In its first precedential guidance published in five years, the California Board of Equalization has unanimously overruled the Franchise Tax Board's disallowance of a like-kind exchange by a group of investors, holding that the exchange was valid under IRC section 1031.
The formal legal opinion -- In re Rago Development Corp., 2015-SBE-001, dated June 23 -- has been flying under the radar.
But Edward Kaplan of Greene Radovsky Maloney Share & Hennigh LLP, who represented the taxpayers in Rago, called the decision a big win for investors and a signal to the FTB "to pull back from some of its more aggressive positions in 1031 cases that have strayed too far from established federal law."
"The Franchise Tax Board has, for years, aggressively tried to create its own body of law, advancing arguments that the IRS has directed its own agents not to raise," Kaplan said. "It's not much of an overstatement to say, prior to issuance of this opinion, that the Franchise Tax Board had never seen an exchange that properly qualified for tax deferral."
According to Thomas Henning of Allen Matkins Leck Gamble Mallory & Natsis LLP, California law is equivalent to federal law regarding the qualification of an exchange under section 1031, but the FTB interprets tax cases more restrictively than the IRS.
BOE Vice Chair George Runner (R) said the appellate board agrees with that assessment of the FTB's positions on like-kind exchanges.
"We believe they have been too narrow in their interpretation of like-kind, and that's really why we chose to publish this, to help give some direction in the future," Runner said. "And I think we'll see some FTB cases in the queue that hopefully will get resolved now without coming to the board."
According to BOE member Diane Harkey (R), who moved that the Rago decision be a precedential formal opinion, more than 50 section 1031 like-kind exchange cases are on appeal from the FTB. She added that the backlog should be alleviated now that the FTB has guidance from the BOE.
"We are an appellate body, and I think it's very important for tax practitioners, taxpayers, and others to know how we're issuing judgments and what facts we're relying on," Harkey said. She added that when the BOE has a case that can be applied broadly, the board "ought to publish precedential opinions because it provides guidance for the Franchise Tax Board as to where we're going to rule."
Regarding like-kind exchanges, Harkey said it's the FTB's job to audit and investigate transactions.
"But when the investors or owners or taxpayers complete the 1031 exchange per the federal guidelines, I think that's kind of where it should stop," Harkey said.
Harkey added that the BOE decided another section 1031 case the same day it decided Rago. In the second case, which is not precedential, the BOE denied the taxpayer's appeal because the taxpayer withdrew funds in the middle of the process, which disqualified the transaction per the federal code.
"I think this sets it up pretty clearly," Harkey said. "Two separate cases, two separate instances where the board ruled where the requirements had been met, the 1031 was completed -- and I doubt that we'll see many more of those," she said.
While the BOE's decision in favor of the investors in Rago was unanimous, the vote to make it a precedential formal opinion was 3 to 2. BOE Chair Jerome Horton (D) was against making the opinion guidance that can be cited as precedent.
"The Rago case was fact-intensive, and I voted for the taxpayers because the transaction was arranged in concert with the law, court cases, and IRS rulings," Horton said in an e-mail to Tax Analysts. "I voted not to adopt the decision as precedential because the case was based on a unique set of intricate facts and might mislead taxpayers to believe that the board somehow changed the application of existing law."
Horton said the law, IRS rulings, and court decisions governing exchanges under section 1031 "are clear; what will vary are the facts, the credibility of the evidence, and the argument by taxpayer's representatives."
"If you want to protect your client from lengthy appeals and incurring massive fees, I suggest you arrange your finances in accordance with court decisions on the law and not fact-intensive precedents established by the Board of Equalization," Horton said. "The board is not a court of law, and at times the law may be complicated. If we really want guidance that we can rely on, the Franchise Tax Board should be able to seek a writ of mandate and resolve the case in court, or the legislature should make it easier for the courts to review cases that are in the gray area."
Swap and Drop
The Rago case involved a "swap and drop" -- an exchange followed by a capital contribution of the replacement property to an entity in return for an ownership interest in the entity.
Henning has explained in legal alerts to clients how the FTB's interpretation of like-kind exchanges is more restrictive than the IRS's interpretation. He said the FTB's position on swap and drops is that the taxpayer did not conduct a like-kind exchange if, at the end of the related transactions, the taxpayer has given up real property and received intangible personal property in the form of membership or partnership interest.
Henning laid out the swap and drop in Rago:
- The group of taxpayers sold properties and exchanged into tenancy-in-common interests in a replacement property. This was the swap.
- The group, as required by their lender, contributed its individual co-tenancy interests into a single-purpose limited liability company seven months after the exchange. This was the drop.
The BOE rejected the FTB's arguments that the drop disqualified the section 1031 exchange. Henning said the BOE instead held that there was independent significance to the taxpayers' holding the property as co-tenants for seven months and that the roll-up of the co-tenancy interests into an LLC was merely a change in the form of ownership that did not disqualify the exchange.
Harkey said that as long as the transaction has closed and the taxpayers have completed the section 1031 exchange, "the fact that you then shift the interest to a limited liability corporation probably shouldn't matter."
"I don't believe it alters the nature of the transaction," Harkey said. "It surely didn't in this case, where the same investors were in the same LLC, and in fact they kept the LLC and the investment property -- they didn't just flip it. All we can say is that by the federal law you have to complete the transaction, and they did complete the transaction under all the requirements."
The step transaction doctrine disallows section 1031 exchanges if artificial steps have been created for tax avoidance. Harkey said the BOE did not find that the step transaction doctrine applies in this case because the taxpayers' reasons for changing from an LLC to tenants in common "are pretty obvious to anyone who invests," ranging from liability reasons to the banks that hold the mortgages preferring to package and syndicate them.
Kaplan, meanwhile, said the IRS "understands that substance over form and step transaction arguments are normally out of place when testing the qualification requirements of like-kind exchanges."
"No deferred exchange, with use of a qualified intermediary, would ever pass these tests," Kaplan said, adding that entering into like-kind exchanges in California is generally done with the caveat to expect qualification to be challenged.
"Hopefully, this formal opinion will help bring California back in line with the federal law and the IRS's positions and allow tax practitioners and planners to rely on the same authority and use the same structures that qualify for 1031 treatment in California that are used in the rest of the country," Kaplan said.
Kaplan said he's gratified to see the current BOE take a more proactive role in publishing clarifying, precedential guidance.
"A long-standing problem with California's tax administration is due, in great part, to its shortage of published precedent," Kaplan said.
Kaplan said that without a formal tax court to issue opinions, practitioners often find themselves relying only on BOE summary opinions. In 2012 the State Legislature required the BOE to issue written taxpayer appeal rulings when at least $500,000 is at issue, but Kaplan said the summary opinions are essentially the equivalent of letter rulings, limited to their facts, and not binding on the FTB to follow.
Greg Turner of Sheppard, Mullin, Richter & Hampton LLP said there had been a feeling among some in the Legislature that the BOE's decisions, particularly in high-profile cases, were not being promulgated according to a rigorous application of the law to the facts and at times even appeared inconsistent.
The new requirement for written explanations of taxpayer appeal rulings "was an effort to force that sort of judicial rigor in a more transparent fashion," Turner said. He added, however, that the legislation "really didn't have much in the way of teeth to it."
"From a taxpayer's perspective, aside from the inter-governmental-branch dispute, I'm glad to see that the new board is embracing publishing opinions," Turner said. "It will substantially improve guidance available to taxpayers and the Franchise Tax Board. In the long run, published opinions will help reduce appeals to the Board and conserve everyone's resources."