One of the biggest challenges tax professionals face is how to advise business owners where some owners have divergent goals. This situation can easily arise in the case of a real estate partnership or limited liability company. Some of the members may want to ensure that the entity is well-capitalized, and therefore seek to delay member distributions and tax payments as long and as much as possible. Other members need or desire more frequent cash flow, and are willing to pay any taxes that accompany the distributions. They could disagree about continuity, where some wish to keep the entity in business while others would like to exit entirely. Since each member is our client, we strive to ensure that each member pays the lowest amount of tax that he or she is required to pay. At the same time, we look to find solutions that serve their non-tax needs. We don’t want the tax tail to wag the business entity dog. Fortunately, the IRS Code contains several provisions that can be used to create a win-win for all parties involved.
Section 1031 provides for a deferral of the gain on an exchange of a property where a similar, or “like-kind” property is received in return. The Tax Cuts and Jobs Act restricts this transaction to exchanges of real property for all exchanges occurring in 2018 and future years. Section 1031 also contains the following primary requirements:
- All properties exchanged must be held either for the productive use in a trade or business or for investment.
- The taxpayer who relinquishes the property must identify the replacement property within 45 days of the sale and take possession within 180 days of the sale.
- The receipt of “boot,” defined as cash, personal property or real property not of like-kind status will void the 1031 classification either in part or whole.
A business or individual taxpayer cannot defer a gain to the extent of boot received. If the gain is less than or equal to the boot, then the entire gain is recognized. If the gain is larger than the boot, then the taxable gain will be limited to the boot.
Section 453 stipulates that a business or individual taxpayer does not pick up a capital gain on an installment sale until cash payments are received. An installment sale requires that at least one payment must be due and received by the seller in the year following the year of the sale. It can be used for sales of business interests, but not for sales of personal property.
The seller will recognize taxable income in proportion to the cash received. A taxpayer who makes a sale under the installment method with a gross price of $1,000,000 and a net profit of $100,000 will recognize a taxable gain based on the percentage of cash received in a single year divided by the $1,000,000 sales price and then take that percentage of $100,000. Thus, it is a deferral based upon the timing of cash received rather than based on the items involved in the transaction.
Example 1:
Arlington, Baltimore, Fairfax and Rockville each own 25% of DMV Properties, LLC. Each member has an outside basis of $10,000,000. DMV owns a piece of real property known as “Georgetown,” which has a fair market value of $140,000,000 and no associated liabilities. There are no other assets or liabilities. DMV has an inside basis of $40,000,000 in Georgetown, equivalent to the combined outside basis of all four members. DMV sells Georgetown to an outside party for $140,000,000 in cash. DMV recognizes a capital gain of $100,000,000, the excess of the sales price over the inside basis of the asset sold. Each member recognizes a $25,000,000 capital gain and now has an outside basis in DMV of $35,000,000.
Baltimore, Fairfax and Rockville would like to purchase another piece of real property known as “Capitol Hill” for $105,000,000. However, Arlington decides that he wants to leave DMV before the entity has a chance to purchase the new property. DMV provides Arlington with a $35,000,000 cash liquidating distribution. Arlington does not have to pick up any capital gain at liquidation, because the cash received is equivalent to his outside basis.
The three remaining members are likely to feel disgruntled. They each have to pick up a $25,000,000 capital gain before they receive any cash distributions. Arlington is able to walk away with $35,000,000 in cash, but recognize a taxable capital gain of just $25,000,000! Since there was no advance planning, there was no correlation between the cash received from the entity and the taxes to be paid by each member.
Example 2:
Assume the same facts as Example 1, but where Baltimore, Fairfax and Rockville know that Arlington wants to surrender his interest for cash. DMV enters into a 1031 exchange with DC Metro Real Estate, LLC. DC Metro owns Capitol Hill. DMV agrees to swap Georgetown with DC Metro for Capitol Hill and $35,000,000 in cash. DMV still realizes a $100,000,000 gain – a $105,000,000 property (Capitol Hill) and $35,000,000 in cash for an asset with a basis of $40,000,000 (Georgetown). However, DMV only recognizes a taxable capital gain to the extent of boot received, which is $35,000,000. The remaining $65,000,000 of capital gain is deferred.
Each DMV member must recognize 25% of the recognized gain, or $8,750,000. Each member’s outside basis in DMV increases by the same amount and now totals $18,750,000. Arlington receives the same $35,000,000 as a liquidating distribution and recognizes a gain of $16,250,000 at liquidation ($35,000,000 in cash received less an outside basis of $18,750,000). Arlington recognizes the same total long-term capital gain of $25,000,000 – $8,750,000 for the sale of Georgetown and $16,250,000 for the liquidation of his interest. Arlington is thus indifferent between Example 1 and Example 2.
Baltimore, Fairfax and Rockville are much better off in this scenario. Each member recognizes a reduction of $16,250,000 in taxable capital gain income for the current year. They also face a smaller taxable gain for the future. DMV can make a 754 election upon the liquidation of Arlington’s interest. The three remaining members have a combined outside basis of $56,250,000. The inside basis in Capitol Hill is just $40,000,000. The 754 election adjusts the inside basis of Capitol Hill to equal the collective outside basis of the members. Capitol Hill now has an increases in basis of $16,250,000, which will be beneficial when it is eventually sold.
Example 3:
This case is identical to Example 2 except that DC Metro offers DMV an installment note for $35,000,000 rather than $35,000,000 in cash. The first payment on the installment note is due in the following year. This exchange can be broken into two parts – the 1031 exchange and the installment note. For the 1031 portion, DMV receives Capitol Hill and takes its pre-existing basis in Georgetown, $40,000,000 as the new basis for Capitol Hill. It does not receive any basis in the installment note. However, DMV does not pick up any taxable income for the installment note at the sale date, because no payments have been received. The receipt of an installment note does not translate into taxable income in the absence of a 1031 exchange, and the 1031 does not make it taxable.
DMV distributes the installment note to Arlington in complete liquidation of his interest. The distribution occurs before the close of the year. Arlington takes a basis of $10,000,000 in the installment note, which was his outside basis before liquidation. He will eventually recognize taxable income of $35,000,000 in proportion to the payments received. Since Baltimore, Fairfax and Rockville each have an outside basis of $10,000,000 ($30,000,000 in total), DMV will need to step down the basis of Capitol Hill to $30,000,000. However, this is a small price to pay for the three remaining members to defer the full $100,000,000 gain that resulted from the exchange of Georgetown.
Breaking up is always hard to do, but it need not be so expensive to do. Proactive tax planning can minimize and delay taxes due while allowing all members in an entity to pursue their desired course of action. It will ensure that all participants will be able to share a story with a happy ending.
Contact a PBMares tax professional if you have questions related specifically to your business.
