A Like-Kind Exchange To Avoid Tax

 

Let’s talk about like-kind exchanges.

A key point is - if done correctly - it is a means to exchange real estate without immediate tax consequence.

There was a time when one could exchange either personal property or real property and still qualify under the tax-deferral umbrella of a like-kind exchange. Congress removed the personal property option several years ago, so like-kinds today refer only to real estate.

The Code section for like-kinds is 1031, but today let’s focus on Section 1031(f):

(f) Special rules for exchanges between related persons

(1) In general If—

(A) a taxpayer exchanges property with a related person,

(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C) before the date 2 years after the date of the last transfer which was part of such exchange—

(i)  the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2) Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—

(A) after the earlier of the death of the taxpayer or the death of the related person,

(B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

(3) Related person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

(4) Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

This verbiage came into the tax Code in 1989.

What is the issue here?

Let’s use an easy example:

CTG owns a hotel building worth $1 million. Its adjusted basis is $175,00.

CTG II owns a warehouse worth $1 million and an adjusted basis of $940,000.

If CTG sells its building, the gain is $825,000 ($1 million minus 175,000).

If CTG II sells its building, the gain is $60,000 ($1 million minus 940,000).

Say that someone wants to buy CTG’s hotel. Can we beat down that $825,000 gain?

What if we have CTG and CTG II swap buildings? CTG Jr would then own the hotel but keep its $940,000 adjusted basis. CTG II would then sell the hotel at a gain of $60,000.

Yeah, no. Congress already thought of that.

You better wait at least two years before the (second) sale, otherwise you have smashed right into Section 1031(f)(1)(C). The Code then says that- unless you can sweet talk the IRS - there was never a like-kind exchange. You instead have taxable income. Thanks for playing.

Let’s look at the Teruya Brothers case.

This case requires us to determine whether two like-kind exchanges involving related parties qualify for nonrecognition treatment under 26 U.S.C. § 1031.

This appeal concerns the tax treatment of real estate transactions involving two of Teruya's properties, the Ocean Vista condominium complex (“Ocean Vista”), and the Royal Towers Apartment building (“Royal Towers”).

We will look at the Ocean Vista (OV) transaction only.

Someone wanted to buy OV.

Teruya was initially not interested. It relented – IF it could structure the deal as a Section 1031 like-kind exchange.

So far this is relatively commonplace.

Teruya wanted to buy property from Times Super Market (Times) as the replacement.

Issue: Teruya owned 62.5% of Times.

The gain (which Teruya was trying to defer) was in excess of $1.3 million.

Teruya exchanged and filed its tax return accordingly.

The IRS balked.

The IRS argued that Teruya went foul of Section 1031(f)’s “established to the satisfaction” and “structured to avoid” prohibitions.

Teruya argued that the IRS was making no sense: Times reported the gain on its tax return. It had no deferred gain from the like-kind exchange. Who would structure a transaction to avoid tax when one of the parties reported gain?

On first impression, the argument makes sense.

The Court noted that Times had a net operating loss that wiped out the gain from the sale. There was no tax.

Teruya had a problem. It sold the property within two years, meaning that the IRS had a chance to challenge. The IRS challenged, both under Section 1031(f)(2)(C) and (f)(4).

Here is the Court:

We conclude that these transactions were structured to avoid the purposes of Section 1031(f).

Teruya lost.

Teruya went into this transaction in 1995, when Section 1031(f) was relatively new. There would not have been much case law on working and planning with this Code section.

Teruya provided practitioners some of that case law. 

We now know that an advisor must expand his/her perspective beyond just the Section 1031 exchange and consider other tax attributes sitting on the tax returns of the related parties.

And sales within two years are courting death.

Dodge that and Section 1031(f)(4) might still nab you.

Our case this time was Teruya Brothers, LTD v Commissioner, 124 TC No. 4.

FICA’s Special Timing Rule

 

I do not often read ERISA cases.

ERISA deals with employee retirement plans and refers to federal law: Employee Retirement and Security Act. It is old law (1974), and provides protection for individuals enrolled in private retirement and health plans. It can be as abstruse as the tax Code, and as difficult to follow. It is more in the purview of retirement specialists and not so much that of a general tax practitioner.

What made me think about it was a reference to the Henkel case from 2015.

Henkel involved a top hat plan for selected management and other highly compensated employees. The idea behind a top hat is to provide benefits in excess of those available to employees through regular plans (think 401(k), cafeteria plans and the like.) Top hats are mostly exempt from ERISA because of that select group of covered employees, You and I are unlikely to ever be enrolled in a top hat plan.

In Henkel, select employees were covered by a nonqualified deferred compensation plan. After benefits began, the company (Henkel Corporation) reduced the monthly benefits for federal tax withholding. ERISA has restrictions on reducing someone’s benefits – hence the litigation.

The federal withholding was FICA.

There is an odd rule in the tax Code for FICA taxation of deferred compensation. What sets it up is the income taxation of the deferred compensation itself.

Generally speaking, deferred compensation will include some kind of qualifying event. For example, say that an executive is entitled to 1% of his/her 2025 division profits as compensation, payable in 2028. To be entitled to the bonus, the executive must remain employed with the company through December 31, 2026.

It is that condition subsequent that makes the income taxation tick. It would be unfair to tax the executive in 2025, as he/she may never receive a dime if they are not employed through December 2026. Let’s say that they are employed through December 2026. It would still be unfair to subject the bonus to income taxation in 2026, as there is no cash until 2028. In general (and a big general at that) the tax Code will slow the income tax horses until 2028.

But this is compensation, meaning that there will also be FICA tax due.

When is that tax due?

A reasonable person would expect the FICA and income tax to lock arms and be due at the same time.

A reasonable person would be wrong.

FICA tax will be due at the later of:

The date the employee performs the services causing the deferred compensation (in our case, 2025), or

The date on which the employee is no longer subject to a substantial risk of forfeiting the deferred compensation (in our case, 2026).

Our executive would be subject to FICA tax in 2026.

What about concern for having cash to pay the tax?

It does not appear to apply to the FICA tax, only to income tax.

In practice, this is rarely as big an issue as it may first appear. FICA is divided into two parts: the old age (which is 6.2%) and Medicare (which is 1.45%). The old age (the acronym is OASDI) cuts off at a certain dollar amount. Medicare does not cut off. Odds are that someone in a top hat plan is well over the OASDI limit (meaning no old age tax), leaving only Medicare. 

It is unlikely that one is going to do a lot of tax planning for 1.45%.

This FICA trigger is called the “special timing rule.”

There is an upside to the special timing rule, and it depends on how the deferred compensation is determined.

If one can flat-out calculate the deferred compensation (in our case, 1% of division profits), the plan is referred to as an account balance plan. Granted, one can add interest or whatever to it to allow for the passage of intervening years, but one can calculate the beginning number.

If one pays FICA on an account balance plan under the special timing rule, there is no additional FICA when the plan finally pays out. This means that interest (for example) added to the beginning number is never subject to FICA.

Sweet.

Switch this over to a nonaccount balance plan and FICA can change. FICA is calculated on the actual distribution, but one is given credit for FICA previously paid under the special timing rule. In this case, one would pay FICA on the interest added to the beginning number.

There are also different ways to calculate the FICA under the special timing rule: the estimated method, the lag method, the administrative convenience method and so on.

Throw all the above in a bag, shake thoroughly, and that is how we got the Henkel case. How can the benefits go down? Take a nonaccount balance plan, with FICA being paid later rather earlier.

Is it a reduction in benefits?

Yes and no. It is technically a reduction if one was not thinking about the FICA.

It is not however a reduction for purposes of ERISA.

Our case this time was Davidson v Henkel, USDC, Eastern District of Michigan Southern Division, Case No. 12-cv-14103.