Sometimes things are not what they appear to be in business law and business tax. For example, in one area of tax law involving real estate, limited liability companies and partnerships there are disguised sale rules which change what appear to be straight forward and simple business transactions into a tax trap for the unwary.
I recently had a situation where two investors formed a limited liability company so they could acquire rental properties. Each of them owned some rental properties and contributed those to the LLC. The LLC also acquired additional rental properties with cash contributed by the owners and with loans obtained by the LLC. After a period of time, the LLC had successfully accumulated twenty properties and the owners decided it was time to divide up the properties between themselves so that they could each take their respective share of the properties and set off in different business directions free of the LLC and each others involvement.
That seems pretty straight forward and ultimately, the proposed plan was successful and avoided some unintended tax consequences because we liquidated the limited liability company concurrently with the distribution of the properties. However this simple situation revealed a number of potential land mines in these scenarios.
Here is a brief summary of some of the unexpected tax issues. IRC section 704(c) provides that if any property is contributed by an owner and within seven years distributed to another owner that this is presumed to be a disguised sale and any precontribution gain is recognized to the owner who had contributed the property!
Treasury regulation Section 1.707-3(c) provides that if an owner transfers property to a LLC and the LLC transfers money or other consideration to the contributing owner within two years from the date of contribution that the transfer is presumed to be a sale of the property to the LLC or partnership.
IRC section 737 addresses the situation where an owner who contributed property to the LLC/Partnership which had precontribution gain, receives different property from the LLC. In that case, the owner’s precontribution gain attributable to the other property previously contributed is triggered.
Treasury Regulation Section 1.701-2 has an anti-abuse rule which overlays the other tax rules. For example, even if you are able to fall outside one of these more specific rules, this regulation says that in order for the transaction to be respected by the IRS it must be entered into for a “substantial business purpose” and satisfy the substance over form principals.
Lastly, on March 30, 2010, the Health Care and Education Reconciliation Act of 2010 added a new subsection to IRC Section 7701 intended to clarify the Economic Substance Doctrine. It provides that in any case where the IRS and the parties look to the Economic Substance Doctrine to determine whether the transaction will hold up, the transaction is treated as having economic substance only if the transaction changes in a meaningful way (apart from federal income tax effect) the taxpayer’s economic position, and the taxpayer has a substantial purpose for entering into the transaction. The result of these anti-abuse rules is to require owners of LLC’s to take into account rather subjective criteria for whether a proposed transaction will hold up for tax purposes.
Years ago, it used to be that the starting point for advising clients regarding distribution of property out an LLC or partnership was that the distribution could be made tax free. Now the starting point is that the distribution is taxable unless we can find an exception. In many cases, the transaction can be planned in such a way as to achieve a tax deferred distribution. But as indicated, the disguised sale rules make the analysis more complicated.