partnership exchanges after tax reform: structuring drop...

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Partnership Exchanges After Tax Reform:

Structuring "Drop and Swap" and

"Mixing Bowl" TransactionsMinimizing the Risk of an Unfavorable Audit Outcome; Impact of Tax Reform on Structuring Transactions

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

WEDNESDAY, FEBRUARY 27, 2019

Presenting a live 90-minute webinar with interactive Q&A

Professor Bradley T. Borden, Professor of Law, Brooklyn Law School, Brooklyn, N.Y.

Marie C. Flavin, Senior Vice President/Northeast Regional Manager, Investment Property Exchange Services, Armonk, N.Y.

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Partnership Exchanges After Tax Reform: Structuring "Drop and Swap" and "Mixing Bowl" Transactions

BRADLEY T. BORDEN

MARIE C. FLAVIN

5Bradley T. Borden

Speaker Bios

Bradley T. Borden• Bradley T. Borden. Brad is a Professor of Law at

Brooklyn Law School. He teaches Federal Income Taxation, Partnership Taxation, Taxation of Real Estate Transactions, and Unincorporated Business Organizations. Before entering the legal academy, he practiced law at Oppenheimer, Blend, Harrison & Tate, Inc., in San Antonio, Texas. He also frequently works as an expert witness or consultant in cases related to partnership and real estate taxation and other aspects of partnerships and LLCs. He is the author of numerous articles and books on topics related to section 1031 and frequently speaks at professional conferences on section 1031. He is a past chair of the ABA Tax Section Sales, Exchanges & Basis Committee and is licensed to practice law in New York and Texas and is as CPA.

• [email protected]

Marie C. Flavin • Marie C. Flavin, Esq., Senior Vice President and

Northeast Regional Manager of Investment Property Exchange Services, Inc. (IPX), is a member of the New York and Connecticut Bars, and has been practicing real estate law since 1992. Marie has been specializing in 1031 exchanges with IPX since 1999. In her position as Northeast Regional Manager of Investment Property Exchange Services, Marie frequently lectures and writes articles on IRC § 1031 tax deferred exchanges. Marie teaches Continuing Legal Education and Continuing Professional Education to Attorneys and CPA’s. She is an adjunct professor at the University of New Haven where she teaches Business Law. Marie received her B.A. from St. John’s University and her J.D. from St. John’s School of Law in 1992.

• [email protected]

Overview of Contents

7Bradley T. Borden

Effect of 2017 Tax Reform on Section 1031 Exchanges

Section 199A deduction and like-kind exchanges

Drop-and-Swaps

Drop-Swap Cash-Outs

Swap-and-Drops

Mixing-Bowl Transactions

Corporate Drop-Swaps

Effect of 2017 Tax Reform on Section 1031 Exchanges

8Bradley T. Borden

Real-Property Requirement

9Bradley T. Borden

TCJA of 2017 added Real-Property Requirement

No Section 1031 definition of real property• Generally accepted Real Property

• Land

• Permanent structures

Real-Property Definitions

10Bradley T. Borden

Section 512 (UBTI)• All real property• Any property that is not personal property• Three types of real property

• Intangibles—leaseholds• Building and structural components• Other tangible real property

Section 263A (capitalization rules)• Land• Unsevered natural products of land• Buildings• Inherently permanent structures

Section 856 (REIT)• Land

• Water, air space, natural products, deposits unsevered from the land

• Improvements to land• Inherently permanent structures and their

structural components

Real-Property Definitions

11Bradley T. Borden

Section 897 (FIRPTA, ECI)• Land• Unsevered natural products of the land• Improvements• Personal property associated with the

use of real property• Property used in mining, farming,

forestry• Property used in improvement of

real property• Property used in operation of

lodging facility• Property used in the rental of

furnished office and other work space

Like-Kind Property Requirement

12Bradley T. Borden

Nature and character

Not grade or quality

General interests in real property (land and permanent structures) are like-kind

All Real Property Like Kind?

13Bradley T. Borden

Each partial interest must be examined • Natural resources

• Water rights

• Leasehold interest of less than 30 years

• Easements

• Life estates & remainder interests

• Carve-outs

Foreign Property not like-kind to U.S. real property

Like-Kind Property Requirement

14Bradley T. Borden

Nature and character

Not grade or quality

General interests in real property (land and permanent structures) are like-kind

Each partial interest must be examined • Natural resources

• Water rights

• Leasehold interest of less than 30 years

• Easements

• Life estates & remainder interests

• Carve-outs

Foreign Property not like-kind to U.S. real property

Holding & Use Requirements

15Bradley T. Borden

Replacement Property and Relinquished Property must be• Investment property or • Business-use property

Excluded• Personal-use property • Property held for sale

Holding Period• No minimum period• Determine intent at the time of exchange

Business-Use Property• Held for productive use in trade or business.

Investment Property• Held for future appreciation • Not personal-use property (i.e., not principal

residence and vacation home)

Mixed-use property

Qualified-Asset Requirement

16Bradley T. Borden

Qualified Asset—any real property not held primarily for sale

Dealer Property v. held for sale• Dealer: Hold property primarily for sale to customers in

ordinary course of trade or business

• Dealer property factors:

1. Nature & purpose of the acquisition of the property & duration of ownership

2. Extent & nature of taxpayer’s efforts to sell property

3. Number, extent, continuity, and substantiality of the sales

4. Extent of subdividing, developing, and improving the property

5. Use of a business office and advertising for the sale of the property

6. Supervision or control over representative selling the property

7. Time and effort the taxpayer actually devotes to the sale of the property

Section 199A and Section 1031

17Bradley T. Borden

Overview of Section 199A

Unadjusted Basis Immediately After Acquisition (UBIA)

Depreciable Period

Qualified Trade or Business and Rental Real Estate

Overview of Section 199A Deduction

18Bradley T. Borden

20% of qualified business income

Subject to wage and UBIA limits

Only apples to qualified business income (QBI)

• QBI is not from: o Specified service trade or business (SSTB)

Law Accounting Medical practice Etc.

o Services as an employee• QBI is from a trade or business under section 162.

Treas. Reg. § 199A-1(a)(14).o Includes rental of property that is not

section 162 activity, if rented to a trade or business controlled by the property owner

o Safe harbor from rental real estate enterprise (RREE, discussed below)

Effect of Section 199A Deduction

19Bradley T. Borden

Marginal Tax Rates Before and After Section 199A Deduction

Marginal Income Tax Rate Before 199A

Deduction

Marginal Income Tax Rate After 199A

Deduction

10% 8.0%

12% 9.6%

22% 17.6%

24% 19.2%

32% 25.6%

35% 28%

37% 29.6%

Wage and UBIA Limit

20Bradley T. Borden

Deduction limit

• 50% of W-2 wages

• 25% of W-2 wages + 2.5% of UBIA of qualified property

Qualified property

• Subject to depreciation

• Used in a qualified trade or business

• Depreciable period has not ended

o Longer of 10 years and recovery period

UBIA of Replacement Property

21Bradley T. Borden

Replacement property must be qualified property

Step-in-the-shoes rule. Treas. Reg. § 1.199A-2(c)(3)(ii).

UBIA of replacement is UBIA of relinquished property

• Decreased by

o Excess boot

Boot – appreciation in relinquished property

• Increased by

o Cash or other property transferred by exchanger

Apportion UBIA among multiple replacement properties based upon their FMV

UBIA of non-like-kind property is its FMV

Depreciable Period of Replacement Property

22Bradley T. Borden

Replacement property must be qualified property

Step-in-the-shoes approach. Treas. Reg. §1.199A-2(c)(2)(iii).

For carryover UBIA

• Begin with date relinquished property placed in service

For new UBIA

• Begin with date replacement property placed in service

Non-like-kind property

• Begin with date placed in service

Qualified Trade or Business and Rental Real Estate

23Bradley T. Borden

Does owning rental real estate come within the section 199A definition of trade or business?

Common law does not answer:

• Holding property for rental is use in trade or business (Hazard v. Comm’r, 7 T.C. 372 (1946))

• Holding property for rental is NOT trade or business (Grier v. U.S., 120 F.Supp. 395 (D. Conn. 1954))

Proposed Safe Harbor for Rental Real Estate Qualified Trade or Business

24Bradley T. Borden

Notice 2019-07

• If requirements satisfied rental real estate enterprise (RREE) will be treated as a trade or business for section 199A purposes

o RREE: “[A]n interest in real property hold for the production of rents and may consist of an interest in multiple properties.”

o Treat each property as separate enterprise, or treat similar properties as single enterprise

o Commercial and residential cannot be part of same enterprise

o Need significant change in facts to vary from year to year

o Effective for taxable years ending after Dec. 31, 2017

Rental Real Estate Enterprise (Safe Harbor Requirements)

25Bradley T. Borden

Rental real estate enterprise (RREE) treated as trade or business if

• Separate books and records for each RREE• Prior to Jan. 1, 2023

o At least 250 hours of rental services per year with respect to RREE

o After Dec. 31, 2022 In any 3 of 5 years, at least 250

hours of rental services with respect to RREE

o Contemporaneous records Hours of all services performed Description of services Dates on which services performed Who performed services

Rental Real Estate Enterprise (Rental Services)

26Bradley T. Borden

Included Services• Advertising to rent or lease the real estate• Negotiating and executing leases• Verifying information contained in

prospective tenant applications• Collection of rent• Daily operation, maintenance, and repair of

the property• Management of the real estate• Purchase materials• Supervision of employees and independent

contractors Performance by owners, employees, agents,

contractors• Can a tenant be an agent or contractor for

some services?

Rental Real Estate Enterprise (Rental Services)

27Bradley T. Borden

Excluded Services• Financial or investment management

activities• Arranging financing• Procuring property• Studying and reviewing financial

information• Planning, managing, or constructing long-

term capital improvements• Hours spent traveling to and from the real

estate

Rental Real Estate Enterprise (Safe Harbor)

28Bradley T. Borden

Excluded Arrangements• Real estate used by the taxpayer as a

residence for any part of the year under section 280A

• NNN propertyo Lease agreement that requires the

tenant or lessee to Pay taxes Pay fees Pay insurance Be responsible for maintenance

activities for a property in addition to rent and utilities

o Applies to portions of rented property Disclosure Requirement

• Include statement attached to return claiming section 199A deduction

Rental Real Estate Enterprise (Safe Harbor)

29Bradley T. Borden

Procedural requirements• Must include statement attached to return

that safe-harbor requirements are met• Signed by taxpayer or authorized

representative• Statement: “Under penalties of perjury, I

(we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

• Person signing must have personal knowledge of the facts and circumstances related to the statement

Exchanges and Business Transactions

30Bradley T. Borden

Types of Exchanges of Business Transactions

31Bradley T. Borden

PARTNERSHIPS CORPORATIONS Drop-and-Swaps

• Typical drop-and-swap scenario• Section 1031 issues and law• Judicial doctrines

Drop-Swap Cash-Outs• Tax Treatment of various

alternatives

Swap-and-Drops• Typical swap-and-drop• Section 1031 issues and law• State-law theory of partnerships• Partnership tax issues

Drop-and-Swap/Swap-and-Drop Variant

Corporate Tax Basics• Double-Tax Problem• Entity-Tax Problem

Corporate Liquidations

• C-to-S Conversions• Built-in-Gains Tax

S-Corporation-to-Partnership Conversions

• Constructive Liquidation

S Corporation Divisions

Other Strategies

Drop-and-Swaps

33Bradley T. Borden

• A, B, and C are equal members• A, B, and C wish to sell Office• A wishes to reinvest individually• B and C wish to reinvest together

Typical Drop-and-Swap Scenario

A B C

Office

LLC

Each Member’s Unrealized Gain

Fair Value $300,000

Adjusted Basis $100,000

Unrealized Gain $200,000

Share Unrecap § 1250 Gain $150,000

Outside Basis = Share of Adjusted Basis

Capital Accounts = Outside Basis

LLC’s Unrealized Gain

Fair Value $900,000



Unrecaptured § 1250 Gain $450,000

34Bradley T. Borden

Same issues if B and C also wish to reinvest individually

Typical Drop-and-Swap Strategy (distribute first)

A B C

2/3 Office

1/3 Office

LLC’s Exchange

1/3 Office LLCQI

QI

35Bradley T. Borden

Section 1031 Issues

36Bradley T. Borden

Exchange Requirement• Same person must transfer and receive

• Lose Section 1031 nonrecognition if LLC transfers relinquished property, and A receives replacement property

Holding Requirement• A must be the tax owner of real property

Use Requirement• A must hold 1/3 Office for business use

or investment

Qualified-Asset Requirement• Cannot be tax-partnership interest

• Rev. Proc. 2002-22, Condition 3

• No prior entity ownership

Use Requirement

37Bradley T. Borden

Negative Authority• Rev. Rul. 77-337, 1977-2 C.B. 305

Positive Authority“[T]he intent to exchange property for like-kind property satisfies the [use] requirement, because it is not an intent to liquidate the investment or to use it for personal pursuits.”

Bolker v. Commissioner, 760 F.2d 1039 (9th Cir. 1985)

• Mason v. Commissioner, 55 T.C.M. (CCH) 1134 (1988)

Form 1065, Schedule B, Line 14• “At any time during the tax year, did

the partnership distribute to any partner a tenancy-in-common or other undivided interest in partnership property?”

Holding Requirement

38Bradley T. Borden

LLC must distribute interest in Office to A

• Commissioner v. Court Holding, 324 U.S. 331 (1945)

• Tax-free distribution from corporation followed by sale to avoid entity-level tax

A must be tax owner of the interest in Office

• Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981)

• Chase v. Commissioner, 92 T.C. 874 (1989)

• Bad facts. Substance over form?

Holding period requirement?• Tax ownership is all or nothing—not transfer by

degrees as closing approaches

Qualified-Asset Requirement

39Bradley T. Borden

TIC under state law, tax partnerships?• Rev. Proc. 2002-22

• Dozens of cases (more than 100)

Basic Strategies• Limit management activity

• Do not file tax return

• Do not treat as a partnership

• Do not hold in separate entity unless it is a DST that is compliant with Rev. Rul. 2004-86

Drop-Swap Cash-Outs

40Bradley T. Borden

Drop-Swap Cash-Out Scenario

A B C

Office

• A, B, and C are equal members• A, B, and C wish to dispose of Office• A wishes to cash out• B and C wish to reinvest together in like-kind property• B and C might consider bringing in right person as a new member

LLC

Each Member’s Unrealized Gain

Fair Value $300,000






LLC’s Unrealized Gain

Fair Value $900,000




41Bradley T. Borden

Cash-Out Concerns

42Bradley T. Borden

A not concerned about Section 1031 requirements

LLC concerned about transfer of tax ownership on distribution

LLC does not want A’s actions to taint its Section 1031 exchange

What is character of A’s recognized gain?

What is character of LLC’s deferred gain?

What are the various cash-out alternatives and what are their tax consequences?

Cash-Out Alternatives

43Bradley T. Borden

1) Distribution-first cash-out

2) LLC exchanges/sells, uses regular allocations, distributes cash

3) LLC exchanges/sells, uses special allocations, distributes cash

3(a) LLC exchanges/sells, uses fill-up allocations, distributes cash

4) LLC exchanges/sells, receives installment note, distributes note

5) Member sells tax-partnership interest

6) Other members buy cash-out member’s tax-partnership interest

7) Single other member buys cash-out member’s tax-partnership interest

8) Leveraged cash-out

Tax Accounting Refresher

44Bradley T. Borden

Long-Term Capital Gains (IRC § 1(h)(1)–(6))• Regular long-term capital gain: 20%

• Unrecaptured § 1250 gain (“§ 1250 gain” or “§ 1250” below): 25%

• Recognized gain on § 1031 exchange is unrecaptured § 1250 gain first (IRC § § 1(h), 1250(d)(4))

• Long-term capital loss offsets regular LTCG first

Installment-Sale Rules• One payment must be in subsequent year (IRC § 453(b))

• Installment note takes the first gain on § 1031 exchange (IRC §453(f), Prop. Reg. § 1.453-1(f))

• Recognize unrecaptured § 1250 first (Treas. Reg. § 1.453-12)

• No gain on partnership distribution (Treas. Reg. § 1.453-9(c)(2))

• Tax partnership’s character goes to distributee with note (Treas. Reg. § 1.453-9(c)(3))

• Gain on satisfaction of installment obligation is FMV – Basis (Treas. Reg. § 1.453-9(b)(1), (2))

Partnership Tax Refresher — Distributions

45Bradley T. Borden

Distributions• No gain recognized on liquidating distribution (IRC § 731(a))

• Distributee takes outside basis in property received in liquidating distribution (IRC § 732(b))

• § 731 distribution does not trigger § 1250 gain (IRC § 1250(d)(3); Treas. Reg. § 1.1250-3(c)(1))

• Unrealized § 1250 gain goes with distributed property (IRC § 1250(d)(5); Treas. Reg. § 1.1250-3(c)(3))

• § 734 adjustment of inside basis if § 754 election in effect

• Increase for gain recognized by distributee, basis lost under § 732

• Decrease for loss recognized by distributee, basis gained under § 732

• Mandatory, if loss recognized and substantial basis reduction

• Adjust distributee’s capital account to reflect § 734 adjustment (Treas. Reg. 1.704-1(b)(2)(iv)(m)(4).

• No look-through rule for redemptions (Treas. Reg. § 1.1(h)-1(b)(3)(ii))

Partnership Tax Refresher—Sales of Tax-Partnership Interests

46Bradley T. Borden

Sale of Interest• § 1250 look-through on disposition of tax-partnership

interest (Treas. Reg. § 1.1(h)-1(b)(3), (c))

• § 743 adjustment related to inside basis if § 754 election in effect

• Increase or decrease as appropriate to account for purchaser’s new basis

• Mandatory decrease, if substantial built-in loss

• Increase makes additional depreciation zero for § 1250 gain purposes (Treas. Reg. § 1.1250-1(f))

Drop-Swap Cash-Out Alternative 1(distribution-first cash-out)

A B C

2/3 Office

1/3 Office

Buyer

LLC’s Exchange

1/3 Office

$300K

LLC

QI

LLC’s Exchange

Fair Value $600,000


Gain Realized $400,000

Gain Recognized $0

Unrecap. § 1250 Gain $0

Deferred Gain $400,000

Deferred § 1250 Gain $300,000

A’s Disposition

Fair Value $300,000


Gain Recognized $200,000


Unrecap. § 1250 Gain $150,000

Ordinary income possible?

47Bradley T. Borden

Drop-Swap Cash-Out Alternative 2(exchange/sell first, regular allocation)

A B C

$300K

LLC Exchanges/Sells$300K RP 2

Office

LLC

QI

LLC’s Exchange

Fair Value $900,000




Unrecap. § 1250 Gain $300,000



Regular Allocation

Gain to each member $100,000

§ 1250 to each member $100,000

Consequences to A

Outside basis increase $100,000

Distribution $300.000

Outside basis $200,000

Gain on distribution $100,000

A’s total gain $200,000

A’s unrecap § 1250 gain $100,000

Consequences to LLC if § 754 Election

§ 734(b) basis step-up $100,000

Step-up offsets regular LTCG first

LLC’s deferred gain $200,000

LLC’s Deferred § 1250 $150,000

48Bradley T. Borden

Drop-Swap Cash-Out Alternative 3(exchange/sell first, special allocation)

A B C

$300K


Office

LLC

QI

LLC’s Exchange

Fair Value $900,000




Unrecap. § 1250 Gain $300,000



Special Allocation

Gain to A $300,000

§ 1250 to A $300,000

Distribution to A


Distribution $300,000


Loss on distribution ($100,000)

A’s net gain $200,000

A’s unrecap § 1250 gain(?) $300,000

LTCL offsets regular LTCG first

Consequences to LLC (Mandatory?)

§ 734(b) basis step-dn (?) ($100,000)



49Bradley T. Borden

Drop-Swap Cash-Out Alternative 3A(exchange/sell first, fill-up allocation)

A B C

$300K


Office

LLC

QI

LLC’s Exchange

Fair Value $900,000




Unrecap. § 1250 Gain $300,000



Allocation to A

Gain to A $200,000

§ 1250 to A $200,000

Allocations to B and C

Gain $50,000

§ 1250 $50,000

Distribution to A




Gain/Loss on distribution $0

A’s net gain $200,000

A’s unrecap § 1250 gain(?) $200,000

50Bradley T. Borden

Drop-Swap Cash-Out Alternative 4(installment-note distribution)

A B C

$300KNote

LLC Exchanges/Sells$300K

Note RP 2

Office

LLC

QI

LLC’s Exchange

Fair Value $900,000



Gain Recognized $0




LLC’s Attributes in Note

Basis in note $0

Deferred gain $300,000

§ 1250 portion $300,000

Consequences to A

A’s basis in note $100,000

Settlement $300,000


A’s § 1250 gain $200,000

Consequences to LLC (Mandatory?)

§ 734(b) basis step-dn (?) ($100,000)



51Bradley T. Borden

Drop-Swap Cash-Out Alternative 5(disposition of tax-partnership interest)

A B C

LLC ExchangesReplacement

Buyer 1/3

LLC

$300K

Office

LLC

QI

Consequences to LLC

Fair Value $900,000



Gain Recognized $0



Deferred § 1250 Gain $450,000Consequences to A


A’s § 1250 gain $150,000

Consequences to Buyer if § 754 Elect’n

§ 734(b) basis step-up $200,000

§ 734(b) Adj. to B’s § 1250 $150,000



52Bradley T. Borden

Drop-Swap Cash-Out Alternative 6(members buy tax-partnership interest)

A B C


A sells

1/3LLC

$300K

OfficeLLC

QI

Consequences to LLC

Fair Value $900,000



Gain Recognized $0




Consequences to A


A’s § 1250 gain $150,000

Consequences to Each Members if § 754 Elect’n

§ 734(b) basis step-up $100,000

§ 734(b) Adj. to § 1250 $75,000



53Bradley T. Borden

Drop-Swap Cash-Out Alternative 7(member buys tax-partnership interest)

A B C


A sells

1/3

LLC

$300K

Office

LLC

QI

Consequences to LLC

Fair Value $900,000



Gain Recognized $0




Consequences to A


A’s § 1250 gain $150,000

Consequences to Each Member if § 754 Elect’n

§ 734(b) basis step-up $200,000

§ 734(b) Adj. to § 1250 $150,000



54Bradley T. Borden

Drop-Swap Cash-Out Alternative 8(leveraged cash-out)

A B C

$300K

LLC Exchanges/Sells

Office

ReplacementBank

$300K

LLC

QI

Consequences to LLC

Fair Value $900,000



Gain Recognized $0




Distribution to A



Gain on distribution $200,000


A’s § 1250 gain $0

Consequences to LLC if § 754 Election

§ 734(b) basis step-up $200,000



55Bradley T. Borden

Summary of Drop-Swap Cash-Outs—No § 754 Election, No Mandatory Adj.

Alternative Cash-Out Member LLC/Other Members Total

1 Distribution-firstGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $150,000 Deferred § 1250 $300,000 § 1250 $450,000

2Exchange/sale, regular allocation

Gain $200,000 Deferred/Recog’d Gain $500,000 Gain $700,000

§ 1250 $100,000 Deferred/Recog’d § 1250 $350,000 § 1250 $450,000

3Exchange/sale, special allocation

Gain $200,000 Deferred Gain $300,000 Gain $500,000

§ 1250 $300,000 Deferred § 1250 $150,000 § 1250 $450,000

4 Installment-note distributionGain $200,000 Deferred Gain $300,000 Gain $500,000

§ 1250 $200,000 Deferred § 1250 $150,000 § 1250 $350,000

5 Disposition of P/S interestGain $200,000 Deferred Gain $600,000 Gain $800,000§ 1250 $150,000 Deferred § 1250 $450,000 § 1250 $600,000

6 Members buy interestGain $200,000 Deferred Gain $600,000 Gain $800,000§ 1250 $150,000 Deferred § 1250 $450,000 § 1250 $600,000

7 Member buys interestGain $200,000 Deferred Gain $600,000 Gain $800,000§ 1250 $150,000 Deferred § 1250 $450,000 § 1250 $600,000

8 Leveraged buyoutGain $200,000 Deferred Gain $600,000 Gain $800,000

§ 1250 $0 Deferred § 1250 $450,000 § 1250 $450,000

56Bradley T. Borden

Summary of Drop-Swap Cash-Outs—With § 754 Election, Mandatory Adj.

Alternative Cash-Out Member LLC/Other Members Total

1 Distribution-firstGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $150,000 Deferred § 1250 $300,000 § 1250 $450,000

2Exchange/sale, regular allocation

Gain $200,000 Deferred/Recog’d Gain $400,000 Gain $600,000

§ 1250 $100,000 Deferred/Recog’d § 1250 $350,000 § 1250 $450,000

3Exchange/sale, special allocation

Gain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $300,000 Deferred § 1250 $150,000 § 1250 $450,000

4 Installment-note distributionGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $200,000 Deferred § 1250 $150,000 § 1250 $350,000

5 Disposition of P/S interestGain $200,000 Deferred Gain $400,000 Gain $600,000§ 1250 $150,000 Deferred § 1250 $300,000 § 1250 $450,000

6 Members buy interestGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $150,000 Deferred § 1250 $300,000 § 1250 $450,000

7 Member buys interestGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $150,000 Deferred § 1250 $300,000 § 1250 $450,000

8 Leveraged buyoutGain $200,000 Deferred Gain $400,000 Gain $600,000

§ 1250 $0 Deferred § 1250 $400,000 § 1250 $400,000

57Bradley T. Borden

Drop-Swap Assumptions

58Bradley T. Borden

The LLC will not liquidate

In alternatives 1, 5, 6, 7, and 8, the LLC would allocate gain from the sale to the other members, and they would recognize loss on the distribution if

• The LLC did not have a § 754 election in effect

• It were to sell the replacement property immediately

• The net effect of the gain and loss recognized by all members would equal the LLC’s original $600,000 of unrealized gain

In alternatives 3 and 4, the other members would recognize gain on a liquidating distribution that would bring the overall gain up to $600,000

The different scenarios appear to affect the timing of gain and loss recognition and the total amount of unrecaptured § 1250 gain the members recognize

The analysis also assumes that the allocations and distributions have economic effect in each alternative

Swap-and-Drops

59Bradley T. Borden

Swap-and-Drop Scenario

A B C

OfficeLand

• A owns Land• B and C own Office as tenants-in-common• A would like to sell Land and acquire an interest in Office• A, B, and C would like to own Office in an LLC

Alternatively, B and C could own Office in a tax partnership A would like to sell Land and become a member of LLC Or A, B, and C may wish to exchange their respective

properties and acquire property together to hold in an LLC

60Bradley T. Borden

Typical Swap-and-Drop Strategy

A B C

2/3 Office

1/3 Office

Land

1/3 Office

1/3 Office

2/3 Office

LLC

QI

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Section 1031 Issues

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Use Requirement• A must hold Office interest for

business use or investment

Holding Requirement• A must acquire tax ownership of

interest in Office, not a tax-partnership interest

• Similar to drop-and-swap issues

Exchange Requirement• A must transfer Land and acquire

interest in Office

• Similar to drop-and-swap issues

Use Requirement

63Bradley T. Borden

Negative Authority• Rev. Rul. 75-292, 1975-2 C.B. 333

Positive Authority• § 1031 and § 721 represent “continuation,

not liquidation, of old investment”

• Use requirement: “So long as . . . the taxpayers continue to own the property and to hold it for investment, a change in the mechanism of ownership which does not significantly affect the amount of control or the nature of the underlying investment does not preclude nonrecognition under section 1031(a).”

• Step-transaction doctrine: “Between two equally direct ways of achieving the same result, [taxpayers are] free to choose the method which entail[s] the most tax advantages to them.”

Magneson v. Commissioner, 753 F.2d 1490 (9th Cir. 1985)

State-Law Entity Theory

64Bradley T. Borden

Magneson Court’s Distinctions Overstated• Entity v. Aggregate View

• Always have both entity and aggregate aspects, especially with closely-held entities

• Control and Management• Shareholders of close corporations

control

• General partners’ control can be limited

• Distinctions with closely-held entities is often nominal

Partnership Tax Issues

65Bradley T. Borden

Section 704(c) for contributed property• Does Section 1250 follow Section 704(c)

allocation?

LLC’s holding period could vary with different interests• A’s holding period could be long term• B’s and C’s holding periods could be short

term

Character Taint• Section 724(b) applies if B and C held as

inventory/dealer property—ordinary income for 5 years after contribution

Form 1065, Schedule B, Line 13

• “Check this box if, during the current or prior tax year, the partnership . . . contributed [property received in a like-kind exchange] to another entity (other than disregarded entities . . . .)”

Drop-and-Swap/Swap-and-Drop Variant(exchange-first Drop-and-Swap)

A B C

RP 1

LLC Exchanges

RP 1 RP 2

• Does LLC satisfy use requirement?

• Does LLC satisfy holding requirement?

• What about non-tax concerns of LLC holding RP 1? Office

LLC

QI

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Section 1031 Issues

67Bradley T. Borden

Exchange and Holding Requirements

• Same as distribution-first

Use Requirement

• Exchange followed by liquidation of corporation under old § 333

• “Instant case can be viewed as a variant of Magneson . . . or as a variant of Bolker.”

• “[Corporation’s] purpose was the purpose of [the shareholders].”

• “[W]here a taxpayer surrenders stock in his corporation for real estate owned by the corporation, he continues to have an economic interest in essentially the same investment, although there has been a change in the form of ownership.”

Maloney v. Commissioner, 93 T.C. 89 (1989)

Section 1031 Issues

68Bradley T. Borden

Use Requirement (continued)

• “A trade of property A for property B, both of like kind, may be preceded by a tax-free acquisition of property A at the front end, or succeeded by a tax-free transfer of property B at the back end.”

Maloney v. Commissioner, 93 T.C. 89 (1989)

Form 1065, Schedule B, Line 13

• “Check this box if, during the current or prior tax year, the partnership distributed any property received in a like-kind exchange” or contributed such property to another entity (other than disregarded entities wholly owned by the partnership throughout the tax year)”

Mixing-Bowl Transactions

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Mixing-Bowl Concept

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Parties use partnership non-recognition rules to sale or exchange property

Scenario 1

• A contributes appreciated property to partnership

• B contributes money to partnership

• Partnership distributes property to B

Scenario 2

Partnership acquires and distributes property A

Anti-Mixing-Bowl Rules

72Bradley T. Borden

Section 704(c)(1)(B)—Distribution of contributed property

• If

o Partnership distributes contributed property

o To other partner

o Within 7 years of contribution

• Then

o Contributing partner recognizes pre-contribution gain

• Recognized gain increases

o Contributing partner’s basis in its partnership interest

o Basis of contributed property

Section 704(c)(1)(B) Mixing-Bowl

A B

Step 1:A’s Prop

• A contributes Prop, appreciated real property

• FMV = $10,000• AB = $5,000

• LLC distributes Prop to B

• A recognizes pre-contribution gain

• Gain = $5,000

LLC

73Bradley T. Borden

Step 2:A’s Prop

Anti-Mixing-Bowl Rules

74Bradley T. Borden

Section 737(a)—Distribution of property to contributing member

• If

o Partnership distributes property

o To contributing partner

o Within 7 years of contribution

• Then

o Contributing partner recognizes net pre-contribution gain

• Recognized gain increases

o Contributing partner’s basis in its partnership interest

o Basis of contributed property

Section 737 Mixing-Bowl

A B

Step 1:A’s Prop


• FMV = $10,000• AB = $5,000

• LLC distributes Other Prop to A

• FMV = $13,000• AB = $5,000

• A recognizes net pre-contribution gain

• Gain = $5,000

LLC

75Bradley T. Borden

Step 2:Other Prop

Anti-Mixing-Bowl Exception for Like-Kind Property

76Bradley T. Borden

Section 704(c)(2)

• If

o Contributed property distributed to other partner

o Like-kind property distributed to contributing partner

Within 180 days after distribution of contributed property, or

Contributing partner’s return due date

• Then

o Contributing partner can avoid gain based upon FMV of like-kind property. I.R.C. § 704(c)(2) (flush language)

o Avoided gain is limited to built-in gain of distributed property immediately following distribution. Treas. Reg. § 1.704-4(d)(3)

o Section 737 reduced by amount of gain not recognized. Treas. Reg. § 1.737-1(c)(2)(iv)

o Only the built-in gain of distributed property is deferred

Section 704(c)(2)(B) Mixing-Bowl Exchange

A B

Step 1:A’s Prop


• FMV = $10,000• AB = $5,000


• LLC distributes like-kind property to A

• FMV = $13,000• AB = $5,000

• A recognizes no gain

LLC

77Bradley T. Borden

Step 2:A’s Prop

Step 3:Like-Kind

Prop

Section 704(c)(2)(B) Mixing-Bowl Exchange

A B

Step 1:A’s Prop


• FMV = $10,000• AB = $5,000


• LLC distributes like-kind property to A

• FMV = $8,000• AB = $5,000

• A recognizes $2,000 of gain$5,000 (704(c)(1)(B)) - $3,000 (BIG of contributed)

LLC

78Bradley T. Borden

Step 2:A’s Prop

Step 3:Like-Kind

Prop

Anti-Mixing-Bowl Exception for Like-Kind Property

79Bradley T. Borden

Section 704(c)(2)

• No holding and use requirement

o Contributing member does not have to hold contributed or distributed property for investment or productive use in a trade or business

• No section 1031 exchange requirement

• No section 1031(d) basis in distributed property

Corporations: Tax Basics

80Bradley T. Borden

Fundamentals of Corporate Taxation

81Bradley T. Borden

Generally• Corporate-level tax

• Shareholder-level tax on dividends

• Contributions of property generally taxed

• Distributions of property

• Taxed at corporate level

• Taxed at shareholder level

S-Corporations• No entity-level tax—Income flows through to

shareholders

• Contributions and distributions subject to general corporate rules

Taxation of C-Corporation Income

Office

C-Corporation

A B C

Corporate-Level Tax

Corporate Income $100,000

Tax Rate 21%

Tax $21,000

Distributable Income $79,000

Aggregate Shareholder-Level Tax

Distributed Income $79,000

Tax Rate 23.8%

Tax $18,802

Net Cash to Shareholders $60,198

$

$

$

82Bradley T. Borden

Distributions are dividends.

Fundamentals of S-Corporation Taxation

83Bradley T. Borden

Corporate-level income, gain, and losses flow through to shareholders

Allocated corporate items affect shareholder basis• Allocated income and gain increase basis

• Allocated losses decrease basis

Nonliquidating distributions• Nontaxable return of basis to extent of basis

• Distributions in excess of basis treated as gain

Liquidating distributions treated as consideration for stock

S-CorporationRequirements

84Bradley T. Borden

No more than 100 shareholders

Shareholders are individuals• Some exceptions for trusts and estates

Shareholders are U.S. residents or citizens

One class of stock• Voting-nonvoting not relevant

Elect to be treated as S-corporation

Terminated S-corporation becomes a C-corporation

Taxation of S-Corporation Income

Office

S-Corporation

A B C

Corporate-Level Tax

Corporate Income $100,000Tax Rate 0%Tax $0

Distributable Income $100,000

Taxation to Each Shareholder on Allocated Gain

Share of Income $33,333Sec. 199A Deduction (20%) $6,667

Taxable Income $26,666Tax Rate 37%Tax $9,866

Shareholder Tax Attributes

Stock Value $300,000Basis in Stock $250,000Unrealized Gain $50,000

$

$

$

Effect on Each Shareholder’s Basis

Beginning Basis $250,000Allocation of Income $33,333Basis After Allocation and Distribution $283,333

85Bradley T. Borden

Corporate income is allocated to shareholders.

Each shareholder has share of income.

Income increases shareholder basis.

Taxation of S-Corporation Distribution

Office

S-Corporation

A B C


Basis After Allocations $283,333Distribution ($33,333)Basis After Distribution $250,000

$$

$

86Bradley T. Borden

Distributions decrease shareholder basis.

No gain on distribution because basis is greater than distribution.

Corporate Liquidations

87Bradley T. Borden

Distributions of property treated as fair-value sale at corporate level• Gain taxed at C-corporation level

• Gain passes through S-corporation pro rata to shareholders

• Gain from S-corporation increases shareholder basis

Distributions to shareholders equal fair value of property received

Taxation of C-Corporation Liquidations

Office

C-Corporation

A B C

Aggregate Shareholder-Level TaxValue of Property Received $300,000

Basis in Stock $250,000

Gain Recognized $50,000Tax Rate 23.8%Tax on Distribution $11,900

Shareholder Tax AttributesStock Value $300,000Basis in Stock $250,000Unrealized Gain $50,000

Corporate Tax AttributesFMV of Office $900,000AB of Office $300,000Unrealized Gain $600,000 1/3

Office

1/3 Office

1/3 Office

*Corporation needs cash to pay tax.

Corporate-Level TaxAmount Realized $900,000Adjusted Basis $300,000Gain Recognized $600,000Tax Rate 21%Tax $126,000*

88Bradley T. Borden

FMV Distributions are consideration for stock.

Taxation of S-Corporation Liquidating Income

Office

A B C

$

$

$

Corporation is treated as selling distributed asset.

Income increases shareholder basis.


Beginning Basis $250,000Allocation of Income $200,000Basis After Allocation $450,000

Each shareholder has share of income.

Corporate-Level Gain

Amount Realized $900,000Adjusted Basis $300,000Gain Recognized $600,000Corporate Tax Rate 0%Corporate-Leve Tax $0

Taxation to Each Shareholder on Allocated Gain

Share of Income $200,000Sec. 199A Deduction (20%) $0Taxable Income $200,000Tax Rate 23.8%Tax $47,600

89Bradley T. Borden

S-Corporation

Taxation of S-Corporation Liquidating Distribution

Office

S-Corporation

A B C

1/3 Office

1/3 Office

1/3 Office

Taxation to Each Shareholder on Liquidating Distribution

FMV of Property Received $300,000Basis in Stock $250,000Gain Recognized $50,000Tax Rate 23.8%Tax $11,900

Gain on distribution because basis is less than distribution.

90Bradley T. Borden

S-Corporation Drop-and-Swaps

91Bradley T. Borden

• A, B, and C are equal shareholders• A, B, and C wish to sell Office• A wishes to reinvest individually• B and C wish to reinvest together Same issues if B and C also wish to reinvest individually

Typical S-Corporation Drop-and-Swap Scenario

A B C

Office

Each Shareholder’s Unrealized Gain

Fair Value $300,000






S-Corporation’s Unrealized Gain

Fair Value $900,000




S-Corporation

92Bradley T. Borden

Tax Considerations for S-Corporation Drop-and-Swaps

93Bradley T. Borden

Distributions from S-corporations trigger gain recognition

S-corporations must allocate gain pro rata to shareholders

Stock redemptions can trigger gain to the redeemed shareholder

Consequences of Typical S-Corporation Drop-and-Swap Strategy

A B C

2/3 Office

1/3 Office

LLC’s Exchange

1/3 Office

QI

QI

S-Corporation’s Gain on Distribution

Fair Value of 1/3 Interest $300,000




Consequences to Shareholders

Gain Allocated to Each Shareholder $66,667

Stock Basis Following Allocations $166,667

Value of 1/3 Interest Dist. to A $300,000

A’s Gain on Redemption $133,333

A’s Basis in 1/3 Interest $300,000

A’s Tax Deferred on Exchange $0

S-Corporation



94Bradley T. Borden

C-to-S Conversions

95Bradley T. Borden

C-corporation elects to be S-corporation

Built-in-gains tax• Pre-conversion gain is subject to corporate

rate for 5 years following conversion

• Ensure pre-conversion gain is subject to double tax for at least 5 years following conversion

Earnings and profits carryover• Pre-conversion earnings and profits

carryover

• Distributions from pre-conversion earnings and profits treated as dividends from the S-corporation

S-Corporation-to-Partnership Conversions

96Bradley T. Borden

Mechanics• Transfer assets

• Assets-up• Assets-over• Interests-over

• Revoke S-election and check-the-box election of non-corporate entity

• State law conversion of S-corporation to noncorporate entity• Revokes S-election • Revokes check-the-box election

Tax Consequences• Constructive liquidation• Follow the assets

Assets-Up Conversion

Office

S-Corporation

A B C

1/3 Office

1/3 Office

1/3 Office

1/3 Office 1/3

Office1/3

Office

1

2

Office

LLC

97Bradley T. Borden

Following Assets-Up Conversion

Office

A B C

LLC

98Bradley T. Borden

Tax Consequences of Assets-Up Conversion

99Bradley T. Borden

Distribution is liquidating distribution• Entity-level gain*

Distribution is redemption of shareholder interests• Gain to shareholders on receipt of interests in Office*• Shareholders take fair-value basis interests in Office

Shareholders enter chain of title

Contribution to LLC should be tax-free• LLC takes fair-value basis in Office

*Assume facts from examples above

Assets-Over Conversion

Office

S-Corporation

A B C

1

2

Office

Office

1/3 LLC

1/3 LLC

1/3 LLC

LLC

100Bradley T. Borden

Following Assets-Over Conversion

Office

A B C

LLC


Tax Consequences of Assets-Up Conversion


Contribution to new LLC can be tax free• LLC takes carryover basis in Office

Distribution is a liquidating distribution• Entity-level gain*• Shareholders take fair-value basis in distributed LLC interests

Distribution is redemption of shareholder interests• Gain to shareholders on receipt of distributed LLC interests*

Shareholders do not enter chain of title

Asset basis• Outside basis = fair value• Inside basis = carryover basis• 754 election = inside basis step-up?

*Assume facts from examples above

Interests-Over Conversion—Step 1

Office

S-Corporation

A B C

LLC

1/3S-Corp 1/3

S-Corp 1/3S-Corp


Interests-Over Conversion: Step 2

Office

S-Corporation

A B C

LLC


Tax Consequences of Interests-Over Division


Contribution of interests to LLC is tax-free• LLC takes shareholders’ carryover bases in contributed

stock

Distribution of Office is a liquidating distribution• Entity-level gain*

Distribution is redemption of LLC’s interest in S-Corporation• Gain to LLC on distribution of Office*• LLC takes fair-value basis in Office

*Assume facts from example above

Conversion to Partnership by Revocation of Election


Non-corporate entity • Partnership by default• Can elect to be corporation—check-the-box election• Can elect to be S-corporation

Revocation of S-election and check-the-box election• Constructive conversion to partnership

Constructive conversion • Treated as assets-up conversion

• Entity-level gain on deemed distribution

• Shareholder gain on deemed redemption

Inadvertent S-Corporation Conversion to Partnership


Shareholders wish to divide S-corporation as drop-and-swap

Form LLCs to hold respective interests

Transfer of property to the LLCs is a liquidation of S-corporation or conversion to tax partnership• If form is ambiguous, assets-up conversion

• All forms trigger gain

S-Corporation Divisions


partnership exchanges after tax reform: structuring drop...

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