Tuesday, March 31, 2009

Related-Party 1031 Using QI KO'd

In only the second Tax Court decision to interpret the related party rules for like-kind exchanges using a qualified intermediary (QI), an exchange was deemed to have been structured to avoid the related party rules, and to have tax avoidance as one of its principal purposes (Ocmulgee Fileds v. Comm'r, 132 T.C. No. 6 (March 31, 2009)).

In Ocmulgee, a Georgia corporation owned several shopping centers and office buildings; it arranged to sell one low-basis appreciated shopping center to an unrelated party. The corporation intended to carry out the transaction as a like-kind exchange. It began hunting for sutiable replacement property, but was unable to locate an acceptable replacement other than a parcel (the "replacement property") which the corporation had previosuly sold to a related party (an LLC). The replacement property was part of three contiguous parcels; the corporation already owned the other two. Perhaps not coincidentally, the LLC had a relatively high basis in the replacement property.

To carry out the transaction, the corporation transferred the shopping center to a QI, which sold it, using the proceeds to purchase the replacement property from the LLC. The LLC reported the disposition of the replacement property as a sale, paying tax on the gain. The QI then transferred the replacement property to the corporation. Functionally this was no different from the related parties swapping properties, followed by the LLC immediately selling the property it received in the exchange. Had the transaction been structured without the use of a QI, it would have run afoul of Code Sec. 1031(f)(1).

Although this is not the first time a taxpayer has attempted to use a QI to in essence swap low basis property (“relinquished property”) for high basis property (“replacement property”) with a related party (see Teruya Brothers et. al. v. Comm’r, 124 TC 45 (2005)), what made this case interesting was that the taxpayer argued that there were important non-tax considerations for the exchange. This included the seemingly logical desire to reunite ownership of the replacement property with the two adjacent parcels the corporation already owned. Moreover, the corporation offered proof that an exchange with a related party didn't drive the transaction; the corporation intended to dispose of the shopping center and find suitable replacement property from an unrelated third party. It only entered into an exchange with the LLC when appropriate replacement property could not be located.

While the Tax Court questioned the factual and logical integrity of some of the corporation’s arguments, the following language from the decision confirms that even being able to prove an independent business motive is inadequate to circumvent Code Sec. 1031 (f)(2) and (4) when a principal purpose is tax avoidance:

“ [E]ven had petitioner shown a legitimate business purpose for the acquisition of the replacement property], that would not necessarily preclude a finding that either the deemed exchange of [the relinquished property] for the [replacement property] or [the related party’s] deemed sale of [the relinquished property] had as a principal purpose the avoidance of Federal income tax."

The language shows that the standard is “a” principal purpose, not “the” principal purpose. When a taxpayer has dual motives or objectives, any one of which is tax avoidance, the like-kind related party rules will be invoked, and use of a QI will not cure the problem.

As to the issue of intent at the time that an agreement is reached to dispose of the relinquished property, Ocmulgee provides a judicial explication of the analysis in Letter Ruling 9748006, issued in 1997. In the PLR the Service concluded that not having an intent to engage in a related-party exchange from the outset did not negate the transaction from being deemed to have tax avoidance as a principal purpose; the use of a QI in the PLR, as in Ocmulgee and Teruya, failed to save the day.

Thursday, March 26, 2009

Is the First Circuit Backing Off its Taxpayer-Friendly Stance

Workpapers Privileged Ren't They–

Back in January, the First Circuit Court of Appeals dealt the IRS a blow when it decided that Textron did not have to disclose documents it used to calculate its tax reserve. Now, the Appeals Court has agreed to rehear the issue.

The IRS had subpoenaed the documents because it discovered that Textron had participated in several Sale in/Lease out (SILO) transactions. The documents listed the various controversial positions that the company had taken on its tax returns and calculated the amount of additional tax that would result if the positions were disallowed after an audit and/or litigation. The documents also rated the different positions’ likelihood of success (that would tell a litigator which positions to give up on and which positions to hold on to when negotiating a settlement).

Despite establishing its case for enforcing the summonses, the IRS was denied access to the corporation's tax accrual work papers because they were protected by the work product privilege. The First Circuit concluded that documents prepared for alternative dispute resolution purposes (such as an audit or administrative appeal) could qualify for the work product privilege because they were prepared “because of litigation” and the company’s use of the documents for other purposes did not vitiate the privilege. However, since the company had shown the documents to its outside auditor, the case was remanded to see if the auditor’s work papers could be obtained and if those documents would disclose the company’s tax accrual positions.

The District Court had found that disclosing the documents to an outside auditor did not vitiate the privilege either, since it did not make their disclosure to the IRS more likely. However, some would argue that any disclosure would vitiate the privilege – More to come-

Who Profits from New Markets?

The new markets tax credit (NMTC) was introduced in 2000 as a vehicle to stimulate investment in qualified low-income communities. It’s a credit on equity investment claimed over a 7-year period (5 percent over the first 3 years and 6 percent over the next 4 ). A "low-income community" is basically a census tract with a poverty rate of at least 20%, or with median income of up to 80% of the area or statewide median, whichever is greater.

The NMTC is allowed for a percentage of a qualified equity investment in a qualified community development entity (CDE). A CDE is a domestic corporation of partnership, certified by the Dept. of Treasury, which is organized to provide investment capital for low-income communities or persons and which allows residents of the community to be represented on the entity’s governing board.

At its best, NMTC provides an important tool in the development of low-income housing and retail facilities in areas where both are needed. But as with every deduction or credit, the potential for abuse exists. And so it is perhaps no surprise that with a minimal investment of time, we found some NMTC projects which raised our (high-arched, well tweezed) eyebrows. We’re not saying these projects are abusing NMTCs, but we are wondering if this is what was really intended. We’ve also come up with a few suggestions which might help to curb any potential abuses.

White Stag Building Redevelopment is a project in the Old Town China Town part of downtown Portland, OR built with a $28.5 million NMTC allocation. It consists of three historic buildings, all of which were built before 1910. The White Stag building, named for former tenant White Stag clothing, had been vacant for many years. It’s connected to the Bickel and Skidmore buildings which now form a single complex. It houses several University of Oregon programs, as well as United Fund Advisors, which describes itself as providing “a broad suite of traditional and innovative investment banking services that provide triple bottom line returns to our client partners.” United Fund Advisors is involved with 10 NMTC projects.

What White Stag doesn’t house are low-income families, retail operations at which low income families shop, or significant employment for low income workers. The Univeristy describes the space it is occupying in the building as including “six classrooms, new event space for up to 250 people, a new library for architecture and journalism programs, a shared computer laboratory, and a new university book store and Duck Shop, which will also feature a cafĂ©.” Yes, the building is green (it has a Leadership in Energy and Environmental Design Gold Certifcation), has won design awards and certainly spiffs up a blighted part of the city, but are we convinced that this really meshes with the true objectives of the NMTC?

Liberty Station is a mixed-use residential and commerical project located at the former Naval Training Center in San Diego built with a more than $14 million NMTC allocation. Even in the current economic climate, prices of Liberty Station townhomes and single family homes generally range from $500,000 (for approximately 1,000 sf of living space) to in excess of $1 million. Liberty Station has more than 170,000 square feet of retail shops, grocery stores (Trader Joe’s, Vons), no fewer than 11 beauty and wellness merchants, 19 fast food and fine dining restaurants, and office space. It has two hotels, a golf course, and a waterfront park. It may provide some employment to displaced workers, but what it doesn’t have is low income housing or retail establishments geared to low income individuals.

Indeed, the city of San Diego requires redevelopment areas to reserve 15 percent of homes for people of low and moderate in­comes, or else provide twice that amount of affordable housing elsewhere. However, Liberty Station contains no afford­ably priced homes, so the redevelopment agency was required to set aside tax revenue to provide housing elsewhere in the city for the kinds of people the NMTC was supposed to be assisting. (see: www.sandiego.gov/ntc/housing/affordable.shtml).

It would appear that the only way this sort of project, located in an otherwise upscale neighborhood of prime real estate, would qualify for NMTC would be based on census figures which used the former military base residents in computing income for the area. We’re not aware of anything which requires that census figures be modified for redevelopment on former army and navy bases, and that may be a rather disturbing blind spot in the law. Excluding the median income of former military personnel from closed army bases would certainly seemed to be called for in light of the desirable locations of several of these closed bases.

The Sheraton Duluth Hotel in Duluth, MN was built with a $16.5 million NMTC allocation. It includes a 147 guest room hotel on 6 floors, on top of which the plans call for 35 market rate condominiums, and an adjoining Plaza ballroom for the hotel adjacent to the Greysolon Plaza senior housing project. So what exactly did the community gain for the $16.5 million? Well, a pretty hotel which will form part of a larger complex which may revitalize a part of downtown, arguably 83 permanent jobs (though there’s no indication these are only going to low income workers) and renovation of 150 existing units of senior housing. Oh, and the hotel will offer discount rooms for visiting doctors. But there appears to be no non-senior low income housing, and no low income community retail.

Without some demonstrable enhancement of housing or retail for low income communities it is questionable whether this kind of project should be authorized. Overall, NMTCs should require something beyond general revitalization, and its potential handmaiden—gentrification-- of downtown areas.

We’d like to identify other projects which are benefiting from NMTC allocations, particularly closed bases, to gain a better understanding of, and insight into, the issues before recommending concrete action. And if we’re wrong about all this, or missing some important benefits which projects like the ones described above provide- we want to hear that too!

Tuesday, March 24, 2009

The Law That Dares Not Speak Its Name: Gay Marriage and Taxes

As the Supreme Court of California ponders the validity of Prop 8, let's take a moment and contemplate the variety of tax issues which gay marriage presents, particularly in community property jurisdicitions such as California. Last summer, in the window between the In re MARRIAGE CASES decision, and the passing of Prop 8, approximately 18,000 gay marriages were solemnized in California. In many California counties marriage license applications were amended to denominate the applicants as "Party A" and "Party B" instead of "bride" and "groom." Thus, let's call these A/B marriages for brevity's sake, and refer to husband/wife unions as X/Y marriages.

Had Prop 8 not halted A/B marriages, the anticipated numbers of gay people marrying in California would have been impressive. The Williams Institute at UCLA School of Law estimates that there are 102,639 same-sex couples living in California; 51,319 of those are couples who were projected to marry in the next three years. In addition, it was anticipated that approximately 67,513 same-sex couples from other states would come to California to marry. That means that in just the next three years there might have been more than 230,000 taxpayers impacted by the outcome of In re MARRIAGE CASES.

At the federal level, the Defense of Marriage Act (DOMA) prohibits the recognition of such marriages by any federal agencies, including the IRS. This means that while for California purposes A/B couples incur the tax benefits and burdens of other married couples, they are treated as two unrelated individuals on their federal 1040. What concerns us is that in the "Defense of Marriage" politicians are allowing social policy to trump economic reality, triggering several tax anomalies.

For example, A/B couples are not subject to Code Secs. 267, 318, 1239, and 1041 despite standing in a marital relationship. From a strictly economic viewpoint the advantage of not being tagged with attribution, or being able to sell property at a loss to one's spouse, might mitigate or eclipse the disadvantages of not being able to file a joint return. But regardless of one's political leanings, the refusal to recognize A/B couples as an economic unit is sheer tax folly.

DOMA's tampering with family relationships extends beyond the A/B couple themselves. The basic rule in California is that a child born during a marriage and up to 300 days thereafter is presumed to be a child of both spouses and no adoption is necessary. But if the IRS and other federal agencies don’t recognize the marriage, will adoption be necessary for federal purposes? If no such adoption takes place then how will Code Secs. 267, 318, and 1239 apply to such family relationships? Will such child be considered a child of the taxpayer, and therefore a dependent, under Code Sec.152(c)(2)(A)?

Moreover, in refusing to recognize the legitimacy of a marriage contracted in California, the IRS is also negating the character of property held by A/B spouses as community property. This impinges on the bedrock U.S. Supreme Court doctrine that property rights are characterized under state law. The IRM at states:

"Federal law determines how property is taxed, but state law determines whether, and to what extent, a taxpayer has "property" or "rights to property" subject to taxation. Aquilino v. United States, 363 U.S. 509 (1960); Morgan v. Commissioner, 309 U.S. 78 (1940). Accordingly, federal tax is assessed and collected based upon a taxpayer's state created rights and interest in property. "

DOMA therefore directly conflicts with prior Supreme Court precedent and IRS policy. How will this play out? Will only ½ of community property be liable for the tax debts incurred by one spouse, contrary to how such property is treated in X/Y marriages? To which property will a federal tax lien of a debtor spouse in an A/B couple attach? Will such community property be considered joint tenancy property for federal purposes including inheritance? Tenancy-in-common property? Interestingly here’s what the IRM (at says about community property and perhaps illustrates the contradictions in applying the DOMA statute to property owned by A/B couples:

"[t]he natural inclination to think in terms of "his" and "hers" must be discarded with regard to community property. It is inaccurate to refer to community property acquired by the wife as "the wife's income" or to community property acquired by the husband as "the husband's income." These terms have no meaning under community property law and instead reflect the inappropriate application of common law principles. Community property is simply property that both spouses share equally, just as partnership income is income that all partners share equally, regardless of which partner was responsible for acquiring the income on behalf of the partnership. "

Finally, there is another issue we've been pondering. We tend to employ imprecise phrases like “same-sex” marriage, and therefore assume we can categorize a marriage as either same-sex or not. It is actually far more complicated. In the past driver’s license records, as a practical matter, were used to make a determination of sex for purposes of marriage. Thus the state has historically functioned as kind of a “gatekeeper” in not permitting A/B marriages. This is a determination the Feds have relied on and virtually never questioned. But once California allowed gay marriage it no longer considered the sex shown on a driver’s license; it allowed marriage between any two of-age unmarried persons. California did not record whether such marriage was “same-sex.”

With the state not functioning as the “gatekeeper” who will determine whether a marriage is a same-sex marriage for purposes of the federal DOMA statute, IRS definitions etc? Is the IRS going to become the “sex police”, rendering determinations on audit about whether the marriage is of people of the same sex? What documents and standards will be used to determine the sex of the individuals in the marriage? We assume it won’t be driver’s licenses. Are Social Security records going to be used exclusively?

There may be many cases of “civil disobedience” with A/B couples filing joint federal returns. When a joint return is filed by any married couple (X/Y or A/B) will their Social Security #s now be automatically run through the Social Security database to determine whether it is filed by two individuals which Social Security shows are of the same sex?

Regardless of whether you support or oppose gay marriage the tax issues are real, and the answers aren't easy. But sane economic policy, and not personal politics, ought to be paramount in implementing the Code.

Monday, March 23, 2009

COBRA Premium Assistance - A Snake in the Grass?

The new COBRA premium assistance provision may prove to be a snake in the grass for many businesses. For the balance of 2009, involuntarily-terminated employees eligible for COBRA continuation coverage will pay only 35% of their COBRA premiums. The employer is obligated to front the remaining 65%. The employer doesn't really go out-of-pocket for such cost, however, because it's entitled to claim a credit on its payroll tax returns. If the COBRA obligation is in excess of its payroll liability, Code Sec. 6432(c)(1) provides “the Secretary shall credit or refund such excess in the same manner as if it were an overpayment of such taxes.”

This is supposed to be about the government subsidizing the cost of health insurance for the swelling ranks of the newly unemployed who would otherwise be unable to afford such coverage. Instead of making the Fed deal with insurance companies directly, the premium subsidy is channeled through the employer. Such administrative efficiency was meant to provide a mechanism for premium payments without significant increase in the employer’s cost.

But a benefit to the terminated employee might wind up causing a venomous bite to the employer. It should be no surprise that a startling number of employers (especially employers now laying off employees) owe back employment taxes. And the above-quoted language suggests that the new COBRA provision can be used as a back door mechanism for collecting these taxes instead of refunding the excess premium to the employer.

Imagine the shock to an employer already struggling with cash flow challenges, now having to pay the 65% COBRA premium, and then discovering that instead of a credit and reimbursement, the reimbursement portion has been applied to oustanding employment taxes for prior quarters. Yes, the employer owed the back taxes, but it never expected to pay the obligation this way.

Employers pyramiding their employment tax liabilities aren't likely to be offering health insurance and, even if they were, aren't apt to comply with their obligation to pay 65% of the COBRA premium. But what of the tens of thousands of small and mid-size businesses who offer health insurance, fall under COBRA, need to lay off workers and happen to owe some back employment taxes? Many of them are on installment agreements and keeping current in their obligations. Yet even they stand to forfeit all or a part of the refund for premium payments in excess of the credit claimed on their payroll tax returns.

Small employer statistics confirm that the potential problem is significant. Sixty two percent of small firms (3–199 workers) offered health insurance benefits in 2008; for the smallest firms bound by COBRA (25 to 49 workers), approximately 90% offered such benefits. Covered workers on average contribute 16% of the premium for single coverage, and 27% of the premium for family coverage (source: The Kaiser Family Foundation and Health Research and Educational Trust 2008 Annual Survey).

While historically the percentage of employees leaving such firms and electing COBRA continuation coverage has been relatively small (29%), this no doubt is a function of having to pay 102% of the full premium to continue coverage. With ARRA now reducing the premium during 2009 to 35%, there will almost certainly be an increase in the percentage of terminated employees electing COBRA coverage. This, in turn, has the potential to spell disaster for any firm caught unaware that the amount it expects to have refunded will instead be applied to past employment tax obligations.

Unfortunately, the Service doesn't seem anxious to mitigate the potential nightmare; in fact, it appears to be exploiting it. Its just-updated “COBRA Questions and Answers: Form Preparation” confirms the worst:

“If an employer with unpaid employment or income taxes claims a credit on Line 12a of Form 941 for the amount of COBRA premium assistance provided during the quarter, and the amount of the credit exceeds the amount of payroll tax liabilities shown on Form 941, the IRS will offset the other unpaid taxes against the balance due before refunding any balance. In this case, the IRS will notify the employer of the offset.”

This is dirty pool. Under these circumstances the Service should not grab refunds from any employer staying current and honoring its installment agreement. And if the Service is allowed to grab the payment, the employer should at least be allowed to treat it as a voluntary payment and designate that it be applied to trust fund taxes.

In any event, careful tax planning is required. At a minimum an employer owing back taxes may want to have a modified 433 at the ready, reflecting the out-of-pocket COBRA expense, loss of reimbursement dollars, and need for a reduced installment payment. Selling the business for fair market value to a new entity (which may be owned by the former owners of the employer) is another option, but such strategy should only be implemented with extreme care to ensure that the transfer satisfies all requirements of law (from license transfers to obtaining new worker’s comp and so forth), isn't a fraudulent conveyance, and doesn't trigger successor liability.

Spotting the problem is an important first step in working around it, but there are bound to be further developments in the coming days and weeks. Watch this space and get the lowdown on how this all shakes out.