Property 1 on October 16, year 1, subject to the liability. On January 17, year 2, P receives Property 2, which has a fair market value of $260x, and is subject to a liability of $60x. Thus P has a net decrease in liability of $40x.

Situation 2 is the same except that now Property 2 has a fair market value of $340x and is subject to a liability of $140x. Thus P has a net increase in liability of $40x.

Under Treasury Regulation section 1.1031(b)-1(c), consideration in the form of an assumption of liabilities (or a transfer subject to a liability) is to be treated as boot for purposes of Code section 1031(b). If both parties assume liabilities of the other, the liabilities net out.[44] The Code also provides that an increase in a partner’s share of partnership liabilities shall be considered as a contribution of money by the partner to the partnership, and that a decrease in a partner’s share of partnership liabilities shall be considered as a distribution of money to the partner by the partnership.[45]

The potential problem under these rules is that, if an exchange straddles two tax years, the partners could have income in the year their partnership transfers the relinquished property subject to a liability, despite the fact that the partnership may timely receive, in the next year, replacement property that is subject to an offsetting liability.

Revenue Ruling 2003-56 provides the solution to this dilemma. According to the ruling:

If the exchange straddles two taxable years of the partnership, the amount of the relinquished liability that exceeds the amount of the replacement liability is treated as money or other property received in the first taxable year of the partnership, since the excess is attributable to the transfer of the relinquished property subject to the relinquished liability in that year. In addition, any gain resulting from the receipt of money or other property in the first taxable year of the partnership must be recognized and reported in that year.[46]

The ruling also states that the “liability offsetting rule . . . is taken into account for purposes of determining the amount of any decrease in a partner’s share of partnership liability under § 752(b), which is treated as a deemed distribution of money to the partner.”[47] Thus “[a]ny net decrease is taken into account in the first taxable year of the partnership since it is attributable to the transfer of the relinquished property subject to the relinquished liability in that year.”[48]

In addition, the ruling holds that if a partner’s share of the replacement liability exceeds his share of the relinquished liability, only the net increase in liability is taken into account for purposes of determining the increase in the partner’s share of partnership liability. That net increase will be taken into account in the second taxable year of the partnership since it is attributable to the receipt of the replacement property subject to the replacement liability in that year.[49]

Going back to the examples, in Situation 1, P’s relinquished liabilities exceed its replacement liabilities by $40x. The revenue procedure holds that P’s gain recognized will be $40x and will be recognized in year 1. That gain will be allocated evenly between the partners and each will be deemed to have received a distribution equal to $20x in year 1. In Situation 2, P’s relinquished liabilities are $40x less than its replacement liabilities. Thus P recognizes no gain due to liability relief. Furthermore, each partner is treated as having made a capital contribution to P of $20x in year 2.

E. Build-to-Suit Exchange Transactions and Private Letter Ruling 200251008[50]

In a typical build-to-suit exchange transaction, a taxpayer and an exchange party enter into an agreement whereby the exchange party acquires land and constructs improvements thereon (at the taxpayer’s direction), and subsequently the exchange party exchanges the improved land for like kind property held by the taxpayer.[51] In order for the exchange party to not be deemed the agent of the taxpayer, and for such a transaction to be respected, the exchange party must have the requisite benefits and burdens of ownership and must undertake construction period risks. From a business perspective, however, many exchange parties are unwilling to take on such risks, with the result that many potentially beneficial build-to-suit transactions never happen.

However, since the enactment of Revenue Procedure 2000-37[52] in which the Service gave its blessing to reverse exchange transactions,

commentators [have] suggested using Rev. Proc. 2000-37 to achieve what was often practically unattainable before, namely, receive build-to-s