Two-member LLC as disregarded entity.
As a result of market conditions in recent years since the downturn in real estate values, lenders' requirements have become more stringent, increasingly relying on bankruptcy-remote entities as a form of insurance against a borrower's declaration of bankruptcy. For taxpayers seeking to structure a tax-free exchange under Sec. 1031, this demand creates an obstacle by calling for an entity other than the relinquished property's owner to receive the replacement property, because Sec. 1031 requires that the owner of the property relinquished receive the replacement property.
The taxpayer in the letter ruling was able to satisfy both the lender's demand for an "insurance policy" through the use or a bankruptcy-remote entity, as well as the taxpayer's own requirements under Sec. 1031 for a tax-free exchange. In the ruling, the trustees of a grantor trust (trust) wished to exchange a parcel of real estate owned by the trust for another property of their choosing in a Sec. 1031 exchange. The trustees assigned all their rights in a contract to sell the property (relinquished property) to a qualified intermediary (intermediary) (as defined in Regs. Sec. 1.031-1(g)(4)). It was intended that the intermediary would acquire a like-kind property (replacement property) and transfer it to the trust in a transaction qualifying for tax-free treatment under Sec. 1031 (a)(3).
The trustees intended to finance the replacement property through a loan. The lender, as a condition for making the loan, insisted that the legal title to the replacement property be held by a bankruptcy-remote entity. Accordingly, to secure the loan, the trust formed a state LLC under an LLC agreement between the trustees and Member2, a corporation wholly owned by the trust. A representative of the lender was appointed to Member2's board of directors. The intermediary was instructed by the trustees to transfer the replacement property directly to the LLC rather than to the trust.
Under the LLC agreement, the trust has sole authority for making decisions on behalf of the LLC, with certain exceptions delineated in the LLC agreement. The trust is allocated 100% of the LLC's profits, losses and credits. The trust is also entitled to all distributions of net cash flow and capital proceeds. On the LLC's dissolution, the trust will settle its affairs as required by law, giving priority of payment to any outstanding obligations owed to the lender.
For Member2, the LLC agreement specifies certain rights for managing the LLC. The LLC agreement provides that, as long as the loan from the lender is outstanding, the LLC may not, without unanimous approval from the Member2 board of directors (which includes a representative of the lender):
1. File or consent to file a bankruptcy or insolvency petition or otherwise institute insolvency proceedings;
2. Dissolve, liquidate, merge, consolidate or sell substantially all of its assets;
3. Engage in any business activity other than those specified in its certificate of formation;
4. Borrow money or incur indebtedness other than the normal trade accounts payable and any other indebtedness expressly permitted by the documents evidencing and securing the loan from the lender;
5. Take or permit any action that would violate any provision of any of the documents evidencing or securing the loan from the lender;
6. Amend the certificate of formation concerning any of the aforesaid items; or
7. Amend any provision of the agreement concerning any of the aforesaid items.
The trustees requested a ruling that the LLC would be treated as having a single owner for purposes of Regs. Secs. 301.7701-2(c)(2) and -3, that the LLC therefore would be disregarded as an entity separate from its owner, and consequently that the LLC's acquisition of the replacement property would be treated as an acquisition of the replacement property directly by the trust for Sec. 1031 (a)(3) purposes.
In general, a business entity with two or more members is classified for Federal tax purposes as either a partnership or a corporation (Regs. Sec. 301.7701-2(a)). Under Regs. Sec. 301.7701-3(b)(1)(i), a domestic eligible entity with more than one member is treated as a partnership unless it elects to be treated as a corporation. A business entity with a single owner is disregarded as an entity separate from its owner unless it elects to be treated as a corporation (Regs. Sec. 301.7701-3(b)(1)(ii)).
The IRS concluded, based on an analysis of judicial doctrine on the intent of parties to join together as partners, that the LLC will be disregarded as an entity separate from the trust. In reaching its conclusion, the Service stated that the treatment of an entity under state law was not controlling for Federal income tax purposes. Therefore, even though a two-member LLC was created under state law, the relevant facts and circumstances must be analyzed to determine the LLC's classification as either a partnership or a disregarded entity under Federal law.
Three cases (Tower, 327 US 280 (1946); Culbertson, 337 US 733 (1949); and Luna, 42 TC 1067 (1964)) provide guidelines for determining whether parties intend to join together for the operation of business and the sharing of profits and losses. The IRS concluded that the members did not intend to operate jointly in a business, based predominantly on the following:
1. The trust and Member2 did not enter into the agreement to operate a business and share profits and losses;
2. Member2 was a member of the LLC for the sole limited purpose of preventing the trust from placing the LLC into bankruptcy of its own volition; and
3. Member2 had no interest in the LLC's profits or losses and neither managed the enterprise nor had any management rights other than those limited rights described above.
Because the Service found the members did not come together to form a partnership for Federal tax purposes, it concluded that the LLC would be deemed (for Kegs. Sec. 301.7701-1 (3)(c) purposes) as owned solely by the trust. Accordingly, the transfer of the replacement property directly to the LLC is treated as a transfer directly to the trust for purposes of Sec. 1031(a)(3).
The conclusion reached in this letter ruling, if followed by the IRS for other taxpayers, would simplify structuring Sec. 1031 exchanges under similar circumstances and would also facilitate, from an administrative as well as cost perspective, financing for acquisitions. The ruling suggests possible tax planning with disregarded entities, at least in the domestic arena. Any effect of the letter ruling approach on the international front, where the Service has expressed concerns about the check-the-box regulations for certain hybrid entities, is not certain.
The analysis supporting the conclusion is interesting in and of itself, as it appears to add a twist to the otherwise factual and straightforward check-the-box regulations. The IRS analysis of the members' "intent to form a joint venture" adds a "facts and circumstances" analysis in determining an entity's classification to what previously was a taxpayer's choice made by "checking a box."
FROM SUSANA NOLES, B.A., WASHINGTON, DC
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|Publication:||The Tax Adviser|
|Date:||Jul 1, 1999|
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