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.

The IRS Does Not Believe You Made A Loan

The issue came up here at command center this past week. It is worth discussing, as the issue is repetitive and – if the IRS aims it your way – the results can be brutal.

We are talking about loans.

More specifically, loans to/from yourself and among companies you own.

What’s the big deal, right? It is all your money.

Yep, it’s your money. What it might not be, however, is a loan.

Let’s walk through the story of James Polvony.

In 1996 he joined his wife’s company, Archetone Limited (Limited) as a 49% owner. Limited was a general contractor.

In 2002 he started his own company, Povolny Group (PG). PG was a real estate brokerage.

The real estate market died in 2008. Povolny was looking for other sources of income.

He won a bid to build a hospital for the Algerian Ministry of Health.

He formed another company, Archetone International LLC (LLC), for this purpose.

The Algerian job required a bank guaranty. This created an issue, as the best he could obtain was a line of credit from Wells Fargo. He took that line of credit to a UK bank and got a guarantee, but he still had to collateralize the US bank. He did this by borrowing and moving monies around his three companies.

The Algerian government stopped paying him. Why? While the job was for the Algerian government, it was being funded by a non-Algerian third party. This third party wanted a cut of the action. Povolny did not go along, and – shockingly – progress payments, and then actual job progress, ceased.

The deal was put together using borrowed money, so things started unravelling quickly.

International was drowning. Povolny had Limited pay approximately $241,000 of International’s debts.

PG also loaned International and Limited approximately $70 grand. PG initially showed this amount as a loan, but PG amended its return to show the amount as “Cost of Goods Sold.”

COMMENT: PG was making money. Cost of goods sold is a deduction, whereas a loan is not, at least not until it becomes uncollectible. I can see the allure of another deduction on a profitable tax return. Still, to amend a return for this reason strikes me as aggressive.

Limited also deducted its $241 grand, not as cost-of-goods-sold but as a bad-debt deduction.

Let’s regroup here for a moment.

• Povolny moved approximately $311 grand among his companies, and
• He deducted the whole thing using one description or another.

This caught the IRS’ attention.

Why?

Because it matters how Polvony moved monies around.

A loan can result in a bad debt deduction.

A capital contribution cannot. Granted, you may have a capital loss somewhere down the road, but that loss happens when you finally shut down the company or otherwise dispose of your stock or ownership interest.

Timing is a BIG deal in this area.

If you want the IRS to respect your assertion of a loan, then be prepared to show the incidents of a loan, such as:

• A written note
• An interest rate
• A maturity date
• Repayment schedule
• Recourse if the debtor does not perform (think collateral)

Think of yourself as SunTrust or Fifth Third Bank making a loan and you will get the idea.

The Court made short work of Povolny:

·       The $241 thousand loan did not have a written note, no maturity date and no required interest payments.

·       Ditto for the $70 grand.

The Court did not find the commercially routine attributes of debt, so it decided that there was no debt.

Povolny was moving his own capital around.

He as much said so when he said that he “didn’t see the merit” in creating written notes, interest rates and repayment terms.

The Polvony case is not remarkable. It happens all the time. What it does, however, is to tentpole how important it is to follow commercially customary banking procedures when moving monies among related companies.

But is it all your money, isn’t it?

Yep, it is. Be lax and the IRS will take you at your word and figure you are just moving your own capital around.

And there is no bad debt deduction on capital.

Our case this time was Povolny Group, Incorporated et al v Commissioner, TC Memo 2018-37.

Blowing Up An IRA

I am not a fan of using retirement funds to address day-to-day financial stresses.

That is not to downplay financial stresses; it is instead to point out that using retirement funds too easily can open yet another set of problems.

Those who have followed me for a while know that I disapprove of using retirement funds to start a business: the so-called Rollovers as Business Startups, whose humorous acronym is ROBS. I know that – in a seminar setting – it is possible to mitigate the tax risks that ROBS pose. I do not however practice in a seminar setting. Heck, I am lucky if a client calls in advance to discuss whatever he/she is getting ready to do.

Let me give you a couple of ROBS pitfalls:

(1) You have your IRA buy a fourplex. You spend time cleaning, doing maintenance and repairs and routinely running to Home Depot.

Question: Is there a tax risk here?

(2) You have your IRA buy a business. You have your son and daughter run the business. You work there part-time and draw a paycheck.

Question: Is there a tax risk here?

The answer to both is yes. Consider:

(1) You are buying stuff at Home Depot, stuff that the IRA should have been buying - as the IRA owns the fourplex, not you. If you are over age 50, you can contribute $6,500 to the IRA annually. Say that you have already written that check for the year. You are now overfunding the IRA every time you go to Home Depot. Granted, one trip is not a big deal, but make routine trips – or incur a major repair – and the facts change. That triggers a 6% penalty – every year - until you take the money back out.

(2) There are restrictions on direct and indirect benefits from an IRA. You are receiving a paycheck from an asset the IRA owns. While arguable, I am confident that your paycheck is a prohibited benefit.

I am looking a Tax Court case where the taxpayer had her IRA lend $40,000 to her dad in 2005. A few years went by and she had the IRA lend $60,000 to a friend.

In 2013 she changed IRA custodians. The new custodian saw those two loans, and she had problems. Perhaps the custodian could not transfer the promissory notes. Perhaps there were no notes. Perhaps the custodian realized that a loan to one’s dad is not allowed. This part of the case is not clear.

COMMENT: It is possible to have an IRA lend money. I have a client who does so on a regular basis. Think however of acting like a bank, with due diligence, promissory notes, periodic interest and lending to nonrelated independent third-parties.

The IRS saw easy money:

(1)  There was a taxable distribution in 2013;

(2)  … and a 10% penalty for early distribution;

(3)  … and the “substantial understatement” penalty because the tax numbers changed enough to rise to the level of “substantial.”

How do you think it turned out for our tax protagonist?

Go back to the dates.

She loaned money to her dad in 2005.

Let’s glance over IRC Section 408(e)(2)

 (2)  Loss of exemption of account where employee engages in prohibited transaction.

(A)  In general. If, during any taxable year of the individual for whose benefit any individual retirement account is established, that individual or his beneficiary engages in any transaction prohibited by section 4975 with respect to such account, such account ceases to be an individual retirement account as of the first day of such taxable year.

The loan was a prohibited transaction. She blew up her IRA as of January 1, 2005. This means that she should have reported ALL of her IRA as taxable income in 2005, of which we can be quite sure she did not.

Can the IRS assess taxes for 2005?

Nope. Too many years have gone by. The standard statute of limitations for assessments is three years.

So, the IRS will tag her in 2013, right?

Nope, they cannot. For one thing, the prohibited transaction did not occur in 2013, and the IRS is not allowed to time-travel just because it serves their purpose.

But there is a bigger reason. Read the last part of Sec 408(e)(2) again.

There was no IRA in 2013. There could be no distribution, no 10% penalty, none of that, as “that” would require the existence of an IRA.

And there was no IRA.

The name of the case for the home gamers is Marks v Commissioner.

Vanguard's Whistleblower Tax Case

Can the IRS go after you for not making enough profit?

There is a whistleblower case against Vanguard, the mutual fund giant. Even though there is a tax angle, I had previously sidestepped the matter. Surely it must involve some mind-numbing arcana, and –anyway- why enable some ex-employee with a grudge? 

And then I saw a well-known University of Michigan tax professor supporting the tax issues in the whistleblower case.

Now I had to look into the matter.

My first reaction is that this case represents tax law gone wild. It happens. Sometimes tax law is like the person looking down at his/her cell phone and running into you in the hall. They are too self-absorbed to look up and get a clue.

What sets this up is the management company: Vanguard Group, Inc. (VGI). Take a look at other mutual fund companies and you will see that the management company is separately and independently owned from the mutual funds themselves.  The management company provides investment, financial and other services, and in turn it receives fees from the mutual funds.  

The management company receives fees irrespective of whether the funds are doing well or poorly. In addition, the ownership of the management company is likely different from the ownership of the funds. You can invest in the management company for T. Rowe Price (TROW), for example, even if you do not own any T. Rowe Price funds.

Vanguard however has a unique structure. Its management company – VGI – is owned by the funds themselves. Why? It goes back to Jack Bogle and the founding of Vanguard: he believed there was an inherent conflict of interest when a mutual fund is advised by a manager not motivated by the same financial interests as fund shareholders.  Since the management company and the funds are essentially one-and-the-same, there is little motivation for the management company to maximize its fees. This in turn has allowed Vanguard funds to provide some of the lowest internal costs in the industry

My first thought is that every mutual fund family should be run this way.

VGI and all the funds are C corporations under the tax Code. The funds themselves are more specialized and are “registered investment companies” under Subchapter M. Because the funds own VGI, the “transfer pricing” rules of IRC Section 482 apply.

COMMENT: The intent of Section 482 is to limit the ability of related companies to manipulate the prices they charge each other. Generally speaking, this Code section has not been an issue for practitioners like me, as we primarily serve entrepreneurs and their closely-held companies. This market tends to be heavily domestic and unlikely to include software development, patent or other activity which can easily be moved overseas and trigger transfer pricing concerns. 

Practitioners are however starting to see states pursue transfer pricing issues. Take Iowa, with its 12% corporate tax rate as an example. Let’s presume a multistate client with significant Iowa operations. Be assured that I would be looking to move profitability from Iowa to a lower taxed state. From Iowa’s perspective, this would be a transfer pricing issue. From my perspective it is common sense.

Section 482 wants to be sure that related entities are charging arm’s-length prices to each other. There are selected exceptions for less-than-arm’s-length prices, such as for providing routine, ministerial and administrative services. I suppose one could argue that the maintenance and preparation of investor statements might fit under this exception, but it is doubtful that the provision of investment advisory services would.  Those services involve highly skilled money managers, and are arguably far from routine and ministerial.

So VGI must arguably show a profit, at least for its advisory services. How much profit?

Now starts the nerds running into you in the hall while looking down at their cell phones.

We have to look at what other fund families are doing: Janus, Fidelity, Eaton Vance and so on. We know that Vanguard is unique, so we can anticipate that their management fees are going to be higher, potentially much higher. An analysis of Morningstar data indicates as much as 0.5 percent higher. It doesn’t sound like much, until you consider that Vanguard has approximately $3 trillion under management. Multiply any non-zero number by $3 trillion and you are talking real money.

It is an interesting argument, although it also appears that the IRS was not considering Vanguard’s fact pattern when it issued Regulations. Vanguard has been doing this for 40 years and the IRS has not concerned itself, so one could presume that there is a détente of sorts. Perhaps the IRS realized how absurd it would be to force the management company to charge more to millions of Vanguard investors.

That might attract the attention of Congress, for example, which already is not the biggest fan of the IRS as currently administrated.

Not to mention that since the IRS issued the Regulations, the IRS can change the Regulations.

And all that presumes that we are correctly interpreting an arcane area of tax law.

The whistleblower is a previous tax attorney with Vanguard, and he argues that Vanguard has been underpaying its income taxes by not charging its fund investors enough.

Think about that for a moment. Who is the winner in this Alice-in-Wonderland scenario?

The whistleblower says that he brought his concerns to the attention of his superiors (presumably tax attorneys themselves), arguing that the tax structure was illegal. They disagreed with him. He persisted until he was fired.

He did however attract the attention of the SEC, IRS and state of New York.

I had previously dismissed the whistleblower argument as a fevered interpretation of the transfer pricing rules and the tantrum of an ex-employee bent on retribution.  I must now reevaluate after tax law Professor Reuven S. Avi-Yonah has argued in favor of this case.

I am however reminded of my own experience. There is a trust tax provision that entered the Code in 1986. In the aughts I had a client with that tax issue. The IRS had not issued Regulations, 20 years later. The IRS had informally disclosed its internal position, however, and it was (of course) contrary to what my client wanted. I in turn disagreed with the IRS and believed they would lose if the position were litigated. I advised the client that taking the position was a concurrent decision to litigate and should be addressed as such.

I became extremely unpopular with the client. Even my partner was stressed to defend me. I was basing professional tax advice on chewing gum and candy wrappers, as there was nothing else to go on.

And eventually someone litigated the issue. The case was decided in 2014, twenty eight years after the law was passed. The taxpayer won.

Who is to say that Vanguard’s situation isn’t similar?

What does this tax guy think?

I preface by saying that I respect Professor Avi-Yonah, but I am having a very difficult time accepting the whistleblower argument. Vanguard investors own the Vanguard funds, and the funds in turn own the management company. I may not teach law at the University of Michigan, but I can extrapolate that Vanguard investors own the management company – albeit indirectly – and should be able to charge themselves whatever they want, subject to customary business-purpose principles. Since tax avoidance is not a principal purpose, Section 482 should not be sticking its nose under the tent.

Do you wonder why the IRS would even care? Any income not reported by the management company would be reported by fund investors. The Treasury gets its pound of flesh - except to the extent that the funds belong to retirement plans. Retirement plans do not pay taxes. On the other hand, retirement plan beneficiaries pay taxes when the plan finally distributes.  Treasury is not out any money; it just has to wait. Oh well.

It speaks volumes that someone can parse through the tax Code and arrive at a different conclusion. If fault exists, it lies with the tax Code, not with Vanguard.

Then why bring a whistleblower case? The IRS will pay a whistleblower up to 30% of any recovery, and there are analyses that the Vanguard management company could be on the hook for approximately $30 billion in taxes. Color me cynical, but I suspect that is the real reason.