In the article that appeared in last month’s blog, I indicated that we utilize a structure that avoids the taxing authorities’ challenges to “drop and swap” transactions and, instead, that is structured to comply with an Internal Revenue Code provision and the Treasury Regulations. The transaction is known as a “partnership division” and this article will describe how and why it is a safer alternative compared to a drop and swap structure.
To understand these transactions, assume that ABC Partnership is owned by Ann, Bob, and Cindy such that each has a 33-1/3% interest in the partnership’s capital and profits. The partnership has owned an apartment building for ten years and is in escrow to sell the building. If the partnership sold the apartment building, it would easily qualify as a Section 1031 exchange. However, Ann, Bob, and Cindy would each like to do a separate IRC Section 1031 exchange with their share of the proceeds.
In the classic drop and swap transaction, ABC Partnership, a few days before the closing (or maybe even on the day of the closing), conveys 33-1/3% tenancy-in-common interests in the apartment building to Ann, Bob, and Cindy and the three individuals complete the sales of their 33-1/3% tenancy-in-common interests in separate transactions using an IRC Section 1031 qualified intermediary.
Based on various theories, the California Franchise Tax Board disallows this type of transaction. In almost all cases, the newly-organized California Office of Tax Appeals has taken the Franchise Tax Board’s position. As a general matter, the issue is whether Alice, Bob, and Cindy held their tenancy-in-common interests for use in their trade or business or for investment, which would make the transactions eligible for Section 1031 treatment, or whether they held such tenancy-in-common interests for sale, which would not meet the Section 1031 exchange requirements.
Now, let’s look at a partnership division as an alternative to the drop and swap structure. The partnership provisions of the Internal Revenue Code and the related Treasury Regulations describe how a partnership can be divided into one or more additional partnerships, and if certain requirements are met, each divided partnership will succeed to the tax attributes of its parent. (The same rules apply to limited liability companies that are taxed as partnerships.) In this context, the relevant tax attribute is that if the parent is otherwise eligible for Section 1031 exchange treatment in connection with its disposition of real property, then the divided partnerships, to the same extent, will also be eligible for Section 1031 exchange treatment on their dispositions.
The critical requirement that permits newly-created entities to succeed to their parent’s tax attributes is this: Each new partnership must consist of partners who owned more than 50% of the capital and profits in the parent partnership regardless of their percentage ownership interests in the capital and profits in the new partnership or new partnerships.
Here is how we would divide ABC Partnership to permit Alice, Bob, and Cindy, more or less, to undertake separate Section 1031 exchange transactions.
- On the eve of the closing of the sale of its apartment building, ABC Partnership forms three subsidiary LLCs, LLC 1, LLC 2, and LLC 3, and is the initial manager and member of these LLCs.
- ABC Partnership deeds a 33-1/3% tenancy-in-common interest in the apartment building to each of LLC 1, LLC 2, and LLC 3.
- Pursuant to a document that we call a Division Agreement, ABC Partnership does the following:
- ABC Partnership assigns the membership interest in LLC 1, 95% to Alice, 2-1/2% to Bob, and 2-1/2% to Cindy.
- ABC Partnership assigns the membership interest in LLC 2, 95% to Bob, 2-1/2% to Alice, and 2-1/2% to Cindy.
- ABC Partnership assigns the membership interest in LLC 3, 95% to Cindy, 2-1/2% to Alice, and 2-1/2% to Bob.
- Each new LLC, when owned by Alice, Bob, and Cindy, is owned by partners who owned more than 50% of the capital and profits in ABC Partnership even though they own different percentages in LLC 1, LLC 2, and LLC 3. This structure makes each new LLC a successor to the tax attributes of ABC Partnership.
- Each of LLC 1, LLC 2, and LLC 3 completes a separate Section 1031 exchange.
The reader is probably thinking: But Alice, Bob, and Cindy are not really doing separate exchanges and the reader is correct. Each of LLC 1, LLC 2, and LLC 3 has a minority member who must receive allocations of profits and losses and distributions of cash. But our clients think that is a small price to pay, especially when the deferred gain is tens of millions of dollars, and they are all similarly situated.
The reader is also thinking: Is the majority member married to the minority members forever? The short answer is No.
We utilize a separate agreement that provides that at least 24 months after the last replacement property is acquired, the minority members, for a period of three months, have the option to put their interest to the majority member at fair market value and the majority member is required to purchase the interests of the minority members.
If the minority members do not exercise their put option right during the three-month period, then the majority member, for the succeeding three months, has the option to call the interest of the minority members, also at fair market value, and the minority members are required to sell their interests to the majority member.
Yes, the sales are taxable to the minority members, but, as stated above, the tax is a small price to pay in order to obtain the benefits of a partnership division.
This article was originally published in Genesis Bank's "Insights" newsletter.
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