Tax and Reporting Rules for Escrows and Trusts Used in Deferred Like-Kind Exchanges
Background
Under section 1031(a)(3), a taxpayer can qualify for deferral of gain in a non-simultaneous ("deferred") like-kind exchange if, in addition to meeting the general requirements of section 1031, certain identification requirements are met and the taxpayer acquires the replacement property by the earlier of : (1) 180 days after the transfer of the relinquished property or (2) the due date (determined with extensions) for the taxpayer's return for the tax year in which the transfer of the relinquished property occurs. If, however, on transfer of the relinquished property, the taxpayer actually or constructively receives cash or other property prior to receiving the like-kind replacement property, gain or loss will be recognized. (1)
To provide more certainty for taxpayers engaging in deferred exchanges, Treasury included four safe harbors in Reg. Search7RH1.1031(k)-1. All of the safe harbors enable a taxpayer to avoid the issue of whether there has been constructive receipt of money or other property prior to receipt of the like-kind replacement property. "(2) One safe harbor provides for the use of a "qualified escrow account"(3) or a "qualified trust"(4) to hold the proceeds from the transfer of the relinquished property. Another safe harbor provides for the use of a "qualified intermediary" ("QI")(5), which, in addition to avoiding constructive receipt, avoids two issues that are inherent in almost every multi-party exchange, i.e., whether the intermediary is the agent of the taxpayer and whether there is an "exchange."
Reg. 1.1031(k)-1(g)(1) provides that more than one safe harbor can be used in the same deferred exchange, but the terms and conditions of each must be separately satisfied. Because the QI safe harbor is the only one that avoids both the agency and the exchange issues, most exchanges these days are accomplished through a QI. Nevertheless, it is not uncommon that another safe harbor also would be used, particularly the qualified trust, because of concerns about the potential bankruptcy of the QI.
The deferred exchange Regulations do not address the taxation and reporting of income earned from a qualified escrow account or qualified trust. When they were adopted, the Treasury stated that "guidance on interest reporting should be provided not in a piecemeal fashion under a number of Code sections, but rather in general, comprehensive regulations issued under section 468B(g)."(6)
Section 468B, added to the Internal Revenue Code as part of TRA 86 contains rules for the deductibility of payments to "designated settlement funds" established to extinguish tort liabilities. TRA 86, section 1807(a)(7)(D)(i), clarified that "[n]othing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. If contributions to such an account or fund are not deductible, then the account or fund shall be taxed as a grantor trust." In 1988, this provision was essentially codified by TAMRA, with some modification to the original language: Section 468B(g) states that "[n]othing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. The Secretary shall prescribe regulations providing for the taxation of any such account or fund whether as a grantor trust or otherwise." In late 1992, Treasury promulgated Regulations for "designated settlement funds,"(7) but issued no guidance under section 468B pertaining to qualified escrow and trust accounts used in deferred like kind exchanges.
As a result of the lack of guidance, taxpayer-transferors in a section 1031 exchange, as well as QI's, trustees, and escrow agents, have not been treating the interest earned on the accounts or trusts consistently for income tax reporting purposes. While some escrow or trust agreements typically provide for all the earnings to be credited to the account of the transferor of the relinquished property, others provide that some or all of the earnings are to be retained by the QI, trust, or escrow holder. Further, it is understood that some QI's, trustees, and escrow agents have advised the transferor that the portion of the qualified escrow or trust account's earnings retained by them as a fee is not taxable to the transferor.(8) Therefore, some transferors have not been paying income tax on some or any of the earnings of the qualified escrow account or qualified trust properly attributable to their interest in the account or trust. In addition, some transferors may be unaware that if the deferred exchange straddles two tax years, the earnings of the qualified escrow account or qualified trust for the earlier year must be reported as income in that year.
On February 1, 1999, the Internal Revenue Service issued proposed regulations which set forth taxation and reporting requirements for escrow accounts and other settlement funds. One section of these proposed regulations, Prop. Reg. Search7RH1.468B-6, addresses the taxation and reporting of qualified escrows and qualified trusts utilized in deferred like-kind exchanges under section 1031(a)(3) and is the focus of the discussion below.(9)
Proposed Reg. Search7RH1.468B-6
Taxation of Income
Except for the purpose of determining whether a transaction qualifies as a deferred exchange, Prop. Reg. Search7RH1.468B-6 generally treats the "taxpayer" as the "owner" of the assets of a qualified escrow account or qualified trust. As a result, it is the taxpayer who generally must take into account all items of income, deduction, and credit (including capital gains and losses) of the account or trust in computing income tax liability. Under Prop. Reg. 1.468B-6(b), the "taxpayer" is the transferor of the relinquished property and the "owner" is the person treated as owning the assets of the qualified escrow account or qualified trust under Prop. Reg. Search7RH1.468B-6(c).
If, however, the "transferee" or QI has all the beneficial use and enjoyment of the assets of the qualified escrow account or qualified trust, the transferee or QI is treated as the owner.(10) In determining who has the beneficial use and enjoyment of the assets of the qualified escrow account or qualified trust, Prop. Reg. 1.468B-6(c)(2) provides that the following factors, along with "other relevant facts and circumstances in a particular case", will be considered: (i) which person enjoys the use of the earnings of the account or trust; (ii) which person receives the benefit from appreciation, if any, in the value of the assets of the account or trust; and (iii) which person is subject to a risk of loss from a decline, if any, in the value of the assets of the account or trust. If the transferee or QI is considered the "owner" of the fund or trust under these factors, Section 7872 may apply if the deferred exchange involves a below-market loan from the taxpayer to the owner.(11)
Examples 1 and 2 in Prop. Reg. 1.468B-6(h) confirm that having the beneficial use and enjoyment of the assets of a qualified escrow account or qualified trust is not synonymous with the QI merely receiving some or all of the interest from the account or trust as compensation for services rendered to the taxpayer in the exchange. In that situation, it is the taxpayer (and not the QI) who is enjoying the use of the earnings of the account or trust, using it to satisfy the obligation to recompense the QI for its services. Presumably it does not matter whether the retention of the interest is labeled as additional compensation for this purpose.
Reporting Obligations
The new guidance also establishes reporting obligations for the escrow holder or trustee. In general, Prop. Reg. 1.468B-6(e)(1) requires the escrow holder or trustee to report the income of the account or trust on Forms 1099 for each calendar year (or portion thereof) that the account or trust is in existence, in accordance with the information reporting requirements of Sections 6041 through 6053 Forms 1099 must be prepared reflecting the escrow holder or trustee as payor and must show the proper payee.
Moreover, the escrow holder or trustee must treat the taxpayer as the owner and payee unless a written statement, signed by the taxpayer and the owner, is provided to the escrow holder or trustee specifying that the QI or transferee is the owner. This statement must be furnished to the escrow holder or trustee within 30 days after the taxpayer transfers the relinquished property.(12) If a written statement is provided, the escrow holder or trustee must treat the person specified on the statement as the owner and payee of the income of the account or trust. (13)
Relief from the penalty provisions of Sections 6721 (failure to file correct information returns) and 6722 (failure to furnish correct payee statements) is provided to the escrow holder or trustee for reliance on either: (1) a written statement (as described above) specifying the transferee or QI as the owner and payee, or (2) the absence of a written statement resulting in the escrow holder or trustee treating the taxpayer as the owner and payee of the income of the account or trust.(14) The Proposed Regulations do not require that the escrow holder or trustee undertake any due diligence investigation to qualify for this relief.
Transition Rule and Effective Date
Prop. Reg. 1.468B-6(g)(2) includes a transition rule providing that with respect to a qualified escrow account or qualified trust established after 8/16/86 but on or before the date of publication of final Regulations in the Federal Register, the Service will challenge neither a reasonable, consistently applied method of taxation for income earned by the account or trust nor a reasonable, consistently applied method for reporting such income. The open issue for taxpayers who reported income earned from a qualified escrow or qualified trust on a net basis (i.e., reduced by any income contractually required to be paid to the QI or escrow holder for services rendered in the exchange), is whether the Service will consider such reporting a reasonable, consistently applied method of taxation and reporting for income earned on the account.
The provisions of Prop. Reg. 1.468B3-6 will be effective for qualified escrow accounts and qualified trusts established after the date final Regulations are published in the Federal Register. The IRS business plan for 1999(15) does not include a project to finalize these Regulations, but perhaps they will be issued as part of the Service's year 2000 business plan.
Open Issues
In five areas, the Proposed Regulations fail to provide clear-cut guidance.
Corporate payees. As stated above, Prop. Reg. Search7RH1.468B-6(e)(1) requires that the escrow holder or trustee report the income of the qualified escrow account or qualified trust on Forms 1099 in accordance with the information reporting requirements of Sections 6041 through 6053.(16) This means that no Form 1099 is required where the payee and owner is a corporation since, as affirmed by the Preamble, the Proposed Regulations require the issuance of Form 1099 only "to the extent the information reporting provisions of the Code otherwise require the filing of Forms 1099."(17) Sections 6041 through 6053, and the Regulations thereunder, generally do not require information returns be issued to corporate payees.(18)
While Prop. Reg. Search7RH1.468B-6 appears not to require information reporting for corporate payees, an example in Prop. Reg. Search7RH1.468B-8(j) leads to a contrary conclusion. In that example, dealing with contingent at-closing escrows, the escrow holder is required to furnish Forms 1099 to two corporate payees.(19) Since the reporting requirements under Prop. Reg. Search7RH1.468B-8(g) are identical to those under Prop. Reg. Search7RH1.468B-6(e) (i.e. reporting is only required "in accordance" with Sections 6041 through 6053), there is an inconsistency which obviously needs to be resolved in the final regulations.
We understand, however, that the example in Prop. Reg. Search7RH1.468B-8(j) is a mistake, and the intent was not to require Forms 1099 to be issued to corporate payees. If this is so, the Service runs the risk that many small unsophisticated investors who hold property through corporations may inadvertently fail to report the full earnings of the qualified escrow account or qualified trust (wrongly assuming they can reduce the earnings by any income paid to the QI or transferee for services). In addition, where the exchange straddles two tax years, an unsophisticated calendar-year corporation, for example, that does not receive a Form 1099 may fail to pick up the account or trust earnings attributable to the earlier calendar year in its income tax return for that year. A Form 1099 received by a corporation can serve as a powerful reminder of its reporting obligations.(20)
Escrow account reporting. In connection with the overall thrust of the Proposed Regulations (both with respect to the nondeferred exchange portion of the guidance and the exchange portion), various industry groups have commented that the escrow holder of an escrow account is being treated as the payor of the income earned by that account for reporting purposes, which is not the way most (if not all) escrow holders do business.(21) Generally, escrow agreements in deferred exchanges require the escrow holder to set up an escrow account with a financial institution. The escrow owner provides the financial institution with a Form W-9 that includes the owner's identification number and the financial institution directly issues the escrow owner a Form 1099 for any interest earned on the account. The Proposed Regulations require escrow companies to issue Forms 1099 to escrow account owners, where previously the reporting was done by the financial institution.
The concerns of the escrow industry have some validity, particularly outside the like-kind exchange area (but also because the escrow, unlike a trust, is not considered a separate entity). As a means of satisfying these concerns, while at the same time achieving the compliance objectives relating to like-kind exchanges, we suggest the following: the final Regulations should provide that the information return can be issued by either the financial institution, the trust company, or the escrow company.(22) In the event that no Form 1099 is issued, the financial institution would be the party subject to penalty where it has received the taxpayer identification information and the funds cannot be released from the account without the signature of the taxpayer/owner. In all other circumstances, the escrow holder or trustee would be the ultimate party responsible for issuing the Form 1099. This change would probably eliminate most information reporting by escrow holders and sanction the continuation of current business practices.
Unsegregated funds. There are many situations, particularly in the smaller exchanges, where a QI holds the funds derived from the proceeds of the sale of relinquished property, without using a qualified trust or qualified escrow. The QI typically will deposit the funds in a bank account in its own name. In some situations, withdrawals can be made from the account only with the signature of the QI and the transferor of the relinquished property. This structure is unlikely to occur in larger transactions, where taxpayers usually will insist on the funds being segregated from the QI (e.g., held through a qualified trust) for bankruptcy remote purposes. There may be other situations where a trust or escrow is used, but does not technically constitute a "qualified escrow" or" "qualified trust" (e.g., because a "disqualified person", under Reg.Search7RH1.1031(k)-1(k) is the trustee or escrow agent).
Because a "qualified trust" or "qualified escrow" is not being used in those situations, Prop. Reg. Search7RH1.468B-6 has no applicability and there is no reporting requirement. Where the account is held by the QI directly, and not through a formal trust, it is very possible that under local law a resulting or express trust is created and the QI would be deemed to be holding the funds in trust for the benefit of the taxpayer. For example, in In re Sale Guaranty Corporation, 220 Bkrptcy. Rptr. 660 (Bkrptcy. CA-9, 1998), the bankruptcy appellate panel for the Ninth Circuit was faced with a QI that filed for bankruptcy while holding the proceeds from the sale of a relinquished property in an attempted deferred Section 1031 exchange. The Court concluded, in affirming the bankruptcy court, that under California law the QI held the proceeds in an express trust for the benefit of the taxpayer. It looked to the exchange agreement, which provided that the debtor would carry the proceeds on its books as a credit to the taxpayer for application to the exchange property to be acquired, and that the proceeds were to be returned to the taxpayer if the deadlines of Section 1031(a)(3) were not met.
The Proposed Regulations, not requiring the QI (or perhaps in certain cases as suggested below, the financial institution) to issue a Form 1099 to the taxpayer, create a significant possibility of noncompliance and confusion. Moreover, the Preamble to the Proposed Regulations states that "comments are requested regarding whether there are other types of funds for which rules under section 468B are required."(23) The final Regulations should provide that the reporting requirements of Prop. Reg. Search7RH1.468B-6 will be applicable to either a qualified trust, qualified escrow, or an account with a financial institution held by the QI for the benefit of the transferor of the relinquished property.
Net income. The IRS has received several comments from escrow companies and trade groups to the effect that the taxpayer should not have to pay tax on interest income not received by the taxpayer and instead retained by the QI. It is unlikely that the IRS will change this concept in the final Regulations, since the treatment is the same as if the taxpayer received the full amount of the interest and paid over some or all of it to the QI as compensation.
Owner other than the taxpayer. It is unclear when the rule of Prop. Reg.Search7RH1.468B-6(c)(2), dealing with circumstances in which the QI or the transferee could be considered the owner, would apply. It is probably safe to assume that a QI would be treated as the owner where it has complete investment discretion over the use of the funds in a qualified escrow or trust account, and is obligated to purchase the replacement property, regardless of the amount or value of the funds in the account at the time of the acquisition, with no portion of the account returnable to the taxpayer at the end of the exchange period. In that situation, the QI enjoys any appreciation in the funds over the amount necessary to purchase the replacement property, but suffers any decline in value below such amount. In practice, the authors have never seen this type of structure, and it is questionable whether it actually occurs (a QI normally would be unwilling to assume the risk of a decline in value of the account).
Moreover, the Proposed Regulations state that there are "other circumstances" to be taken into account to determine whether the QI or the transferee is the owner. What exactly are these "other circumstances"? The final Regulations should provide some guidance here, including examples.
Conclusion
Prop. Reg. Search7RH1.468B-6 provides much needed guidance on the taxation and reporting of income from qualified escrow accounts and qualified trusts used in connection with deferred like-kind exchanges. The proposals generally are consistent with the intent of Sections 468B and 1031(a)(3), and provides workable rules for the taxation and reporting of income from qualified escrows and qualified trusts. The reporting requirements, however, should be clarified to increase compliance and make the reporting requirements more consistent with current practices in the real estate sector.
FOOTNOTES______________________
1. Reg. Search7RH1.1031(k)-1(a).
2. Reg. Search7RH1.1031(k)-1(g). Also see Levine, 567-2nd T.M., Taxfree Exchanges Under Section 1031, page A-43 et. seq.
3. Under Reg. Search7RH1.1031(k)-1(g)(3) (ii), in a "qualified escrow account" (1) the escrow holder is not the taxpayer or a disqualified person and (2) the escrow agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held in the escrow account, as provided in Reg. 1.1031(k)-l(g)(6). "Disqualified person" is defined in Reg. Search7RH1.1031(k)-1(k) and generally includes a related person within the meaning of either Section 267(b) or 707(b) as modified by Reg. Search7RH1.1031(k)-1(k)(3) or the agent of the taxpayer (i.e., someone who acted as the taxpayer's employee, attorney, accountant, investment banker, broker, or real estate agent any time within the two-year period ending on the date of the transfer of the first relinquished properties).
4. Under Reg. Search7RH1.1031(k)-1(g)(3)(iii), in a "qualified trust" (1) the trustee is not the taxpayer or a disqualified person and (2) the trust agreement expressly limits the taxpayer's rights to receive, pledge, borrow, or otherwise obtain the benefits of the cash or cash equivalent held by the trustee, as provided in Reg. Search7RH1.1031(k)-1(g)(6). Again, "disqualified person" is defined in Reg. 1.1031(k)-1(k)(see note 4, supra), except that for this purpose the relationship between the taxpayer and trustee created by the qualified trust will not be considered a relationship under Section 267(b).
5. Under Reg. Search7RH1.1031(k)-1(g)(4)(iii) a QI as a person who (1) is not the taxpayer or a disqualified person (again, defined in Reg. Search7RH1.1031(k)-1(k); see note 4, supra) and (2) enters into a written agreement with the taxpayer (the "exchange agreement") and, as required by the exchange agreement, acquires the relinquished property from the taxpayer, transfers the relinquished property, acquires the replacement property, and transfers the replacement property to the taxpayer.
6. See the Preamble to TD 8346, adopting Reg. 1.1031(k)-1 CB 150, at page 154.
7. TD 8459, 1993-1 CB 68. See Harrison and Wilcox. "Settlement Fund Final Regs. Answer Many Questions, but Problems Still Exist, "78 JTAX 342 (June 1993).
8. Many, if not most practitioners thought that in virtually all cases the gross amount of the interest should be reported by the transferor where part of the interest was retained by the QI as compensation. Arguably, any fee paid the QI or escrow company from the account's earnings should be considered an exchange expense which would decrease boot from the exchange.
9. For a discussion of the entire set of Section 468B Proposed Regulations, see Morris and Kahen, "Deferred Exchanges-IRS Issues proposed Rules for Escrow and Settlement Funds," N.Y.L.J., 2/24/99.
10. Prop. Reg. Search7RH1.468B-6(c)(2). The "transferee" is defined as the person treated as owning the relinquished property for federal income tax purposes after its transfer by the taxpayer. See, note 6, supra, for the definition of a QI.
11. Prop. Reg. Search7RH1.468B-6(d). The theory apparently is that the taxpayer is making a loan to the QI or transferee of the amount put into the qualified escrow or qualified trust. The imputed interest under Section 7872 is treated as interest income to the taxpayer who re-transfers the income to the QI or transferee as payment for services rendered.
12. Prop. Reg. Search7RH1.468B-6(e)(2) and (f).
13. Prop. Reg. 1.468B-6(e)(2)(ii).
14. Prop. Reg. Search7RH1.468B-6(e)(3). The penalty under Section 6721 for failure to file correct information returns is $50 for each return with respect to which such failure occurs up to a maximum of $250,000 for any calendar year. The Section 6722 penalty for failure to furnish correct payee statements is also $50 for each return with respect to which such failure occurs, up to a maximum of $100,000 for any calendar year.
15. Treasury Department Office of Tax Policy and Internal Revenue Service, 1999 Priority Guidance Plan (3/9/99).
16. Specifically, "in accordance with ... subpart B, Part III, subchapter A, chapter 61, Subtitle F of the Internal Revenue Code."
17. See the preamble to REG-209619-93, "Explanation of Provisions: 2. Section 1031 Qualified Escrow Accounts and Qualified Trusts Under Search7RH1.468B-6 of the Proposed Regulations," 1999-10 IRB 28, at page 29.
18. See Sections 6049(b)(2)(C)(i) and (b)(4)(A), Section 6042(b)(2)(B), and Reg. 1.6041-3(c).
19. See Prop. Reg. 1.468B-8(j), paragraph (ix).
20. Arguably, to require such reporting would not require an amendment to Section 6049 for interest reporting. Section 6049(b)(2)(C) provides that payment of interest to a corporation does not require information reporting "except to the extent otherwise required by regulations."
21. See "IRS Panel Receptive to Testimony Urging Clarified Reporting Rules in 468B Proposal," Daily Tax Rep. (BNA) No. 92 (5/13/99), page G-1.
22. Another alternative would be to require information reporting by financial institutions for qualified escrow accounts, and trust companies for qualified trusts. This approach recognizes the distinction that a trust company holds assets as a separate legal entity while an escrow company acts merely as a custodian over the funds.
23. See Preamble, supra note 18, at page 31.