Minnesota: Son's use of condo defeats like-kind exchange treatment
Last month, the Minnesota Tax Court issued a decision in Johnson v. Commissioner of Revenue, No. 8544–R, 2014 WL 2965410 (Minn. T.C. June 20, 2014), with respect to taxpayers’ exchange of unimproved land for a two-bedroom condominium. Johnson is a ruling of significance for taxpayers hoping to take advantage of Section 1031 of the Internal Revenue Code (“Section 1031”) as it may apply to their state taxes.
Section 1031 allows taxpayers to defer recognition of the gain or loss “on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” IRC § 1031(a)(1). There are several requirements that must be met in order to qualify for Section 1031 exchange treatment, including certain timing and character of property conditions. With the complexities of Section 1031 in mind, a summary of the background of Johnson follows along with a synopsis of the taxpayers’ arguments and the court’s findings. This article concludes with some lessons which can be taken from Johnson.
Taxpayers Richard and Glenna Johnson are long-time real estate investors, particularly in bare land in Idaho. Richard testified that there are significant advantages to owning bare land in Idaho, particularly: extremely low property taxes (“you end up paying $15 [in property taxes] on a $400,000 piece of land if its farmed”); low insurance (“the liability portion of the policy . . . on your home . . . covers any liability claims on the parcels of land out in Idaho.”); and low maintenance (“We didn’t need to have it supervised or looked after.”). It can be inferred from this case that generally, after one year, the Johnsons would sell one piece of bare land and exchange it for another piece of bare land in a transaction intended to qualify under Section 1031.
In this particular case, the Johnsons sold bare land in Ashton, Idaho in April 2007 at a gain of $144,372 through an intermediary and purchased a condominium in Driggs, Idaho in July 2007.
Several days after the purchase of the condominium, the Johnsons’ adult son, Kristian, moved in and has resided there ever since. Kristian’s only payment to his parents was a one-time payment of $300. Other than a single deduction of $218 in 2007, the Johnsons never deducted any expenses or depreciation with respect to the condo.
The Johnsons did not include the gain of sale of the land in Ashton in their 2007 Minnesota taxable income. In 2011, the Minnesota Revenue Commissioner adjusted the Johnsons’ 2007 income to include the gain on the sales of Ashton land, denied the $218 deduction related to the condo and assessed the Johnsons $10,272 in additional tax, plus penalties and interest.
Opinion and taxpayer arguments
The parties in Johnson did not dispute that the timing of the Johnsons’ purchase of the condominium satisfied the timing requirements of Section 1031. The parties also did not dispute that the bare land and the condominium are like-kind within the meaning of Section 1031. The only item in dispute is whether the Johnsons hold the Driggs condominium as an investment.
Revenue Procedure 2005-14, § 2.05 provides that “[S]ection 1031 does not apply to property that is used solely as a personal residence.” 2005-1 CB 528. Under Code Section 280A(d)(2)(A), a taxpayer’s family member’s use can qualify a property as being used as a personal residence. The court then found that “Kristian’s use of the condominium as his personal residence, without payment of rent, disqualifies the property from [Section 1031 treatment].”
The Johnsons contended that their intent at the time of the purchase of the condominium is controlling in determining their intent for the property for Section 1031 purposes, with which the court agreed. This intent is crucial to the determination of whether property is an investment or otherwise. However, the court did not agree that the Johnsons intended use of the condo was as an investment, as their son moved into the property only a few days after its purchase. The court determined that the evidence indicated that the Johnsons “knew” that they were not purchasing the condo for investment purposes.
Finally, the Johnsons argued that “because the IRS has not challenged their treatment of the transaction, the [Minnesota Revenue] Commissioner is barred from doing so.” The court found that the IRS’ failure to audit the Johnsons’ federal return is no indication of the IRS’ approval of the Johnsons’ characterization of the transaction. Further, the court indicated that even if the IRS had investigated the transaction, the Minnesota Revenue Commissioner is not barred from its own investigation of the taxpayer.
Ultimately, the court found for the Commissioner and denied Section 1031 treatment to the Johnsons’ sale of the Ashton land. The court also affirmed the Commissioner’s addition of penalties and interest to the Commissioner’s assessment.
Lessons from Johnson
Johnson is demonstrative of several important tax planning lessons.
Knowledge of federal tax law is imperative to properly reporting state tax liability, because most states adopt the majority of the Code in arriving at adjusted gross income or taxable revenue for state tax purposes. As such, transactions may not only need to pass IRS muster, but also review of the state taxing authorities.
Even if the IRS makes a favorable determination, this determination may not thwart state tax challenges to the same transaction (not the case in Johnson, but the court indicated that this circumstance may occur).
It is important to provide your tax counsel with all relevant facts. If the Johnsons told their tax counsel (assuming, arguendo, that they had counsel) that they (a) intended that the son move into the condo, or (b) that they decided after they bought the condo to let their son live there, their tax counsel could have better assisted them in structuring the transaction and filing their Minnesota tax return.
Related to item 3, the state taxing authorities and the IRS generally have the benefit of hindsight. If a change of fact occurs after a transaction, contemporaneous documentation may be the most prudent way for a taxpayer to protect him or herself.
California: Franchise Tax Board provides guidance on tax liability of corporate members of multi-member LLCs
On July 22, 2014, the California Franchise Tax Board (FTB) provided guidance in Legal Ruling 2014-01 (Ruling) regarding when a corporation – including a limited liability company taxed as a corporation – is required to file a California return and pay any applicable taxes and fees because of its membership in a multi-member limited liability company (LLC) taxed as a partnership.
“Doing business” in California for franchise tax purposes
For purposes of California’s corporate franchise tax, part (a) of Section 23101 of the Revenue and Taxation Code (“Section 23101”) defines “doing business” as “…actively engaging in any transaction for the purpose of financial or pecuniary gain or profit.” Under part (b) of Section 21301, for taxable years beginning on or after Jan. 1, 2011, a taxpayer is also “doing business” in California if any of the following conditions are met:
The taxpayer is organized or commercially domiciled in California; or
The taxpayer’s California sales, property, or payroll exceed certain thresholds (which amounts include a taxpayer’s pro rata or distributive share from pass-through entities).
Attribution of “doing business” in California to members of LLC
For federal tax purposes, LLCs (with multiple members) are taxed as a partnership unless an election has been made for the LLC to be taxed as a corporation. California follows this federal rule. Most tax law consequences flow from the decision of the LLC to be taxed as either a partnership or a corporation. The Ruling notes that in this context, the term “partnership” refers to a general partnership as opposed to a limited partnership. In a general partnership, all of the partners are general partners and have the right to manage and conduct partnership business.
Under federal tax law, partnerships are treated as flow-through entities, which means that “[t]he character of any item of income, gain, loss, deduction, or credit included in a partner’s distributive share … shall be determined as if such item were realized directly from the source from which realized by the partnership, or incurred in the same manner as incurred by the partnership.” (Section 702(b) of the Internal Revenue Code) California conforms to this federal provision. Therefore, the Ruling explains that the business of the partnership is the business of each partner. Consequently, according to the Ruling, the activities of the partnership are attributed to each partner and the partners will be considered to be “doing business” in the same geographic locations in which the partnership is “doing business.”
The Ruling explains that the same rules discussed above apply to a LLC and its members when the LLC is taxed as a partnership. Therefore, if a LLC classified as a partnership is “doing business” in California, then its members are also “doing business” in California. The Ruling clarifies that this is the case even if the LLC is manager-managed because members of a LLC generally have the right to participate in its management which includes the right to delegate such management power to a manager. Therefore, whether a LLC is manager-managed or member-managed is not relevant for purposes of determining whether a member of a LLC that is classified as a partnership is “doing business” in California within the meaning of Section 23101.
California franchise tax consequences for corporate members of a LLC
The Ruling provides several examples regarding when a corporate member of a LLC taxed as a partnership will have a return filing requirement and be subject to the payment of franchise taxes. In each example, the LLC is taxed as a partnership, has a California return filing requirement, is subject to the LLC taxes and fees, and has a corporate member holding a 15 percent membership interest in the LLC. Generally in each example, such corporate member is not incorporated, organized, or registered to do business in California, and has no activities or factor presence in California other than through its membership in LLC.
In the Ruling’s first two examples, the LLC is (a) either registered to do business in California or organized in California; and (b) does not have sufficient activities to constitute “doing business” within the meaning of Section 23101(a) or (b). In these examples, the corporate member of such LLC is not incorporated, organized, or registered to do business in California, has no activities or factor presence in California sufficient to constitute “doing business” within the meaning of Section 23101, and has no California source income. In those scenarios, the Ruling provides that the corporate member of such LLC is not required to file California returns and is not subject to franchise taxes because the LLC’s acts of registering to do business or being organized in California are not attributable to its members.
In the Ruling’s other examples (“Other Examples”), the LLC is either:
Commercially domiciled (which is the principal place from which the trade or business of the taxpayer is directed or managed) in California;
Is “doing business” in California within the meaning of Section 23101;
Is “doing business” in California within the meaning of Section 23101 and is manager-managed; or
The sales of the LLC in California exceed the applicable thresholds of Section 23101, so that the LLC is “doing business” in California within the meaning of Section 23101.
In each of these Other Examples, the LLC qualifies as “doing business” in California, and has a California return filing requirement and is subject to LLC taxes and fees. In these Other Examples, such corporate member is not incorporated, organized, or registered to do business in California and has no activities or factor presence in California other than through its membership in LLC.
In these Other Examples, the Ruling provides that such “doing business” activities are attributable to the members of the LLC. Consequently, in these Other Examples, the corporate member of such LLC has a California return filing obligation and is subject to franchise taxes. In addition, the Ruling notes that the corporate member is also “doing business” in California if its distributive share of the sales of the LLC in California also exceeds the applicable thresholds of Section 23101.
For additional information regarding these subjects or any other multistate tax issues, please contact:
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