Evaluating and making a choice of "no entity" for real property held for investment or lease.

The choice of entity for real property held for investment or lease is dependent upon many factors. As a general rule, clients wish to have a workable structure--one requiring only the level of sophistication or complication necessary to achieve certain goals. In some situations, this requires a choice of no entity at all, and a structure treated as a co-tenancy for federal income tax purposes (a "tax co-tenancy") is appropriate. This article discusses some of the federal estate and income tax advantages of tax co-tenancies, and then analyzes structures under state law that may be treated as tax co-tenancies.

Advantages of Tax Co-tenancies

The reasons why taxpayers may choose a tax co-tenancy are too numerous, and too dependent upon a particular taxpayer's circumstances, to comprehensively list here. A few recurring reasons why taxpayers chose tax co-tenancies include the following:

* No separate tax return. Each tax co-tenant is treated as the owner of an undivided fractional interest in the property. Consequently, each co-tenant will report a fractional share of the items of income or deduction on the co-tenant's tax return. Because a partnership tax return is not required, a tax co-tenancy may also reduce the probability of audit.

* Separate like-kind exchanges. Notwithstanding the low individual capital gains rates, many clients still wish to defer capital gain upon the sale of property by entering into a like-kind exchange under Code [sections] 1031.(1) For this purpose, a tax co-tenancy allows the owners to reinvest in separate replacement properties. In contrast, partnership interests are excluded from like-kind exchange treatment,(2) making successful like-kind exchanges of partnership property into replacement properties held by different partners difficult or impossible.(3)

* Automatic step-up in basis upon death of tax co-tenant. When a tax co-tenant dies, the basis of the decedent's interest is automatically stepped up to its fair market value.(4) Thus, in contrast with property held through a partnership, it is not necessary to make a Code [sections] 754 election to obtain this favorable tax treatment for appreciated property held in a tax co-tenency.

* Other federal income tax advantages. Tax co-tenants may make separate elections for depreciation and depletion and enjoy other federal income tax advantages associated with separate ownership.

* Estate and gift tax valuation discounts. The determination of appropriate valuation discounts for minority interest and lack of marketability for federal estate and gift tax purposes is a facts and circumstances inquiry,(5) and arguably more resembles an art than a science. Although many believe limited partnerships generate the largest valuation discounts, courts have applied reasonable valuation discounts to co-tenancies, generally rejecting the IRS' arguments that such discounts should be limited to the cost of partition.(6) Taxpayers should be wary, however, that the specialized valuation regime under the federal estate tax for co-tenancies featuring survivorship rights under state law may obviate the advantages of such valuation discounts.(7) As a result, taxpayers seeking valuation discounts with respect to tax co-tenancies are advised to hold title under a structure that does not feature survivorship rights.

Classification as a Tax Co-tenancy

If it is determined that a tax cotenancy is in the taxpayers' best interests, then a form of ownership under state law must be chosen that will be respected as such for federal tax purposes. Not surprisingly, most taxpayers attempt to accomplish this end through one of the co-tenancy arrangements available under state law ("state law co-tenancies").(8)

In the case of the federal estate and gift taxes, rights under state law should generally control the valuation of interests transferred by a decedent or donor. Accordingly, valuation discounts for lack of marketability or control generally are determined based upon the rights transferable under state law in an arms-length transaction.(9) The classification of a state law co-tenancy for federal income tax purposes is more complex because it is not merely a function of the form of ownership under state law.(10) In some circumstances, a state law co-tenancy will be treated as a tax partnership, thus making the federal income tax advantages of a tax co-tenancy unavailable. Therefore, if taxpayers hold property in a state law co-tenancy, it still is necessary to engage in an independent inquiry to determine whether the state law co-tenancy is also a tax co-tenancy or whether the taxpayers instead own the property through a tax partnership.(11)

Code [subsections] 761(a) and 7702(a)(2) define a tax partnership as "a syndicate, group, pool, joint venture or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation, trust, or estate." Treasury Regulations provide a more descriptive test, focusing upon whether "the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom."(12) Taken together, the Code and Treasury Regulations present a two-part test, with each part constituting a necessary condition to the existence of a tax partnership. First, two or more persons must carry on a business or similar activity. Second, there must be a sharing of profits. Under this formulation, the absence of either should preserve the classification of a state law co-tenancy as a co-tenancy for federal income tax purposes.

Case law has generally approached the inquiry more broadly, looking to a multiplicity of factors to determine whether taxpayers subjectively intend to form a partnership.(13) Courts have found that a tax partnership exists when co-tenants characterize their activities as a partnership even when the two-part test described in the Treasury Regulations is not clearly met. This can occur, for example, when taxpayers file partnership income tax returns, represent the activity as a partnership to state or local government officials, enter into a partnership agreement, or otherwise characterize the activity as a partnership among themselves or to others.(14) Consequently, taxpayers holding title as state law co-tenants who wish to avoid tax partnership classification should avoid conduct which could be construed as an expression of a subjective intent to carry on a partnership.

In the absence of overt conduct evidencing the existence of a tax partnership, the two-part test set forth above becomes more important. Under that test, persons who hold title in a state law co-tenancy merely to realize the increase in its value over time generally can expect to avoid tax partnership classification. In the context of property held for lease, however, state law co-tenants almost always share profits. As a result, the existence of a tax partnership with respect to property held for lease frequently depends upon whether state law co-tenants' activities constitute a business or similar activity.

Treasury Regulations acknowledge that "mere co-ownership of property that is maintained, kept in repair, and rented or leased does not constitute" a tax partnership, while also finding that a tax partnership may exist "if co-owners of an apartment building lease space and in addition provide services to the occupants either directly or through an agent."(15) The Internal Revenue Service refined this distinction Revenue Ruling 75-374,(16) when it considered whether a tax partnership exists when state law co-tenants engage an unrelated management company to manage an apartment building. In that ruling, the management company collected rents; negotiated and executed leases with lessees; paid taxes, assessments, and insurance premiums; and performed services characterized by the IRS as "customarily" associated with the maintenance and repair of apartment buildings, including the provision of heat, air conditioning, water, parking, routine repairs, trash removal, and maintenance of public areas. All of these services were provided at no additional cost to the lessees. The management company retained one half of the rents as compensation for these services. The management company also provided lessees additional services for additional fees, including attendant parking, gas, electricity, and other utilities. The management company bore the cost of providing these services and did not share its profits from these services with the state law co-tenants.

On these facts, the IRS found that no tax partnership existed among the state law co-tenants themselves or among the state law co-tenants and the management company. The additional services performed by the management company were not attributable to the state law co-tenants because the management company did not perform these services as the state law co-tenants' agent under the management agreement, and did not share the profits from the additional services with the state law co-tenants. Although the "customary" services performed by the management company were attributable to the state law co-tenants, the IRS found that these activities were not of a sufficient level as to give rise to a tax partnership.

While much of the case law evaluating the existence of a partnership based upon the level of activity among co-tenants is difficult to reconcile, it has generally followed Revenue Ruling 75-374 in spirit.(17) As a result, the authors believe that Revenue Ruling 75-374 continues to provide a useful guide to taxpayers attempting to maintain the integrity of a tax co-tenancy for property held for lease because it sets forth two important planning principles. First, it enables taxpayers to provide customary services to lessees without being deemed to engage in a business or similar activity that would give rise to a tax partnership. Second, it enables state law co-tenants to avoid tax partnership classification when noncustomary services will be performed by structuring a management agreement such that an independent property manager will provide these additional services for its own profit. Taken together, these principles can sometimes make the avoidance of tax partnership classification merely a matter of negotiation over the form of the rights and responsibilities of a property manager and state law co-tenants under a management agreement.(18)

Tax Co-tenancies with Limited Liability

Taxpayers often wish to limit personal liability for creditor claims arising from ownership of real property, and to limit a personal creditor's remedy to a charging order against an interest in a state law entity. A state law co-tenancy among taxpayers does not accomplish these goals. Fortunately, a single-member limited liability company (SMLLC) can enable a taxpayer to enjoy the federal income tax advantages of a tax co-tenancy while also realizing these asset protection goals.(19) Under the "check-the-box" entity classification regulations in place since 1997, property owned by a SMLLC generally is treated for federal income tax purposes as if it is directly owned by the SMLLC's single member.(20) As a result, if each taxpayer holds its interest as a state law co-tenant through a separate SMLLC, then all the taxpayers can take advantage of the asset protection advantages of a limited liability company while still retaining the federal income tax advantages associated with a tax co-tenancy. Moreover, the applicable valuation discounts for federal estate and gift tax purposes should not be diminished by the use of a SMLLC because the owner of the SMLLC should have essentially the same rights with respect to the underlying real property as a person who owns an interest in real property directly.

As a practical matter, taxpayers seeking to avoid tax partnership classification may find it cumbersome to hold title through separate SMLLCs because this form of ownership requires multiple signatures on leases, or for other reasons. Also, some hesitate to rely on the liability shield of a SMLLC because they consider it less proven than that of a multimember limited liability entity.(21) As a result, taxpayers may wish to form one noncorporate limited liability entity to hold real property and still be treated as tax co-tenants.(22) In general, a corporation must be taxed as a corporation for federal income tax purposes. In addition, a noncorporate entity with multiple owners organized under state law is by default classified as a tax partnership.(23) As a result, in this situation, a true tax co-tenancy is not possible. Nevertheless, taxpayers arguably can replicate many consequences of a tax co-tenancy by organizing a single noncorporate entity to hold title to the property, and electing under Code [sections] 761(a) to not be governed by the tax partnership regime.

In the case of state law co-tenancies in real property held for investment or lease, a Code [sections] 761(a) election rarely is helpful because it generally is not available unless the state law co-tenancy is a tax co-tenancy anyway.(24) In the authors' opinion, however, multiple taxpayers who own interests in a single state law entity (such as a limited liability company) that, in turn, holds real property for investment or lease should be permitted to make a Code [sections] 761(a) election if the entity's activities do not constitute a business or similar activity, and the entity's governing instruments give the taxpayers essentially the same rights as state law co-tenants.(25) Nevertheless, taxpayers should consider a number of issues before making a Code [sections] 761(a) election under these circumstances.

First, although Florida law purports to statutorily limit the remedies of personal creditors of owners of certain state law entities to charging orders,(26) drafting an entity's governing instruments to meet the criteria for a Code [sections] 761(a) election could enable such creditors to argue that more expansive remedies should be available. For example, if a member in a limited liability company has the right to dispose of an undivided interest in the underlying real property,(27) then creditors of that member could argue that they should be able to reach the underlying interest in real property to satisfy a judgment rather than be limited to a charging order.(28) On the other hand, the authors are unaware of a successful creditor challenge in this regard to date.

Second, the authors are not aware of a controlling authority clearly authorizing such a Code [sections] 761(a) election with respect to a single entity. In field service advice, the IRS indicated that it "generally" does not allow an entity recognized as a state law general or limited partnership to make a [sections] 761(a) election, and found that two limited partnerships did not qualify for the election because of differences between the default rights of partners under state law and the requirements for [sections] 761(a) election eligibility.(29) Although an entity's governing instruments could be drafted to avoid this problem and field service advice is not a binding statement of IRS policy, at the very least taxpayers should proceed with a Code [sections] 761(a) election with respect to a single state law entity only if they understand that the result they seek is not assured.

Third, even if the [sections] 761(a) election is valid, the election will not necessarily replicate the tax consequences of a situation in which such an election is unnecessary because no tax partnership exists.(30) As a result, taxpayers should independently analyze whether a Code [sections] 761(a) election will produce the particular advantages of a tax cotenancy that they seek.

Finally, although limited partnerships and multimember limited liability companies generally produce larger estate and gift tax valuation discounts than state law co-tenancies, the authors would not expect such enhanced discounts in the case of an entity holding real property for investment or lease and designed to qualify for a Code [sections] 761(a) election. In general, the enhanced valuation discounts associated with certain entities depend upon the rights of the owners under state law. As a result, interests in an entity with governing instruments drafted to replicate the rights of state law co-tenants (to qualify for a Code [sections] 761(a) election) should generally be expected to produce valuation discounts commensurate with the direct interests in a state law co-tenancy.

Looking Ahead

Last year, the Internal Revenue Service announced that it would no longer issue advance rulings concerning whether a state law co-tenancy constitutes a tax partnership because of its concern over certain positions taken by taxpayers in this area.(31) The Service also has announced that it plans to issue new guidance addressing the issue by the end of this year.(32) At least with respect to state law co-tenancies involving relatively few co-tenants, the authors do not expect the new guidance to deviate substantially from the principles recognized under prior law. Regardless of the content of the new guidance, the authors expect analyses of whether state law co-tenancies are tax partnerships to remain deceptively complex, facts and circumstances inquiries. As a result, taxpayers should proceed with caution.

(1) All references herein to the "Code" are to the Internal Revenue Code of 1986, as amended. See, e.g., Rev. Rul. 79-44, 1979-1 C.B. 265.

(2) See I.R.C. [sections] 1031(a)(2)(D).

(3) For a discussion of some potential solutions to this problem, see Richard M. Lipton, The "State of the Art" in Like-Kind Exchanges, J. TAX'N 78, 82-84 (Aug. 1999).

(4) See I.R.C. [sections] 1014(a).

(5) See Treas. Reg. [subsections] 20.2031-1(b); 25.2512-1.

(6) This is the case particularly with respect to improved real estate. See, e.g., Williams v. Commissioner, T.C. Memo. 1998-59 (19981) (44 percent discount); Estate of Cervin v. Commissioner, T.C. Memo. 1994-550 (1994) (20 percent discount); Lefrak v. Commissioner, T.C. Memo. 1993-526 (1993) (30 percent discount).

(7) See I.R.C. [sections] 2040.

(8) For the purposes of this article, "state law co-tenancies' include ownership as tenants-in-common and joint tenants with rights of survivorship. Although a tenancy-by-the-entirety has some similar characteristics to state-law co-tenancies, the authors believe that tenancies-by-the-entirety present unique issues best saved for another article.

(9) See I.R.C. [sections] 2031(a); Treas. Reg. [subsections] 20.2031-1(b); 25.2512-1. But see I.R.C. [sections] 2040 (containing special estate tax valuation rules for co-tenancies featuring survivorship rights). Unless the co-tenants hold title as nominees for a partnership under state law, the special valuation rules in Ch. 14 of the Code are unlikely to apply where property is titled in the name of an individual co-tenant. See generally I.R.C. [sections] 2701-2704.

(10) See Treas. Reg. [sections] 1.7701-1(a)(1).

(11) Technically, the "check-the-box" regulations in place since 1997 describe the inquiry as a two-step process. First, it must be determined whether the cotenancy constitutes a federal income tax "entity." See Treas. Reg. [sections] 301.7701-1(a)(2). Second, a noncorporate "entity" which does not elect to be treated otherwise and which has more than one owner is generally taxed as a partnership. See Treas. Reg. [sections] 301.7701-3(c)(1). Even though the check-the-box regulations describe this as a two-step inquiry, as a practical matter the test in the co-tenancy context should be the same inquiry as to the existence of a partnership that existed before the check-the-box regulations. Compare Treas. Reg. [sections] 301.7701-1(a)(2) with Former Treas. Reg. [sections] 301.7701-3(a); cf. Simplification of Entity Classification Rules, 61 Fed. Reg. 21,989 (1996) (proposed May 13, 1996) (subsequently codified at Treas. Reg. [sections] 301.7701-1 et seq.).

(12) Treas. Reg. [sections] 301.7701-1(a)(2).

(13) See, e.g., Commissioner v. Culbertson, 337 U.S. 733,742-43 (1949).

(14) See, eg., Rothenberg v. Commissioner, 48 T.C. 369 (1967); Luna v. Commissioner, 42 T.C. 1067 (1964); Huckle v. Commissioner, T.C. Memo 1968-45 (1968); Priv. Ltr. Rul. 97-41-017 (Jul. 10, 1997). But see Powell v. Commissioner, T.C. Memo 1967-32 (1967) (no tax partnership even though partnership tax returns were filed).

(15) Treas. Reg. [sections] 301.7701-1(a)(2).

(16) 1975-2 C.B. 261.

(17) See, e.g., McShain v. Commissioner, 68 T.C. 154 (1977) (no tax partnership when state law co-tenants leased under net lease); Estate of Applebee, 41 B.T.A. 18 (1940) (finding no partnership existed among co-tenants who inherited property, improved it, and then rented it, but who did not file a partnership return for federal income tax purposes); Cusick v. Commissioner, T.C. Memo 1998-286 (business activity created tax partnership when co-tenants performed maintenance tasks and helped tenants locked out of offices); Priv. Ltr. Rul. 2000-19-014 (Feb. 10, 2000) (no tax partnership where management company's business activities are not attributable to co-tenants). But see, e.g., Levine v. Commissioner, 72 T.C. 780 (1979) (tax partnership existed where taxpayers found to engage in a business even though they provided only "necessary" management services).

(18) It is important to note that Revenue Ruling 75-374 expressly assumed that the compensation the property manager received for the additional services performed was "adequate." Consequently, while Rev. Ruling 75-374 offers flexibility in negotiating an arrangement to avoid partnership classification, it does not sanction an arrangement under which a property manager provides additional services at a loss while the supposedly passive co-tenants reap a portion of profits attributable to activities constituting a business.

(19) See FLA. STAT. 8608.433(4) (2000) (limitation of member creditor s remedy to a charging order); FLA. STAT. [sections] 608.701 (2000) (same liability shield as corporations).

(20) See Treas. Reg. [subsections] 301.7701-2(b), (c); 301.7701-3(b)(1)(ii).

(21) It is notable, however, that the statutes providing for the asset protection advantages of limited liability companies under Florida law do not contain exceptions for SMLLCs. See FLA. STAT. [sections] 608.433(4) (2000) (limitation to charging order); FLA. STAT. [sections] 608.701 (2000) (same liability shield as corporations).

(22) See Treas. Reg. [sections] 301.7701-2(b)(1).

(23) See Treas. Reg. [sections] 301.7701-3(c)(1). It is assumed that the entity is organized under the laws of one of the United States and does not elect to be taxed other than as a partnership.

(24) In the case of real property held for investment or lease, a Code [sections] 761(a) election generally is not available unless the property is also held "for investment purposes only and not for the active conduct of a trade or business." I.R.C. [sections] 761(a)(1). A state law co-tenancy should not create a tax partnership in the absence of a business or similar activity. See I.R.C. [subsections] 761(a), 7701(a)(2); Treas. Reg. [sections] 301.7701-1(a)(2). As a result, it is hard to imagine a situation in which a Code [sections] 761(a) election would change the tax classification of a state law co-tenancy.

(25) In addition to avoiding the two part test for classification as a tax partnership, an entity attempting to qualify as an "investment partnership" for purposes of making the [sections] 761(a) election must not be "classifiable as an association" (i.e., taxable as a corporation) and must have members that:

"(i) own the property as co-owners,

(ii) reserve the right separately to take or dispose of their shares of any property acquired or retained, and

(iii) do not actively conduct business or irrevocably authorize some person or persons acting in a representative capacity to purchase, sell, or exchange such investment property, although each separate participant may delegate authority to purchase, sell, or exchange his share of any such investment property for the time being for his account, but not for a period of more than a year." Treas. Reg. 1.761-2(a). Under the check-the-box regulations, the default classification of a noncorporate entity is a partnership and not an association. See Treas. Reg. [sections] 301.7701-3(c)(1). Moreover, the governing instruments of a noncorporate entity could be drafted to give its owners the above-listed rights, which essentially replicate the rights of state law co-tenants. In general, characteristics of a common law co-tenancy include each tenant owning an undivided fractional part of the property; the destruction of the co-tenancy by partition or by merger of interest; if a cotenant ousts another co-tenant, the right of the wronged co-tenant to be placed back in possession; the absence of fiduciary duties, although in some circumstances, a constructive trust could arise in favor of co-tenants. See RALPH E. BOYER, SURVEY OF THE LAW OF PROPERTY, 90-91 (3d Ed. 1981).

(26) See FLA. STAT. [sections] 608.433(4) (2000) (limited liability companies); FLA. STAT. [sections] 620.153 (2000) (limited partnerships).

(27) This is arguably required by Treas. Reg. [sections] 1.761-2(a)(2)(ii).

(28) This is one of the concerns that lead some to question the liability protection afforded by SMLLCs. See supra note 21 and accompanying text.

(29) See Fld. Svc. Adv. Mem. 1999-23-017 (June 19, 1999). For a more extensive discussion of this field service advice memorandum, see Shop Talk: Can Limited Partnerships Elect out of Subchapter K?, J. TAX'N 125 (Aug. 1999). For a list of the requirements to make a Code [sections] 761(a) election, see supra note 25.

(30) See generally Martin J. McMahon, Jr., The Availability and Effect of Election Out of Partnership Status Under Section 761(a), 9 VA. TAX REV. 1 (1989).

(31) See Rev. Proc. 2000-46, 2000-2 C.B. 438.

(32) See IRS Officials Update ABA Panel on Section 1031 Developments, 2001 Tax Notes Today 94-12 (May 15, 2001).

E. John Wagner II practices business and tax law with Williams, Parker, Harrison, Dietz & Getzen in Sarasota. He earned his J.D. and LL.M. at the University of Florida, where he was editor-in-chief of the Florida Law Review and a member of the Florida Tax Review.

Susan Barrett Hecker practices estate planning and tax law with Williams, Parker, Harrison, Dietz & Getzen in Sarasota. She earned her J.D. at Stetson University, and her L.L.M. in taxation at the University of Florida. Ms. Hecker served as a notes editor for the Stetson Law Review and managing editor for the Florida Tax Review.

This column is submitted on behalf of the Tax Section, Louis T.M. Conti, chair, and Michael D. Miller and Lester B. Law, editors.