In order to avoid taxable “boot”,the relinquishing party in a §1031 exchange generally “trades up” – that is, the replacement property has a higher value than the relinquished property.
However, using the installment sales method (under §453(f)(6) of the Internal Revenue Code) it is possible to “trade down”and still defer taxes using both §1031 and §453. Consider the following examples: Example 1. A owns real property with a fair market value of $1,000. A’s basis is $400. On December 1, 2012, A transfers the property to a qualified intermediary (QI) who transfers it to B for $1,000. On February 1, 2013, the QI acquires replacement property with a fair market value of $800 and delivers the replacement property and $200 to A. As a result of the transaction, A has $200 in boot which is not recognized until 2013. A takes a $400 basis in the replacement property. Example 2. Same facts as in Example 1, except that B pays $800 in cash and the remaining $200 is financed by A under a four-year installment note. When the QI acquires the replacement property, the QI transfers the property and the note to A. As a result of the transaction, A still has $200 in boot, but A recognizes $50 in 2013, 2014, 2015 and 2015, and takes a $400 basis in the replacement property. Example 3. A owns real property with a fair market value of $1,000. A’s basis is $200. On December 1, 2012, A transfers the property to a qualified intermediary (QI) who transfers it to B for $1,000, of which $400 is paid in cash, and the remaining $600 is financed by A under a six-year installment note. On February 1, 2013, the qualified intermediary acquires replacement property with a fair market value of $400 and delivers the replacement property and the installment note to A. As a result of the transaction, A has $600 in boot of which $100 is recognized in 2013, 2014, 2015, 2016, 2017, and 2018. A takes a $200 basis in the replacement property. What general principals can be derived from these examples? 1. Money or an installment note deposited with a qualified intermediary that is otherwise boot is not constructively received until the end of the exchange period. (The same rule applies in deferred exchanges where the buyer places the purchase price in a qualified escrow and acquires the replacement property for the relinquishing party.) Thus, if the closing of the relinquished and replacement properties occurs in separate tax years, taxable boot may deferred to the year in which the replacement property closes. 2. The basis in the relinquished property carries over to the replacement property. As a result, normal §453 “gross profit percentage rules” do not apply. Under normal installment sale rules, a portion of each payment is recognized as income and a portion is treated as a return of basis. When the installment method is combined with a §1031 exchange, all payments under the note are treated as taxable (because all of the basis carries over to the replacement property). 3. Using the installment method, taxable boot resulting from the exchange may be deferred over the period of the installment note. Regardless of the form of entity (corporation, LLC, limited partnership, etc.), the individuals within a company who are responsible for the company’s management and operation (such as the board of directors, the managers or the officers) often face personal liability to both third parties and to other members or shareholders of the company.
The management can be protected from such liability in two ways: (1) by raising the bar on what constitutes actionable conduct, and (2) by shifting the risk of liability from the management to others. These protections should be worked into the company’s governing documents (such as the bylaws or operating agreement). Raising the Bar on Actionable Conduct. Management does not want to be personally sued when an investment or a business does not perform up to the expectations of others. You can protect management from the risk of shareholder and member suits(but not third party suits) in two ways. First, you can include a provision in the governing documents stating that managment's decisions are subject to the business judgment rule (“BJR”). Very generally, the BJR shields management from liability for decisions made in good faith and in the best interests of the company – even if those decisions turn out to have been harmful to the company. Second, you can include an exculpatory clause in the governing documents. A properly drafted exculpatory clause will shield the management from member and shareholder liability for all decisions other than those that were grossly negligent or intentionally wrong. Shifting the Risk of Loss. If management is sued, you can shift the loss in two ways: (1) by requiring the company to indemnify the management, and (2) by requiring the company to obtain director’s and officer’s insurance (“D&O insurance”). The company may defend and indemnify the management against member/shareholder and third party claims provided that the indemnitee acted in good faith and in the best interests of the company. Similarly, D&O insurance also protects the management, and is often preferable since (1) the company is only paying the premium – and not the defense fees and indemnity costs, and (2) the D&O carrier may indemnify the management without the “good faith” and “best interests” limitations placed upon the company. If the company agrees to indemnify its management and to provide D&O insurance, the governing documents should expressly state the company indemnity available to the management is secondaryto any available D&O insurance. |
blogHi. I'm Stephen Flynn. Attorney and founder of the Law Offices of Stephen M. Flynn. This is my blog. Enjoy! Archives
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