If you spend a substantial amount of time around tax professionals, there’s a decent chance you will encounter the phrase “disregarded entity” at one point or another. This phrase, fear-inspiring though it sounds, is a fairly straightforward concept which has relevance in a variety of contexts. In this article, we will introduce disregarded entities and explain why you and other HTW readers should be familiar with this concept.
Not all business entities are the same. As we have discussed in our webcast on the topic, businesspeople can select between a number of distinct corporate entities depending on which entity best suits their particular situation. Once an entity has been selected, one of the remaining steps is for the owner to determine whether that entity will be “disregarded” for tax reporting purposes. In simple terms, if an entity be disregarded, then it will not file its own separate tax return to the IRS; it is disregarded to whomever is the current owner, and so the current owner will include the financial data of the entity within his or her own return. Disregarded entities, therefore, can be thought of as assets which are fully traceable to the owner, rather than wholly distinct entities.
Only certain corporate entities may be disregarded. For instance, a single member LLC is typically disregarded to the single member unless the single owner specifically elects to treat the LLC as regarded. And so income generated by such an LLC would be included on the owner’s tax return rather than a tax return prepared and owned by the entity itself.
Certain corporate entities can never be disregarded. S Corps, C Corps, and multi-member LLCs in which the two members are not husband and wife in a community property state cannot ever be disregarded and must report income independently.
1031 Exchange Context
Another context in which disregarded entities may show up as an important concept is the 1031 exchange industry. The tax code requires that whichever entity owns the relinquished property in a 1031 exchange must also acquire title to the replacement property. As I’m sure our readers are aware, title to real estate can be held by corporate entities, and so if a regarded corporate entity hold title to real property then this preexisting ownership must kept consistent throughout the exchange. If the entity doesn’t remain consistent then a valid tax-deferred exchange cannot occur.
Here on HTW, we’ve spent considerable time and effort exploring the complexities of Section 1031 tax deferred exchanges. And this is for good reason: if performed correctly, a 1031 like-kind exchange can be an extremely useful wealth maximization tool. Like-kind exchanges not only allow taxpayers to defer the capital gain taxes which would normally be owed, they also allow more capital to be reinvested in the newly acquired property, and this leads to even greater returns. In other words, Section 1031 doesn’t just permit tax deferral, it allows your capital to work more effectively on your behalf. The clear financial benefits of Section 1031 explain the impressive rise in popularity of these transactions in recent years.
As if the existing complexity of 1031 were insufficient, it turns out that there are variations on the standard like-kind exchange which taxpayers may choose to conduct. One of these variations is known as a “reverse exchange.” Given the advantages which this variation can confer in certain contexts, reverse exchanges have become increasingly common. Let’s look more closely at the mechanics of reverse exchanges and then discuss some of the unique benefits of this type of transaction.
In a standard – or “delayed” – exchange, the original property owned by the taxpayer is disposed of prior to the acquisition of the replacement property. In a reverse exchange, the order is flipped, and the replacement property is acquired first and the original property (the “relinquished property”) is sold subsequent to the acquisition of the replacement property. Superficially, this process seems simple, but other aspects of this variation make it considerably more complicated than a standard exchange.
Under current tax law, taxpayers are not permitted to simultaneously hold title to both the relinquished property and the replacement property. This makes intuitive sense, because simultaneous ownership of both properties would conflict with the basic exchange concept. In order to solve this problem, the entity facilitating the exchange for the taxpayer – referred to as the “qualified intermediary” – develops a separate corporate entity which exists solely to temporarily hold title to the replacement property prior to the disposition of the relinquished property. In 1031 nomenclature, the replacement property is “parked” in the entity and then title to the replacement property is transferred to the taxpayer after the relinquished property is sold. This parking arrangement has been approved by the IRS; in fact, the IRS has issued specific guidelines regarding the mechanics of these transactions.
Reverse exchanges also require more documentation and preparatory work compared to standard exchanges. The fees for these transactions are typically much higher given the additional complexity involved.
Reverse exchanges carry unique benefits for investors. Perhaps the most important of these benefits is the timing of the acquisition of the replacement property. The impetus for a reverse exchange usually relates to the desirability of the replacement property; the investor needs to close on the replacement property immediately, or else face the possibility of either losing it to another investor or receiving inferior financing. In some cases, investors know exactly which replacement property they want to acquire and simply haven’t arranged a buyer for their replacement property; but in many other cases, reverse exchanges are a response to market trends.
Another key benefit of reverse exchanges is the effective elimination of the identification requirement. In standard exchanges, replacement property ordinarily must be identified within 45 days after the closing of the relinquished property; reverse exchanges solve this issue from the outset because the replacement property is acquired first. Though it may seem like an easy enough rule to comply with, more than a few exchanges have failed simply because the investor could not properly identify a new property within the specific time window.
There’s much, much more to reverse exchanges, but this serves as a good introduction. In the future, we will go over the structure of reverse exchanges in greater detail and discuss further why they are uniquely beneficial for investors in many cases.
As counter-intuitive as it may seem, many of the most basic terms in tax law were being argued and debated as recently as one century ago. We tend to think of many terms in tax law – particularly very elementary terms such as “property” and “income” – as things which simply emerged with fixed definitions, presenting little or no controversy since their inception. Here at HTW, we know better: in fact, oftentimes the most elementary terms have been fraught with the greatest level of uncertainty. The average person may not realize it today, but the clarity of many of our essential tax law concepts is the result of an immense amount of mental energy on the part of our legal and political establishment.
The case of Towne v. Eisner (1918) is one example of such mental energy being expended to settle a seemingly simple term. In this case, the full breadth of the term “income” came under contention when a shareholder challenged the tax authorities on the issue of the taxability of stock dividend transactions. This case is significant for a number of reasons, but one reason for its significance stands out among others: through this case, the basic principle that income places someone in an advantageous position was firmly pinned down. This “principle of advantageous position,” to coin a phrase, is still at the heart of our definition of income today.
Let’s look at the (relatively simple) factual scenario of this case in greater detail.
After a company transferred $1.5 million in profits to its capital account, the taxpayer received a stock dividend consistent with his preexisting ownership stake in the company. The newly received stock had a value of roughly $417,450. The authorities contended that this stock dividend was income within the meaning of the tax law of 1913 – and that this construction of the term “income” within the tax law of 1913 was also consistent with the construction of the same term in the sixteenth amendment – and assessed a tax liability on the taxpayer. Though the taxpayer received additional shares, he did not take a cash dividend, and so the question before the court was whether a valid tax liability could be assessed given that the taxpayer was not actually placed in a financially superior or advantageous position following the stock dividend.
The applicable law was the Revenue Act of 1913. This act contained an income tax provision which was freed from the traditional rule of apportionment present in previous eras. The taxpayer claimed that stock dividends fell outside of the definition of “income” as construed within this act.
The court (the Supreme Court of the U.S.) ruled in favor of the taxpayer and threw out the tax liability assessed by the tax authorities. The court cited several earlier cases involving corporate stock dividends in its decision; the essential fact which decided the matter was that the taxpayer was not placed in a financially superior position by way of the transaction. What had occurred was merely a reissuing of stock certificates in order to properly reflect the proportional interests of the shareholder. The taxpayer did not actually “gain” anything from the transaction, he was not placed in a more advantageous position, and so the court ruled that it would be incorrect to say that the taxpayer had received taxable income.
As mentioned above, this basic principle has endured up to the present day and continues to inform our conception of taxable income. This principle informed the construction of the term “income” in various other contexts as well; for instance, the provisions of section 1031 of the tax code follow from the idea that gain should not be taxable if it were merely theoretical rather than actual. Again, though we may see this principle as self-evidently true today, this was not always so, and the case of Towne v. Eisner contributed mightily to the development of this principle.
After a great deal of suspense, drama and record-breaking levels of nail-biting on the part of our readers, Huddleston Tax Weekly is proud to announce that we will be picking up our XVI Amendment series. We will contribute a few more articles to this series before we move on to other things. The purpose of our XVI Amendment series is twofold: firstly, our aim is to show how important this political act was to American society; and secondly, by examining some of the issues which were sparked by this amendment, our other goal is to provide our readers with a sense of the complexity of tax law as a field. This latter goal, if realized, should confer significant benefits to our readers: if you’re familiar with some of the essential issues in the field of tax law, the likelihood is strong that you’ll be more effective in how you handle your own tax situation.
One of the things which makes tax law such a fascinating field is that it forces you to formally analyze many terms which are casually – and often carelessly – used in everyday conversation. In common parlance, terms such as “income,” “gain” and “property” are understood intuitively and require little or no clarification. But tax law does not operate in this same way. In tax law, these terms, along with many others, have much more narrow and occasionally shifting meanings which must be carefully examined in whatever context they originally appeared in order to produce a sustainable legal result. Though they may appear simple, these terms can create all sorts of complexity in tax litigation.
The case of Helvering v. Brunn (1940) is a good example of a case which involved formal analysis of a term which is typically grasped very rapidly. The judicial officers had to determine whether the events which occurred in the case could be construed as “taxable gain.” The XVI Amendment only removed the restrictions on the taxing power of Congress, it did not contribute to the issue of what constitutes taxable gain. The case of Helvering v. Brunn explored this issue, and it added an important layer to our understanding of taxable gain. In a sense, it helped to clarify the full scope of the amendment by showing what can – and what cannot – be taxed.
Let’s look at this case more closely to get a sense of its full significance.
The respondent (a landowner) executed a lease with a tenant which provided, among other things, that any improvements or buildings added to the land during the time of the lease would be surrendered back to the respondent when the lease expired. The tenant destroyed an existing building on the land and then developed a new building in its place. The difference in value between the old building and the new one was approximately $51,434.25. The tenant forfeited the lease when he was unable to keep up with rent and taxes. Subsequently, the IRS claimed that the respondent realized a gain of $51,434.25 as a consequence of the new building which had been added to the land. The respondent disputed this claim and contended that any value conferred by the new building did not qualify as taxable gain under the prevailing construction of this term.
The prevailing definition of “gross income” derived from the Revenue Act of 1932. The central question of the case was whether the value conferred by the new building should be treated as a taxable gain under the bounds established by this act.
The court (the Supreme Court of the U.S.) ruled that the respondent had in fact realized a taxable gain when the tenant added the new building to the land. The respondent highlighted the importance of transferability (or exchangeability) to the definition of taxable gain in certain contexts. The new building was not “removable” or “separable” from the land in the sense that it could not be taken off the land and still maintain its current market value. The respondent argued that this lack of transferability made the value bestowed by the new building nontaxable. In support of this of position, the respondent cited a number of cases which apparently held that transferability was a key component of taxable gain in stock dividend transactions. The court stated that the logic underlying the importance of transferability was limited to those types of transactions and did not apply to the present situation.
The key point to gather from Helvering v. Brunn is that gain can be taxable even outside of a traditional business transaction. And the gain needn’t be transferable, at least not in most contexts. Taxable gain can be triggered whenever value has been added or an event places someone in a financially superior position. Forgiveness of a liability or exchange of property, for instance, can trigger taxable gain even though cash isn’t involved and no sale has occurred.
Owning real estate often brings up tax issues. If you’re a current or future real estate owner and you’d like to learn about the tax perks of real estate ownership, check out our presentation on this topic by our CPA, Jessica Chisholm
We will look at one more case before returning to our article series on the sixteenth amendment. This is a case every HTW reader should become very well acquainted with: Kornfeld v. Commissioner (1998). Though it’s primarily an income tax case, it contains a plethora of other important topics and subtopics, and it presents a message which every HTW reader should commit to memory.
In the past, we’ve learned that whether a transaction be taxable is dependent on its substance, and that courts apply the “substance over form” doctrine to determine the true nature of a business transaction. The substance over form doctrine is not the only tool utilized by courts to review a transaction, however; the so-called “step transaction doctrine” is another tool commonly used by courts to clarify the nature of a transaction for tax purposes. Under the step transaction doctrine, multiple “steps” may be classed together and regarded as a single transaction; in this way, steps which may have been taken simply for the specific goal of altering tax liability can be overturned. The step transaction doctrine does not exist to create tax liabilities where none should exist, but to assess tax liability properly by viewing a transaction with the greatest level of accuracy.
In other words, the step transaction doctrine imposes a sort of coherence to a multistep transaction so that it can be properly adjudicated. This is very common in law: legal theories often condense or codify reality so that it can be interpreted using preexisting categories. But the rationale for theories such as the step transaction doctrine is not only about simplicity; there is also the aim of viewing a matter according to its true nature. Even though the step transaction doctrine may “condense” things for the sake of simplicity, many contend that this theory (and other similar theories) portrays matters in a more accurate way, that it provides a clearer sense of what actually occurred. Let’s look at the details of the Kornfeld case to get a better sense of this doctrine and its rationale.
The facts of this case are a bit complicated. Kornfeld, a highly experienced tax attorney, established a revocable trust which he intended to use to purchase bonds. He entered into an agreement with his daughters in order to claim an amortization deduction on the bonds; the agreement was that Kornfeld would transfer funds (from the trust) to the bond issuing institution equal to the value of a life estate in the bonds and then the daughters would pay the balance on the bonds. The agreement also held that Kornfeld would deliver checks to the daughters for the exact amount which they paid to cover the balance.
Kornfeld and his daughters executed this initial agreement and Kornfeld obtained the bonds. Subsequently, the tax code was changed so that the amortization deduction sought by Kornfeld was made unavailable in situations involving related parties. In response, Kornfeld and his daughters made another agreement which included Kornfeld’s secretary; the second agreement held that the daughters would take a second life estate interest in the bonds following Kornfeld’s death, and that the secretary would have the final remainder interest upon the death of the daughters. Importantly, Kornfeld used IRS valuation tables to create his estimates for the value of his life estate interest. Kornfeld claimed amortization deductions on the bonds and then the IRS assessed a deficiency after they declared that the transaction had failed to produce a genuine life estate in the bonds.
Under U.S. code – specifically section 167 – taxpayers may claim a depreciation deduction of a reasonable amount based on wear and tear for property held primarily for the production of income (such as a bond). IRC subsection 167(d) pertains to life tenants and beneficiaries of trusts. Under these rules, life estate interests in bonds – or “term interests” or limited interests – are considered amortizable (or depreciable) and thus taxpayers may claim a deduction for such an interest. Also see 26 CFR 1.167(a)-1.
Applying the step transaction doctrine, the court rejected the argument made by Kornfeld that the payments made to his daughters (and secretary) had no real connection to the bond transaction, and that a genuine life estate interest had been created for tax purposes. The court based its decision on the fact that the seemingly disparate actions of the case were patently interdependent and all served to produce a single, underlying purpose. Kornfeld thought that he had devised a near foolproof scheme to completely avoid any tax liability on the bond transaction, but the court realized that a genuine limited interest had not been created and that Kornfeld had acquired total ownership of the bonds.
The Kornfeld case is a prime example of the step transaction doctrine at work. All HTW readers need to be aware of how the step transaction can affect their tax liabilities; if you aim to acquire a particular kind of tax treatment, you need to understand that your actions preceding any given transaction, as well as your actions which occur after a given transaction, can impact the tax treatment you ultimately receive. In the future – after a few more installments on the sixteenth amendment – we will look at a few more examples of how the step transaction doctrine has been used to alter the tax classification of a series of events.
In early June of 1794, Congress passed a “carriage tax” aimed at carriages used for business purposes. The tax was to be collected annually for as long as the carriage owner maintained ownership of the carriage. The original Constitution of the U.S. recognized a distinction between direct taxes and indirect taxes, but it did not establish definitive guidelines for determining whether a new tax is direct or indirect. At the time of the adoption of the Constitution, it was established that poll taxes (or “capitation” taxes) and land taxes were direct taxes, but there was no formal mechanism for sorting a given tax into either category. Hence, though the authority of Congress to pass the carriage tax was never brought into question, what category the tax should be assigned was unclear.
In Hylton v. United States (1796), a suit was brought to collect a debt which was derived from the carriage tax. Hylton (the defendant in the original case) claimed that the carriage tax statute was unconstitutional. Hylton reasoned that the carriage tax was a direct tax and because the statute did not follow the rule of apportionment the tax had to be struck down under the Constitution. At the time of the suit, Hylton was in possession of 125 carriages.
The justices of the Supreme Court – who all wrote their own opinion of the case – determined that the carriage tax was an indirect tax and that, consequently, Hylton was liable for the debt. The justices decided that there was no compelling reason to suppose that the carriage tax fell within the meaning of a direct tax as understood by the framers of the Constitution. The framers understood that poll taxes and taxes on land were “direct” taxes; this classification had a basis in the conditions present among the states at that time. Although the carriage tax may have been superficially dissimilar from other indirect taxes in some ways, the justices could not find that this level of dissimilarity warranted classification as a direct tax.
Hylton entered the case with one critical disadvantage: the practical difficulties of apportioning the carriage tax by population were such that classifying the tax as a direct tax would have led to absurd results. Carriage ownership varied greatly from state to state, and so the carriage tax would have imposed an unfair burden on certain states if it were apportioned as a direct tax. The federal government would have been compelled to adopt new and unusual measures in order to artificially correct the unfair burden created by such a tax. The justices all concurred that the unfair results and practical difficulties of apportionment provided sufficient grounds for classification as an indirect tax.
Because the carriage tax was a tax on personal property, the Hylton decision came to the fore nearly one hundred years after it was made during the case of Pollock v. Farmers’ Loan & Trust Co. (1895). The Pollock case ruled that a tax on income from personal property (and real property) was a direct tax and must follow the rule of apportionment; this ruling effectively overturned the decision made in Hylton. Those who objected to the Pollock decision predicated their objection on the fact that the decision made the imposition of a federal income tax a near impossibility. Implementing a federal income tax which followed the apportionment rule would have been excessively burdensome for the federal government for a number of reasons. The sixteenth amendment was drafted in order to bypass the sort of practical difficulties associated with apportionment which was discussed in Hylton.
The phrase “the will of the people” has greater importance for Americans than it has for citizens of other states around the world. In large part, this stems from our deeply entrenched view of our system of government as a system which has developed entirely from the collective will of a free populace. The American public firmly believes that its governmental institutions are a direct extension of its collective will, a sort of living representation of its political voice. And to a good extent this view is accurate: our system has been informed by non-elite citizens to a considerably greater degree when compared with foreign systems across the globe. Though the history of these United States is much less egalitarian than most people care to appreciate, it is correct to say that the American project is more of a “popular” phenomenon than has been the case throughout most of history.
What most Americans do not realize, however, is that the will of the people can move society in any conceivable direction. Common perception tends to see the people’s collective will as an inherently benign force ceaselessly pushing our country in a way which maximizes our freedom and dispels injustice. But, as is often the case, common perception does not faithfully reflect reality. The will of the people is neither benign nor nefarious; it simply expresses whatever whims the people may have at a given moment. And if the people’s whims happen to push us toward less freedom or less justice – however that is defined – then that is precisely the direction we will be pushed in. Our constitution does not guarantee a certain quantum of freedom; as we learned in our prior installment, it provides that our lives may be encroached upon in any number of ways so long as the people’s will is expressed in the form of amendment.
This fact may come as a shock to many Americans. Our optimism tends to impart benevolent motives onto the public’s collective will in nearly every situation. What we have to understand, however, is that it makes little sense to ascribe any particular value to our collective will because our will can be shaped by just about any force imaginable – expediency, necessity, desire, passion. The sixteenth amendment did not simply address the practical difficulties associated with the apportionment requirement, it also expressed a public desire to ameliorate the widespread economic inequality which was present at the time of its passage. And it also enlarged the sovereignty of the federal government in relation to the states. It would be inaccurate to say that the results which followed the amendment were inherently just or proper; what is true is that these results were congruent with the collective sentiment of that era.
As we explore the sixteenth amendment in greater and greater detail, it is important for us to keep in mind that this amendment only represents the ability of our constitution to express the desires of the public, it is not an example of benevolent societal change.
In our next installment, we will discuss the case of Hylton v. United States (1796) and look at the impact that the ruling of this case had on the development of the sixteenth amendment.
In the next several installments of Huddleston Tax Weekly, we will discuss in great detail some of the controversies which were stirred by the sixteenth amendment. As we’ve noted in previous installments of HTC, the sixteenth amendment to the U.S. Constitution was an act of awesome importance. Through this amendment, the Congress was freed of the various constraints on its taxing power which had existed since the founding of the country. The original U.S. Constitution expressly gave Congress the power to tax, but it also set certain restrictions on this taxing power; excise (indirect) taxes had to be uniformly imposed, and direct taxes had to be properly apportioned among the several states. Prior to the sixteenth amendment, judicial opinions on tax law often dealt with determining whether a given tax should be classified as either direct or indirect. The sixteenth amendment removed the necessity of making such determinations.
The full text of the sixteenth amendment is as follows: “The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several states, and without regard to any census or enumeration.” Clearly, this amendment was directly responsive to a number of judicial decisions which, through their treatment of certain forms of taxation, had curtailed the taxing function of Congress. For instance, the Pollock case ruled that taxes on income derived from real property and personal property (such as stocks and bonds) were direct and therefore subject to the apportionment requirement. Pollock and other judicial opinions made the imposition of a federal income tax a practical – though not theoretical – impossibility. By removing the apportionment requirement, the sixteenth amendment made the implementation of such a tax an exceedingly simple matter.
The potential impact of the sixteenth amendment on state sovereignty was an issue immediately recognized by both the legal profession and the political establishment. Since it allowed Congress to collect taxes on incomes from any conceivable source, it apparently encompassed state securities; and by taxing state securities the Congress would be effectively lessening the power of the states in relation to the federal government. In his 1919 essay entitled “Power of Congress to Tax State Securities Under the Sixteenth Amendment,” Albert Ritchie argued that the amendment did not actually extend to state securities because the amendment was never intended to grant any new taxing powers to the Congress; the amendment was merely designed to consolidate Congress’ existing taxing powers, and since the power to tax state securities had historically been considered unconstitutional, and the authors of the amendment were themselves wary of the taxing of state securities, it follows that the amendment could not have granted a new power to tax state securities.
At the time of its publication, this essay by Mr. Ritchie must’ve had a great appeal. If taken solely on its words, the sixteenth amendment undoubtedly encompassed state securities, and it certainly raised the sovereignty of the federal government in relation to the states. But Mr. Ritchie’s reasoning involves looking behind the plain text of the amendment and considering the larger historical context in which this amendment was birthed. Given the conclusions to which it led, this reasoning certainly would’ve found plenty of open ears in 1919.
But Mr. Ritchie’s argument had at least one major weakness: it failed to recognize that the limited nature of state sovereignty has always been an established constitutional principle. As Mr. Harry Hubbard pointed out in his Harvard Law Review article entitled “The Sixteenth Amendment” in 1920, there is no constitutional basis for the notion that either the states or the federal government must have a certain degree of sovereignty. The Constitution provides that state sovereignty may be reduced if the people so desire with the power of amendment. The only principle which cannot be amended is the right of each state to have equal political representation. Thus, if the states choose to enlarge the role of the federal government through a constitutional amendment there is no higher authority which can be invoked to bar such a choice.
Mr. Hubbard argued that, given this reality, the sixteenth amendment was intended to cover state securities. The text did not need to specifically mention state securities in order to address any sort of historical trend against this type of taxation; if the amendment reduced state sovereignty simultaneously at the time that it consolidated Congress’ taxing power then this would have been a natural extension of the will of the people. We may like to suppose that, past a certain point, state sovereignty may not be encroached upon. But there is actually no constitutional foundation for this supposition. State sovereignty may be an ideal, but it is not unassailable and is very much subject to transformation depending on the whims of the public. In the end, the authors must have been aware of the amendment’s impact on state sovereignty, and it follows that any reduction in state sovereignty was fully permissible because these authors were merely acting as instruments of the people.
Nearly every legal concept presently in use in these United States has an established pedigree. Very few of our concepts are recent inventions. This observation holds true not just in one or two areas of law but for quite literally our entire legal edifice. Section 1031 is no exception to this rule. Section 1031 is derived from a number of earlier tax acts which addressed the non-recognition of gains (or losses) when real property held for business or investment purposes is exchanged for like-kind property. Today, courts utilize the judicial opinions made in previous eras which were informed by one of these earlier tax acts. The case of Mercantile Trust Co. v. Commissioner (1935) is among the most significant of these opinions.
As we will see, Mercantile Trust Co. set an important precedent for viewing complex real property exchange transactions. Like the parties in Alderson v. Commissioner, the parties of Mercantile Trust Co. engaged in a complex transaction which involved multiple independent contracts, the use of an intermediary and a cash payment as “boot” on top of the exchange. In its opinion, the court emphasized that non-recognition depends primarily on what actually occurred, rather than on the various methods and motives which ultimately led to the transaction. Simply because a contingency could have given rise to a sale – and therefore would have created a taxable gain – does not necessarily bar non-recognition; the most important fact is whether an exchange of like-kind property actually transpired.
The representatives for Mercantile Trust Co. (the petitioners) appealed a judgment for a tax deficiency arising from a transaction involving Mercantile Trust Co., an intermediary (known as Title Guarantee & Trust Co.) and Emerson Hotel Co. The Commissioner of Internal Revenue (the respondents) claimed that the transaction amounted to a sale and that the petitioners had a recognized gain of $179,621 (approximately $2,521,070.02 when adjusted for inflation in 2016). The petitioners argued that the transaction had been an exchange of real property of like-kind within the scope of existing statutory provisions.
Title Guarantee & Trust Co., the intermediary, developed separate contracts with Mercantile and Emerson. To conclude certain of these contracts Title Guarantee made cash payments to the other party, and to conclude other contracts Title Guarantee accepted cash payments. Mercantile Trust Co. ultimately received the deed to the property (known as Lexington Street) originally held by Emerson Hotel Co. as well as a total of $24,426.90 in cash. Emerson Hotel Co. received the deed to the property originally held by Mercantile Trust Co. (known as Baltimore Street). Title Guarantee received commissions and title fees which added up to $8,573.10.
The respondents assessed the tax deficiency on the premise that Mercantile Trust Co. acquired the Lexington Street property in a separate transaction which should be considered a sale. The question before the court was whether the evidence on record supported this premise.
The statutory provisions which applied to the case arose from section 112 of the Revenue Act of 1928. Section 112 (of the act of 1928) is the predecessor of section 1031 and includes many of the same provisions as the current law.
The court (the U.S. Tax Court, known as the Board of Tax Appeals in 1935) ruled in favor of the petitioners and declared that the deficiency assessed by the Commissioner was without basis. The Commissioner argued that what had occurred was a “fictitious” exchange and that the Lexington Street property was acquired by Mercantile Trust Co. in an independent sales transaction. The tax court rejected this argument. The contract made between Mercantile Trust Co. and Title Guarantee included a contingency whereby Title Guarantee would pay $300,000 in cash in the event that the deed to the Lexington Street property could not be transferred. The court determined that this contingency did not negate non-recognition treatment given that an exchange of like-kind property did occur.
The reasoning employed by the tax court in Mercantile Trust Co. influenced later decisions, including the decision made in Alderson. The determination of non-recognition treatment depends heavily on the end result and not as much on the methods used to reach that result.
Every real estate owner and investor should take the time to become acquainted with the elements of section 1031 of the Internal Revenue Code. This section allows taxpayers to defer recognition of either gain or loss when they exchange property of like-kind with another party. For any number of reasons, it may be wise for an owner or investor to exchange their property for another. Sans 1031, an exchange of real property would necessarily involve the realization of either gains or losses, and the management of such realization would require substantial investments of time and money. Section 1031 promotes a more open and free marketplace by eliminating the burdens which traditionally follow real estate sales.
Because of the heavy benefits it confers, section 1031 has rigid qualifications which are narrowly construed by courts. One case which illustrates the narrow reading of section 1031 qualifications is Starker v. United States (1977). As we will see, the plaintiff in this well-known case attempted to expand the construction of section 1031 so as to include a complex, multiyear financial transaction in which he took part. The court rejected the plaintiff’s attempt and set a precedent for a narrow construction of 1031.
Before hearing Starker, the court had just settled an earlier case, known was Starker I, which was heard in 1975 and involved the son and daughter-in-law of the plaintiff of the 1977 Starker case. The plaintiff’s son and daughter-in-law had also taken part in the same transaction which formed the basis for the suit of 1977; like the plaintiff, they tried to receive non-recognition of their capital gain under section 1031. The judge in Starker I concluded that the son and daughter-in-law correctly invoked section 1031 and were therefore entitled to a refund for taxes paid on the transaction. The next Starker case was heard by the same judge; this judge reconsidered his earlier decision and ruled against the plaintiff. As we’ve noted before, sometimes no amount of preparation can account for the whims of our magistrates.
The plaintiff transferred a very large amount of land – approximately 1,843 acres – to a company known as Crown Zellerbach Corporation. In return, the company created an “exchange value” balance on its books. To reduce the balance, the company was supposed to transfer a number of parcels of land to the plaintiff; as part of the agreement, these parcels did not need to be transferred all at the same time, but could be transferred one by one over the course of several years. Collectively, these parcels were supposed to be equal in value to the land given to the company by the plaintiff. The plaintiff also received a “growth factor,” which was interpreted as a type of interest by both the company and the court.
The plaintiff invoked section 1031 when filing the income tax return which included this transaction. The IRS denied this invocation and assessed a tax deficiency of $300,930.31 plus interest. The plaintiff then brought a suit to receive a refund.
The question before the court was whether the plaintiff was in fact entitled to non-recognition under section 1031 given the peculiar characteristics of his exchange.
Under section 1031 of the Internal Revenue Code, taxpayers are entitled to non-recognition of capital gains or losses which arise from the exchange of property of like-kind. The exchange must be reciprocal and involve a present transfer of ownership; it cannot involve a promise to transfer property in the future.
The court disallowed section 1031 and ruled in favor of the government. The court rested its decision on a number of factors. One factor was the element of time: the parties did not simultaneously exchange property of like-kind, but instead created a balance which was to be paid off incrementally over a period of time. And in the event that the parcels of land given to the plaintiff did not settle the balance after a period of five years, the agreement between the plaintiff and company held that the company would then transfer cash to cover the remainder. What’s more, two properties transferred by the company were not actually given directly to the plaintiff; the properties were given to the plaintiff’s daughter. And on another occasion, the plaintiff did not specifically receive the title to a property, but was given cash equal to the purchase price of the property along with the company’s right to acquire the property. These and other factors combined to provide a foundation on which the court made its decision to deny non-recognition treatment.
More than anything, our readers should use the Starker case to see the limited availability of section 1031. Where Starker applies, it can be an incredibly useful tool, but know that it only applies in scenarios which explicitly fall under its requirements.
In our upcoming installments, we will look at sections 1033 and 121 and highlight how these sections can also be of use to taxpayers.