California State University Tax Deferral and Reinvestment of The Sales Memorandum

MEMORANDUM
From: John Balian (e-mail: john.balian@csun.edu)
To: Acct 697TX Students
Date: 1-30-2023
Re: Tax Challenge Problem 2023
Instructions:
Please confirm receipt of this memo ASAP by sending me a message via email to john.balian@csun.edu
Below is a fact pattern. Please review the facts carefully. Conduct some preliminary research and begin to
outline your solution to the problem. You should approach this project in the same format in which you
would prepare a response to a tax partner at an accounting firm – meaning, your final memo to me should
have the following:
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a statement of the issue or issues presented;
an executive summary of your recommended solution;
a restatement of the key facts;
a statement of the law with citations to tax authorities;
an analysis (where you apply the law to the facts); and
a more detailed conclusion stating what you think the solution should be, and what the
probable outcome would be upon review by the IRS and the Tax Court.
This is not a group project. All work must be performed independently and not in a team.
Please submit the following to me via email by the following dates:
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Optional — an outline of your memo by midnight Monday Feb. 20, 2023;
Optional — a rough draft of your memo by midnight Monday, April 24, 2023; and
Required — a final tax memo by 11:59pm on Monday, May 7, 2023.
The first two deadlines are not hard deadlines. They are for your benefit to make sure you are on track and
to give me enough time to give you feedback.
The May 7, 2023 deadline is a hard deadline and your papers must be in by then.
If you would like to clarify some of the facts and/or instructions, please email me your question. I will reply
the answer to the entire class by email so that the process is fair.
Unlike other tax problems you may have read, these problems contain no “Red Herrings.” A “Red Herring” is
an irrelevant fact or set of facts that may take you down the wrong path – there are no such facts below.
Here, every fact is designed to eliminate a path that might waste your time, or to provide a hint toward a
path that will help with your analysis.
[cont’d.]
Problem 1 (estimated length of reply is about 3 pages single spaced):
About 20 years ago, Joe inherited a 25% membership interest in an LLC that has filed returns as a
partnership for over 25 years. The LLC owns a warehouse that has been rented throughout the 25-year
period. There is no debt or mortgage. There are 3 other members, who are all Joe’s siblings. The property
appreciated significantly over 20 years and is now worth 3 times more than it was worth when Joe inherited
his interest in the LLC. Joe is 58 years old, divorced/single, and has 4 adult children.
A buyer has emerged that has made a $25 million offer, which all members want to accept. After closing
costs, Joe expects that his share will be $6 million. However, Joe has experience in rental property
ownership and wants to take advantage of IRC Section 1031.
Our mission is to figure out how to help Joe accomplish his objective of tax deferral and reinvestment of the
sales proceeds into rental real estate.
Joe has been doing some research and found the following information he wants us to take into
consideration in crafting a tax plan:
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The California FTB has been aggressively auditing 1031 exchange for the past 10 years;
Some 1031 exchange advisers (non-lawyers / non-CPAs) state that the Drop-and-Swap
technique is feasible in this case – meaning, the LLC would transfer the warehouse by deed to the
names of each sibling, each holding a 25% Tenant-in-Common interest in the real estate. The LLC
would be dissolved later and each member would be free to conduct his/her own 1031 exchange.
Joe read that this technique will be challenged by the FTB and that the IRS has been successful in
tax court when the property was not held as an investment by the individual former LLC members for
several years after receiving the property from the LLC in liquidation of his/her interest. Therefore,
Joe does not want to pursue this technique.
Joe also read that since the LLC itself is the property owner, that the LLC must be the
exchanging party (the taxpayer conducting the exchange under 1031), and that the exchange must
be reported under the LLC’s tax return.
None of the other siblings want to reinvest. They would rather pay their taxes and cash out.
Joe is concerned that if he is the only member in the LLC, the LLC will lose its tax status as a
partnership and won’t be able to conduct an exchange as a partnership under its current tax ID
number. Joe is asking us for suggestions on how he might resolve this problem.
Joe read some older tax articles that said that when more than 50% of a partnership changes
its owners/partners, a technical termination occurs, and the partnership ceases to exist. We need to
make sure that is no longer the case, because I recall that may have changed with the Tax Cuts and
Jobs Act. If so, please include in your memo a discussion and citation that relieves Joe of this
technical termination problem.
Each of you should email me an idea about how to avoid termination of the partnership status
of the LLC once Joe’s 3 siblings leave the LLC with their portion of the sales proceeds and hand
over their interests in the LLC (since they want no further financial or tax exposure from Joe’s
continued operation of the LLC).
[cont’d.]
8.
Assuming you come up with a way to avoid termination of the partnership status of the LLC,
Joe read that the IRS or FTB could still allocate 25% of the gain from the sale to Joe, even if the LLC
conducts an exchange with the remaining 25% of the sale proceeds not distributed to Joe. Joe read
that the special allocation rules might not allow him to escape the follow through of capital gains in
this case. You memo must address whether the inability to specially allocate the gains to the 3
exiting members is a real concern.
9.
Assuming the inability to specially allocate gains to the 3 exiting members is a real concern,
Joe has found an alternative. To find the alternative he Googled the words: partnership installment
note 1031 – and found several articles on this idea. Please review some of the articles and include
in your memo some details on how this idea would be implemented and cite the relevant code or
regs sections that are implicated. In other words, are the articles suggesting that the LLC would do
a part installment sale, part exchange type transaction with an Exchange Accommodation
Company? If you are having a hard time understanding how an Exchange Accommodator /
Qualified Intermediary fits in to the picture in this transaction, let me know and we can set up a
phone call and I can explain the role of this third party in the 1031 exchange world.
Optional Problem # 2 for 15% extra credit (estimated length of reply is about 1 page single spaced):
Client called with the following problem: he is the president of Company. He’s been employed with
Company for 15 years.
Company was owned 100% by Owner prior to her death late last year at age 95.
Owner changed her living trust 10 years ago to leave 30% of Company to Client upon Owner’s death.
The Company is an LLC, properly reporting its income on Owner’s form 1040, Sch. C, as a disregarded
entity.
About 6 years ago, Owner’s children were upset at the 30% “gift on death” in Owner’s living trust, and
insisted that Owner amend her trust to not leave 30% of Company to Client, which Owner agreed to do.
Owner amended her trust to delete the 30% provision. However, also about 6 years ago, Owner, as
manager and sole member of the LLC, signed an employment agreement with Client granting Client the
following rights:
In the event of the Member’s [Owner’s] death, then if President [Client] is still employed by
Company at the time of the Member’s death, Company shall transfer a thirty (30%) percent undivided
membership interest in the Company to President.
Owner died on Dec. 29, 2022. Client was employed with Company at the time of Owner’s death.
Owner’s children hired lawyers who claimed the Client was not entitled to any percentage of Company
because the agreement was invalid for various legal reasons. Client hired a lawyer who states that the
contract is clear and must be honored. Negotiations were stopped temporarily because 3 buyers have
emerged wanting to buy the company for $20 million. Negotiations over the validity of the 30% clause in
the agreement will continue once the children sell the company. The sale will take place before Dec. 28,
2023.
[cont’d.]
No need to do research on this if you do not have time. I am mainly interested in your written analysis on the
following issues:
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Should Client recognize income in 2022 due to Owner’s death?
Could we reasonably take the position that since the 30% stake in the Company has not
been transferred to date, was in dispute shortly after Owner’s death, and the dispute is, as of now,
still unresolved, there is no income to report unless and until the family decides to transfer LLC
interests in Company to Client?
If there is income to report, how do we determine the amount of that income?
If you think income need not be reported in 2022, should we file a disclosure form with the tax
return to avoid penalties in the event of an audit (note: an audit of the sale for $20 million for the
2023 tax year is highly likely).
If there is income, is the nature of Client’s income ordinary or capital gains?
If ordinary, is it compensation income, such that Company has an obligation to withhold tax
on deemed wages?
Client would like to defer the tax if possible. Is there a way to receive an interest in the
acquiring company without the present requirement to include that company’s interest in income
(assuming the Company’s buyer and Owner’s family agree to do this). For instance, the buyer
could grant a 5% interest in itself to Client, with his ability to cash-out years later in installments.
But, wouldn’t the receipt of that 5% interest be taxable when received? If so, is there any way to
delay the taxable event contractually?
Could we argue that Owner truly intended to transfer the stock to Client at Owner’s death in a
way to calm her family and still be generous to Client. If so, since the 30% LLC interest is included
in Owner’s estate for federal estate tax purposes, shouldn’t Client claim a basis in the 30% interest
equal to the fair market value of the interest on the date of death of Owner? Or, is this theory a
long-shot because Client received his interest under an employment agreement, making the
gift/inheritance argument weak? Note: IRC Sec. 1014 states in part:
a. (a) In general
Except as otherwise provided in this section, the basis of property in the hands of a person
acquiring the property from a decedent or to whom the property passed from a decedent shall,
if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person,
be—
(1) the fair market value of the property at the date of the decedent’s death,
END