Roberts & Holland LLP

• Back to Article List

Two-Member LLC Can Be Disregarded in 1031 Exchange Where One Member Has No Economic Interest

Because a "member" without an economic interest in the entity is not an "owner," and there is no intent to carry on business as a joint venture, a two-member LLC can qualify as a disregarded entity under a new IRS private letter ruling. Although the ruling's focus is on the practical issues of financing a Section 1031 exchange, the ruling is sure to have considerable impact beyond its specific facts.

A new, as-yet unnumbered letter ruling [subsequently issued as LTR 199911033, December 18, 1998] promises to provide a practical solution to a persistent problem faced by real estate investors, while at the same time expanding the body of law concerning LLCs as disregarded entities. As will be seen in detail below, IRS has for the first time approved a situation in which a two-member LLC is treated as if it were a single-owner LLC.

The Problem

As a result of losses suffered in the real estate downturn of the 1980s and early 1990s, lenders today are much more exacting as to the types of entities to which they will extend credit. In the past, they were hurt by borrowers who declared bankruptcy in an effort to delay or hinder the lender's ability to foreclose on the collateral.¹

In an effort to protect themselves from these delays, many lenders now require that the borrower form a "single purpose 'bankruptcy remote' entity" (SPBRE) to borrow the funds and hold the property. Lenders generally require that the governing instruments of the SPBRE restrict the entity's ability to:

• Borrow additional funds from other sources.

• Add assets other than the collateral.

• Commingle the collateral.

• Engage in any activity not relating to ownership of the collateral.

• Declare voluntary bankruptcy.

• Dissolve, liquidate, merge, consolidate, or sell substantially all of its assets.

For additional protection, the lender may require that it be permitted to nominate its own member of the SPBRE's governing board or that any action taken with respect to the activities listed above requires unanimous approval of the board. By taking these steps, the lender hopes to have sufficiently isolated the SPBRE from the credit-seeking party so that should this party voluntarily declare bankruptcy, the SPBRE will not be included in the bankruptcy estate.²

The bankruptcy-remote protection sought by lenders has resulted in much complexity and additional expense in the area of like-kind exchanges under Section 1031.³ Section 1031(a) provides that gain or loss will not be recognized by the taxpayer on the exchange of property held for productive use in a trade or business or for investment, if it is exchanged solely for property of like-kind held by the taxpayer either for productive use in a trade or business or for investment. Implicit in this provision is the requirement that the same taxpayer who transfers the relinquished property receive the replacement property.⁴ By requiring that the holder of the financed property (i.e., the replacement property) be a newly formed SPBRE, the lender will cause the recipient of the property to be an entity for local law purposes different from the entity that transferred the relinquished property. This creates an issue under Section 1031(a), unless the SPBRE entity is ignored as an entity separate from its owner for purposes of federal income tax.

Inadequate Solutions

Several different approaches have been tried in an attempt to reconcile the SPBRE requirement imposed by lenders with the Code's requirement that the taxpayer giving up the relinquished property ultimately acquire the replacement property. These include Illinois land trusts, Delaware business trusts, LLCs, and an election out of Subchapter K.

Illinois Land Trusts

In certain situations, lenders have been willing to accept, as an SPBRE, an Illinois or Florida type land trust, which for Section 1031 purposes is ignored as an entity separate from its beneficial owner. An Illinois land trust is a device by which legal title to real property is held by a trustee under an agreement reserving to the beneficial owners the full management and control of the property.

In Rev. Rul. 92-105, 1992-2 CB 204, the Service ruled that an interest in an Illinois land trust is an interest in real property that may be exchanged for other real property under Section 1031. The trustee was authorized only to execute deeds, mortgages, or otherwise deal with the property as directed by the beneficiary. The IRS held that the arrangement did not create a trust, since the trustee was the mere agent for holding and transferring title to the real property, and the beneficiary retained direct ownership for federal income tax purposes. Therefore, use of an Illinois land trust as an SPBRE would meet the "same taxpayer" requirement of Section 1031(a).

According to Rev. Rul. 92-105, several states offer arrangements similar to the Illinois land trust, including California, Florida, Hawaii, Indiana, North Dakota, and Virginia. To qualify under the Revenue Ruling, however, the arrangement must provide all of the following:

1. The trustee has title to the real property.

2. The beneficiary (or a designee of the beneficiary) has the exclusive right to direct or control the trustee in dealing with the title to the property.

3. The beneficiary has the exclusive control of the management of the property, the exclusive right to the earnings and proceeds from the property, and the obligation to pay any taxes and liabilities relating to the property.

Unfortunately, the use of an Illinois land trust as an SPBRE may not provide the bankruptcy protection desired by the lender. Federal bankruptcy courts have held that the trust entity is ineffective to shield trust property from the bankruptcy trustee where a beneficial owner of the trust has exercised extensive control over the trustees or the trust property so that the beneficial owner has enjoyed substantially all of the benefits of ownership of legal title to the trust property.⁵ Therefore, the lender may not approve the use of such an entity to hold the real property. In fact, in the authors' experience, lenders generally will not permit the use of an Illinois type land trust to serve as an SPBRE, but this has not always been the lenders' position.

Delaware Business Trust

Another alternative that has been widely used is the Delaware business trust (DBT). The Delaware Business Trust Act (DBTA) defines a business trust as "an unincorporated association which (i) is created by a governing instrument under which property is or will be held, managed, administered, controlled, invested, reinvested, and/or operated, or business or professional activities for profit are carried on or will be carried on, by a trustee or trustees for the benefit of such person or persons as are or may become entitled to a beneficial interest in the trust property, including but not limited to a trust of the type known at common law as a 'business trust,' or 'Massachusetts trust,' or a trust qualifying as a real estate investment trust under Search7RH 856 et seq., of the United States Internal Revenue Code of 1986 [26 U.S.C. Search7RH 856 et seq.], as amended, or under any successor provision, or a trust qualifying as a real estate mortgage investment conduit under Search7RH 860D of the United States Internal Revenue Code of 1986 [26 U.S.C. Search7RH 860D], as amended, or under any successor provision, and (ii) files a certificate of trust pursuant to Search7RH 3810 of this title. Any such association heretofore or hereafter organized shall be a business trust and a separate legal entity."⁶

Under the DBTA, except to the extent otherwise provided in the governing instrument of the business trust, the beneficial owners are entitled to the same limitation of personal liability extended to stockholders of private corporations for profit.⁷ Unlike the Illinois land trust, the DBTA provides that no creditor of a beneficial owner shall have any right to obtain possession of, or otherwise exercise legal or equitable remedies with respect to, property of the business trust.⁸ In addition, the DBTA states that, except to the extent otherwise provided in the governing instrument of a business trust, a beneficial owner has no interest in specific business trust property.⁹

Thus, the beneficial owner's interest is limited to the business trust itself, not its underlying assets. Moreover, the DBTA further provides that, except to the extent otherwise provided in the governing instrument of the business trust, neither the death, incapacity, dissolution, termination, or bankruptcy of any beneficial owner will be cause for the termination or dissolution of a business trust.¹⁰ Presumably, if a beneficial owner voluntarily declares bankruptcy, the provisions of the DBTA should prevent the trust property from being deemed to be part of the bankruptcy estate.¹¹ Therefore, the use of a DBT, with appropriate safeguards provided in the trust agreement limiting the actions of the trustee, would appear to meet the bankruptcy-remote protection required by the lender.

The IRS has yet to rule on the classification of a DBT in the context of a Section 1031 exchange. Some practitioners have advised that the DBT should be treated as a mere agent or nominee of the taxpayer, based on the analysis set forth in Rev. Rul. 92-105, but the applicability of such analysis is doubtful. In a typical Illinois land trust, unlike the DBT, the grantor has the ability at any time to direct a disposition of the property (including to itself), and the purpose of the trust is to solely benefit the grantor/beneficiary. Moreover, the trustee of the DBT has an important role in the payment of expenses such as taxes, repairs, utilities, and insurance, and to protect the lender's interest (until the debt is satisfied).¹²

An alternative argument advanced for use of a DBT as a bankruptcy-remote entity in a Section 1031 exchange is that the DBT is a grantor trust, i.e., the grantor or other person is considered to be the owner of all of the trust's assets for federal tax purposes. In certain situations, however, depending on the requirements of the lender, and in the absence of a ruling, it may not be clear as to who is the "grantor," whether there is more than one grantor,¹³ or whether one of the provisions of Sections 673-678 is applicable to make the taxpayer the sole grantor for purposes of the grantor trust provisions. For example, the trust document may implicitly or explicitly refer to the lender as a beneficiary or as entitled to receive distributions from the trust, or the taxpayer may not have the right to revoke the trust immediately, even on satisfaction of the debt. In the absence of a ruling, it is not entirely clear what effect, if any, these types of provisions have on the applicability of the grantor trust rules. Taxpayers who are using a DBT as an SPBRE in a Section 1031 exchange would be well advised to have their tax counsel review the documentation before they proceed.

Some practitioners have derived comfort from the check-the-box Regulations, on the theory that even if the DBT is not an agent under the analysis of Rev. Rul. 92-105, or if it would not clearly be a grantor trust, it can be disregarded under Reg. 301.7701-2(a). The check-the-box Regulations apply, however, only to an entity "that is not properly classified as a trust" under Reg. 301.7701-4.¹⁴ In general, that Regulation defines a trust as an arrangement "whereby trustees take title to property for the purpose of protecting or conserving it for the beneficiaries under the ordinary rules applied in chancery or probate courts." Other types of trusts, such as business or investment trusts, will not be recognized as trusts if certain conditions exist (e.g., if the trust's only purpose is to carry on a profit-making business that ordinarily would be carried on by a partnership or corporation). Again, in the absence of a ruling, and depending on the terms of the trust, in many situations there likely will be some uncertainty as to whether the DBT will be characterized as a "trust" for purposes of the check-the-box Regulations.

Moreover, and perhaps more important, a DBT has several disadvantages when compared with using an LLC as an SPBRE. The DBTA requires that one of the trustees either be a natural person resident in Delaware or an entity with its principal place of business in Delaware.¹⁵ This could result in increased administrative burdens and costs as compared with the use of an LLC. In the authors' experience, the costs of forming and maintaining the DBT, including the compensation derived by the trustees, can be very high, particularly where a taxpayer and related entities are constantly involved in acquisitions of real estate. Finally, it may not be absolutely clear how a DBT will be treated for state tax purposes--its classification may follow federal law or it may be treated as a corporation or other entity by a state.

Single-Member LLCs With a Manager

In some other situations, lenders have permitted single-member LLCs that have a manager who can veto a bankruptcy filing or a sale of all of the assets and who is contractually obligated to take into account the interests of the lender. While this may be feasible in some deals (particularly smaller ones), it is doubtful that the lender, in many instances, will be comfortable with only contractual protection that may or may not be subject to being set aside in a bankruptcy proceeding.

Transfer to a Two-Member LLC

Another possibility is for the taxpayer to receive the replacement property and thereafter immediately transfer it to an LLC in which a corporation, set up to protect the lender, has a small interest. The LLC would be classified as a partnership for federal tax purposes. Aside from the likely objection of the lender, which probably will be concerned that for a moment in time the property will not be in an SPBRE, the Service would likely challenge the applicability of Section 1031.

In Rev. Rul. 75-292, 1975-2 CB 333, an individual exchanged property used in his trade or business for like-kind property and, pursuant to a prearranged plan, immediately made a Section 351 transfer of the property to a new corporation. The IRS held that Section 1031 was inapplicable because the new property was to be transferred to the corporation rather than the exchanging individual. It reasoned that the property received in the exchange was not to be held either for use in a trade or business or for investment by the taxpayer, but instead was to be transferred to the taxpayer's corporation. Similarly, in Rev. Rul. 77-337, 1977-2 CB 305, the IRS held that a taxpayer had not held the relinquished property for the necessary use where the taxpayer received the relinquished property as a liquidating distribution from his wholly owned corporation and then immediately exchanged the relinquished property for the replacement property. In TAM 9645005, the IRS, citing the above rulings, held that a partner who received a distribution of partnership property immediately prior to a sale under Section 1033(g) had not held the property for the required purpose.¹⁶

There is some authority, in the Ninth Circuit and in the Tax Court, that could be support for a taxpayer's being able to immediately transfer replacement property received in a Section 1031 exchange into an LLC.¹⁷ Nevertheless, until the IRS clarifies, modifies, or revokes Rev. Ruls. 75-292 and 77-337--at least in connection with a transfer to a partnership--an IRS agent may have no alternative but to set up the issue.

Section 761(a) Election

Practitioners also sometimes consider having the replacement property acquired directly by an LLC (in which a corporation set up for the benefit of the lender has a small interest), with the LLC electing under Section 761(a) to treat the assets of the LLC as being owned directly by the LLC members. (Alternatively, the property could be acquired by a previously existing SPBRE that had been formed to acquire other property.¹⁸) In this connection, Section 1031(a) expressly states that for its purposes, "an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership." Usually, however, this election will not be available because one of the conditions under the Regulations for making the election is that the parties own the property as co-owners,¹⁹ which, of course, the lender would not permit.

The New Letter Ruling

Thus, the challenge always has been to select an SPBRE that meets the stringent requirements of the lender, yet will be treated as a non-entity by the Service, so that the transferor of the relinquished property is treated as the recipient of the replacement property for purposes of Section 1031. Until recently, as illustrated above, there was no way of accomplishing this goal without any risk or without incurring significant expense, particularly for those taxpayers and related entities that make continual acquisitions of real estate. Now, however, there is a viable alternative, based on a private letter ruling that the Service issued at the end of last year,²⁰ which permits the disregarding of a two-member LLC where one of the members has no economic interest.

Facts. Taxpayer, a grantor of a grantor trust who, under Section 671, was treated as the owner of the trust's assets, wished to exchange real property held by the trust for other real property in accordance with the deferred exchange provisions of Section 1031(a)(3) and the applicable Regulations. Pursuant to an exchange agreement, the trustees assigned all of their rights in a contract to sell real estate (the "relinquished property") to a qualified intermediary (QI) (as defined in Reg. 1.1031-1(g)(4)). Title to the relinquished property was subsequently deeded directly by the trust to the buyer, pursuant to, and in satisfaction of, the trust's obligations in the exchange agreement.

As contemplated by the exchange agreement, the QI was to acquire (as defined in Reg. 1.1031(k)-1(g)(4)(iv)) like-kind property ("the replacement property") and transfer it to the trust. The replacement property was to be financed by Lender, who insisted that legal title to the property be held by a bankruptcy-remote entity. The trust proposed to use a single-member LLC as the bankruptcy-remote entity, but Lender objected because it did not give the bankruptcy-remote protection desired.

The trust then devised another approach, whereby it would form a Delaware LLC, with the trust and "Member 2," a corporation wholly owned by the trust, as the members of the LLC. One of the members of the board of directors of Member 2 would be a representative of Lender. The trust would have a 100% interest in the profits, losses, and capital of the LLC, while correspondingly, Member 2 would have no interest in the LLC's profits, losses, or capital.

Member 2 would be designated a "manager" in the LLC agreement, and the approval of such manager (via a unanimous vote of its board of directors), together with that of the trust, would be required for the LLC to:

1. File or consent to the filing of a bankruptcy or insolvency petition or otherwise institute insolvency proceedings.

2. Dissolve, liquidate, merge, consolidate, or sell substantially all its assets (with the prior written consent of Lender).

3. Engage in any business activity other than as 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 Lender.

5. Take or permit any action that would violate any provision of any of the documents evidencing or securing the loan from Lender.

6. Amend the Certificate of Formation concerning any of the aforesaid items.

7. Amend any provision of the LLC agreement concerning any of the aforesaid items (with the prior written consent of Lender).

All other decisions of the LLC would be made solely by the trust. The replacement property would be transferred directly to the LLC.

In addition, the LLC agreement provided that all distributions of net cash flow and capital proceeds would be made entirely to the trust. Finally, on the dissolution of the LLC, the trust would wind up the affairs of the LLC in any manner permitted or required by law, provided that the payment of any outstanding obligations owed to Lender would have priority over all other expenses or liabilities.

The key ruling that the taxpayer required from the Service was that the LLC would be treated as having a single owner for purposes of Regs. 301.7701-2(c)(2) and 301.7701-3 and, in the absence of an election to the contrary, disregarded as an entity separate from its owner for purposes of Section 1031(a).²¹

The Analysis

Under Reg. 301.7701-3(b), a domestic eligible entity that does not file an election to be treated as an association is treated as a partnership if it has two or more members or is disregarded as an entity separate from its owner if it has a single owner.

Delaware's LLC law specifically allows an LLC to have a member with no economic interest. Section 18-301(d) of the Delaware Limited Liability Company Act ("the Act") states that "[u]nless otherwise provided in a limited liability company agreement, a person may be admitted to a limited liability company as a member of the limited liability company without acquiring a limited liability company interest in the limited liability company." A "limited liability company interest" (an "LLC interest") is defined as a "member's share of the profits and losses of a limited liability company and a member's right to receive distributions of the limited liability company's assets."²² Thus, the trust owned 100% of the LLC interests and Member 2 owned none. Reg. 301.7701-3(a) provides that an eligible entity with a "single owner" can be disregarded as an entity separate from its owner. The Regulations do not, at any point, refer to a single "member." Since the trust owned 100% of the LLC interests, it was the "single owner" of the LLC, and therefore the LLC should be disregarded as an entity separate from its "owner."

This approach is consistent with Revenue Rulings that ignore a nominal class of stock in a corporation, where that class did not represent an equity interest. For example in Rev. Rul. 64-309, 1964-2 CB 333, the IRS held that stock issued to the Federal Housing Administration (FHA), pursuant to a regulation requiring such stock to be issued by a private corporation holding property covered by FHA-insured mortgages, is not a "class of stock" for purposes of Section 1371(a). The IRS reasoned that the stock held by the FHA did not "represent an equity interest in the corporation."²³

Similarly, Member 2's interest in the LLC "does not represent an equity interest" in the LLC. It has no interest in the profits and losses and no capital interest. It is a member of the LLC only at the insistence of the lender and solely for bankruptcy remote purposes. Therefore, the LLC should be treated as having a "single owner" for purposes of Regs. 301.7701-2(c) and 301.7701-3.

The Service did not, however, rely on the above analysis to reach its conclusion in the ruling. Instead, the IRS relied on partnership principles regarding whether the parties had the intent to join together to operate a business and share in profits and losses.²⁴

Citing Tower, 327 U.S. 280, 34 AFTR 799 (1946), the Service noted that federal, not state law, controls for income tax purposes, regardless of how the parties are treated under state law. The IRS proceeded to analyze the factors presented in Luna, 42 TC 1067 (1964), for consideration in determining whether the parties intended a partnership:

• The agreement of the parties and their conduct in executing its terms.

• Whether business was conducted in the joint names of the parties.

• Whether the parties filed federal partnership returns or otherwise represented to the Service or to persons with whom they dealt that they were joint venturers.

• Whether separate books of account were maintained for the venture.

• The contributions, if any, that each party made to the venture.

• Whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for its services contingent compensation in the form of a percentage of income.

• The parties' control over income and capital and the right of each to make withdrawals.

• Whether the parties exercised mutual control over and assumed mutual responsibility for the enterprise.

Based on the LLC agreement, the Service determined that the trust and Member 2 did not enter into the LLC agreement with the intention of operating a business and sharing profits and losses therefrom. Member 2's sole limited purpose for becoming a member of the LLC was to prevent the trust from voluntarily placing the LLC into bankruptcy. It had no interest in the LLC's profits or losses and did not manage the enterprise or have any management rights other than the limited rights enumerated in the LLC agreement. Therefore, the IRS held that the LLC would not be treated as a partnership between the trust and Member 2, but instead would be treated as an entity owned solely by the trust. Since the LLC will not elect to be treated as an association taxable as a corporation, it will be disregarded as an entity separate from the trust, and the transfer of the replacement property to the LLC will be treated as a transfer of the replacement property to the trust for purposes of Section 1031(a)(3).

The reason the IRS referred to partnership principles may lie in the fact that the check-the-box Regulations appear to result in something of a paradox as applied to the facts of this ruling. Reg. 301.7701-3(b)(1) states that unless a domestic eligible entity elects otherwise, it will be treated as "(i) [a] partnership if it has two or more members; or (ii) [d]isregarded as an entity separate from its owner if it has a single owner." Similarly, Reg. 301.7701-2(c), in defining "business entities", states that a "partnership" is a business entity that is not a corporation and has at least "two members," and that a business entity that has a single "owner" and is not a corporation will be disregarded as an entity separate from its owner. In this ruling, the LLC has both attributes, i.e. two or more members and a single owner. Which attribute takes precedence? As the Service's analysis illustrates, the Regulations can be read only in a way that makes sense of their intended purpose and can be supported by general principles of tax law. Under no circumstances should the LLC be characterized as a partnership, and this is true whether the analysis relies on the notion of a "single owner" or because the entity does not possess the fundamental characteristics of a partnership.

Significance of the Ruling

The private letter ruling is significant because it presents a simple, safe (from a tax viewpoint), and relatively inexpensive option for taxpayers who are acquiring replacement property in a Section 1031 exchange where the lender is insisting on an SPBRE. The organization costs involved in setting up and operating an LLC are relatively minor, and in almost every state the LLC's tax treatment follows from its classification for federal tax purposes.²⁵ Moreover, where the loan amounts are substantial, or where the lender is not otherwise satisfied with the bankruptcy remoteness of the proposed acquisition entity, the ruling may present the only viable solution.

The ruling also is likely to have significance beyond the like-kind exchange area. It provides additional options for any acquisition where the tax planning includes the use of a disregarded entity, irrespective of whether an SPBRE is involved. It remains to be seen, however, whether the ruling will have an impact in the international area, where the IRS has had some concern about the use of hybrid entities. Although this topic is beyond the scope of this article, practitioners should not be surprised if attempts to use this ruling in the international area are monitored closely by the IRS.

Exhibit 1

A redacted copy of Letter Ruling 199911033, December 18, 1998

This responds to a letter dated November 10, 1998, and prior correspondence submitted on behalf of Trust and requesting rulings under Search7RHSearch7RH 1031 and 7701 of the Internal Revenue Code.

Facts

You have represented the facts as follows. A is the grantor of Trust. Under Search7RH 671, all of the income, deductions, and credits against tax of the trust are treated as those of A for purposes of computing A's taxable income. On Date 1, the trustees of Trust assigned all of their rights in a contract to sell a parcel of real estate (the Relinquished Property) to Intermediary pursuant to an exchange agreement dated Date 1. Intermediary is a "qualified intermediary" as defined in Search7RH 1.1031-1(g)(4) of the Income Tax Regulations. As required by those regulations, notice of the assignment was given to the buyer on Date 2.

As contemplated by the exchange agreement, Intermediary will acquire like-kind property (the Replacement Property), and transfer it to Trust. The intent of the parties is that the transfer of the Relinquished Property and the receipt of the Replacement Property will constitute a nontaxable deferred exchange under Search7RH 1031(a)(3). Consistent with the requirements of that section, Trust identified the Replacement Property that it will acquire by Date3.

The Replacement Property will be financed by lender. Lender insists that legal title to the Replacement Property be held by a bankruptcy remote entity. To satisfy this requirement, Trust will form a State limited liability company (LLC) pursuant to a limited liability company agreement (the Agreement) between the trustees and Member 2, a corporation wholly owned by Trust. To protect the Lender's interest, one of the members of the Board of Directors of Member 2 will be a representative of Lender. The replacement Property will be transferred directly to LLC.

Except as otherwise provided in section 7.1 of the Agreement, all decisions of the LLC will be made solely by Trust. Under section 7.1, for so long as the loan from lender is outstanding without the approval of Member 2 (whose Board of Directors vote must be unanimous) the LLC may not: (1) file or consent to the filing of 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 Lender; (5) take or permit any action that would violate any provision of any of the documents evidencing or securing the loan from 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. With respect to items 2 and 7, the LLC must have the prior written consent of the Lender.

With the exception of the rights contained in section 7.1, Member 2 has no other rights relating to the management of the LLC. Section 5 of the Agreement provides that all profits, losses, and credits of the LLC will be allocated to Trust. In addition, all distributions of net cash flow and capital proceeds will be made entirely to Trust. Furthermore, upon the dissolution of LLC, Trust will wind up the affairs of LLC in any manner permitted or required by law, provided that the payment of any outstanding obligations owed to Lender will have priority over all other expenses or liabilities.

Rulings Requested

Based on these facts and representations, you have requested that we rule as follows:

1. The LLC will be treated as having a single owner for purposes of Search7RHSearch7RH 301.7701-2(c)(2) and 301.7701-3 and, in the absence of any election to the contrary, will be disregarded as an entity separate from its owner; and
2. The acquisition of Replacement Property by the LLC will be treated as a direct acquisition by Trust for purposes of Search7RH 1031(a)(3).

Law and Analysis

Section 301.7701-2(a) of the Procedure and Administration Regulations provides that business entities are entities recognized for federal tax purposes but not properly classified as trusts under Search7RH 301.7701-4 or otherwise subject to special treatment under the Code. A business entity with two or more members is classified for federal tax purposes as either a partnership or a corporation. Under Search7RH 301.7701-3(b)(1)(i), a domestic eligible entity (as defined in Search7RH 301.7701-3(a)) will be treated as a partnership unless it elects to be treated as a corporation. A business entity with only one owner is classified as a corporation or is disregarded as an entity separate from its owner. Under Search7RH 301.7701-3(b)(1)(ii), a domestic eligible entity with a single owner is disregarded as an entity separate from its owner unless it elects to be treated as a corporation under Search7RH 301.7701-3(c).

Since LLC is a domestic eligible entity and you have represented that it will not file an election to be treated as a corporation, its federal tax classification depends upon the number of members of LLC. The cases of Commissioner v. Tower, 327 U.S. 280 (1946) and Commissioner v. Culbertson, 337 U.S. 733 (1949), provide general principles regarding the determination of whether individuals have joined together as partners in a partnership. The primary inquiry is whether the parties had the intent to join together to operate a business and share in its profits and losses. The inquiry is essentially factual and all relevant facts and circumstances must be examined. Furthermore, it is federal, not state, law that controls for income tax purposes, regardless of how the parties are treated under state law.

In Herbert M. Luna, 42 T.C. 1067, 1077 (1964), the court stated that the following factors should be considered in determining whether the parties intended to be a partnership: (1) the agreement of the parties and their conduct in executing its terms; (2) whether business was conducted in the joint names of the parties; (3) whether the parties filed Federal partnership returns or otherwise represented to the Service or to persons with whom they dealt that they were joint venturers; (4) whether separate books of account were maintained for the venture; (5) the contributions, if any, which each party has made to the venture; (6) whether each party was a principal and co-proprietor, sharing a mutual proprietary interest in the net profits and having an obligation to share losses, or whether one party was the agent or employee of the other, receiving for his services contingent compensation in the form of a percentage of income; (7) the parties' control over income and capital and the right of each to make withdrawals; and (8) whether the parties exercised mutual control over and assumed mutual responsibility for the enterprise.

In this case, the members of LLC have not come together to form a partnership for federal tax purposes because, as evidenced by the LLC agreement, Trust and Member 2 did not enter into the Agreement to operate a business and share profits and losses. Member2 is a member of LLC for the sole limited purpose of preventing Trust from placing LLC into bankruptcy on its own volition. Member 2 has no interest in LLC's profits or losses and neither manages the enterprise nor has any management rights other than those limited rights described above. Thus, for federal tax purposes LLC will not be treated as a partnership between Trust and Member 2 but rather as being owned solely by Trust. Because Trust is the sole owner of LLC and LLC will not elect to be treated as a corporation for federal tax purposes, LLC will be disregarded as an entity separate from Trust. Accordingly, the transfer of Replacement Property to LLC will be treated as a transfer of the Replacement Property to Trust for purposes of Search7RH 1031(a)(3).

Conclusion

Based on the fats submitted and the representations made, we rule as follows:

1. Provided that LLC does not file an election to be treated as a corporation for federal tax purposes under Search7RH 301.7701-3(c), LLC will be disregarded as an entity separate from Trust; and
2. The acquisition of Replacement Property by LLC will be treated as a direct acquisition by Trust for purposes of Search7RH 1031(a)(3).

Except as specifically ruled on above, no opinion is expressed or implied concerning the federal tax consequences of the facts described above under any other provisions of the Code. In particular, no opinion is expressed concerning whether the transaction described above otherwise meets the requirements for non-recognition of gain treatment under Search7RH 1031.

This ruling is directed only to the taxpayer requesting it. Section 6110(j)(3) provides that it may not be used or cited as precedent.

Sincerely yours,

Signed/Dianna K. Miosi

Chief, Branch 1, Office of the Assistant Chief Counsel

 

ARTICLE FOOTNOTES______________________

1 Thanks to the automatic stay in the Bankruptcy Code (11 U.S.C. section 362), borrowers, by voluntarily declaring bankruptcy, often can put off foreclosure and repayment to the lender.

2 See Cuff, "Tax Free Real Estate Transactions: How Do You Do an Exchange With a Special Purpose Entity?," 24 J. Real Est. Tax'n 375 (Summer 1997).

3 Today, most like-kind exchanges involve new financing, rather than assumptions of, or transfers of property subject to, existing debt. The mortgage on the relinquished property is paid off, and the taxpayer must obtain financing for the replacement property--hence involvement of lenders in Section 1031 transactions.

4 See TAM 9818003, in which the Service ruled that a partnership did not qualify for like-kind exchange treatment on relinquishing property when the replacement properties were deeded directly to the partners in liquidation of their partnership interests. The IRS held that the partnership transferred the relinquished property but received no reciprocal transfer of replacement property. See Shop Talk, "How a Partnership Should Not Do a Like-Kind Exchange," 88 JTAX 381 (June 1998).

5 See In re Langley, 30 Bkrptcy. Rptr. 595 (Bkrtcy. DC Ind., 1993) (property of an Indiana land trust held to be part of the bankruptcy estate of the settlors, who were the sole beneficiaries of the trust).

6 12 Del. Code section 3801(a).

7 Id., section 3803(a).

8 Id., section 3805(b).

9 Id., section 3805(c).

10 Id., section 3808(b).

11 Nevertheless, the bankrupt beneficial owner's interest in the business trust, entitling the beneficial owner to receive distributions in accordance with the governing instrument of the business trust, would become part of the assets of the beneficial owner's bankruptcy estate.

12 See, e.g., Rev. Rul. 79-77, 1979-1 CB 448, in which the Service ruled that a trust was properly classified as a trust, and not a business entity, where it was formed to hold title to land, and the trustee was empowered to sign leasing and management agreements, hold title to the property, determine whether to allow minor repairs to the building, and institute legal or equitable action to enforce any provision of the lease. See also Rev. Rul. 78-371, 1978-2 CB 344, where the trustees had the power to raze or erect any building or other structure and make any improvements they deemed proper on the land contributed to the trust, and also borrow money and mortgage and lease the property; here, the Service classified the entity as an association taxable as a corporation.

13 Prop. Reg. 1.671-2(e)(1) provides that "grantor" includes "any person to the extent such person either creates a trust, or directly or indirectly makes a gratuitous transfer ... of property to a trust." Prop. Reg. 1.671-2(e)(2) also provides that a grantor "includes a person who acquires an interest in a trust from a grantor of the trust if either--(i) [t]he transfer is nongratuitous ...; or (ii) [t]he transfer is of an interest in a fixed investment trust."

14 Reg. 301.7701-2(a).

15 12 Del. Code section 3807.

16 See "Partner Cannot Defer Gain on Property Distributed One Day Before Condemnation Sale Closed," 86 JTAX 120 (February 1997). See also Ltr. Rul. 9818003, supra note 4.

17 See Magneson, 753 F.2d 1490, 55 AFTR2d 85-911 (CA-9, 1985), aff'g 81 TC 767 (1983); Bolker, 760 F.2d 1039, 56 AFTR2d 85-5121 (CA-9, 1985), aff'g 81 TC 782 (1983); and Maloney, 93 TC 89 (1989).

18 It is highly unlikely that the lender would accept an SPBRE that previously has owned other property (albeit temporarily), because of the possible risk of undisclosed liabilities. See Cuff, supra note 2, page 379.

19 Reg. 1.761-2(a)(2)(i).

20 The ruling was obtained by the authors' law firm, on behalf of a client, on 12/18/98, and will not be released to the public until at least 3/19/99. Therefore, the identification number the IRS will assign to the ruling is unknown at this time.

A taxpayer, other than the taxpayer to whom the ruling was issued, may not rely on a private letter ruling as precedent; see Section 6110(k)(3). A ruling does provide insight into the Service's position on an issue, however, and has been used by the IRS itself as precedent.

21 The IRS has ruled at least twice that the acquisition of replacement property by an LLC that has a single "owner," and for which an election has not been made under Reg. 301.7701-3(a) to be classified as an association, will be treated as an acquisition directly by the single "owner" for purposes of Section 1031(a). See Ltr. Ruls. 9751012 and 9807013. See also Schinner, "IRS Rulings Expand Opportunities for Using Single-Member LLCs in 1031 Exchanges," 88 JTAX 286 (May 1998).

22 6 Del. Code section 18-101(8).

23 See also Rev. Rul. 66-333, 1966-2 CB 114 (stock issued to FHA, under circumstances similar to Rev. Rul. 64-309, 1964-2 CB 333, "does not represent an equity interest in the corporation" and will not be considered a class of stock for purposes of Section 368(c)), and Rev. Rul. 120, 1953-2 CB 130 (special stock issued by cooperative housing apartment corporation to the Federal Housing Commissioner should not be treated as a class of stock for purposes of section 216 of the 1939 Code).

24 See Culbertson, 337 U.S. 733, 37 AFTR 1391 (1949), where the Court stated that a partnership exists for federal income tax purposes only when "... the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise."

25 See CCH State Tax Review, 8/3/98, pages 16-17, and State Tax Guide (CCH), 15-245. The exceptions include Texas, which taxes an LLC as a corporation, and Arkansas, which taxes an LLC as a partnership if it has two or more members.