By George E. Foss III
The New Hampshire Department of Revenue (DRA) has recently developed a new audit tactic that could cost your Clients a lot of money, and expose you or your firm to professional liability. The intent of this message is to describe the current situation.
With the advent of the Single-Member LLC (SMLLC), an entity disregarded for Federal tax purposes, it became a popular planning tool to suggest to clients they acquire their real estate in this vehicle.
A SMLLC is taxed as a sole proprietorship, and accounted for on Schedule C or E of the Client’s Federal Tax return. Not much attention was paid to how the entity was taxed in New Hampshire, however. It turns out that the state requires each such entity to file a separate Business Profits Tax (BPT) return, so having such an entity to hold the real estate investment was just a tiny bit more burdensome than having the asset held directly, and the Client picked up additional liability protection in the process.
As the popularity of Section 1031 Exchanges grew, it became even more creative on the part of the advisor to recommend to the Client that the new property be taken in the name of the SMLLC directly, despite the fact that the old property had been held differently, as a transfer tax savings would result over having the Client take first in the original name and then change the resulting deed; this step would cost an additional 1.5%.
The issue goes further than mere advisor creativity. With the advent of the Tenant-In-Common (TIC) investment, made popular by the IRS issuance of Rev. Proc. 2002-22, an investor could sell old property in New Hampshire, held in any way (corporate, individual, trust, etc.), and take a fractional interest in new property somewhere else in the country, up to a 1/35th interest in a signature building, shopping center, medical facility, and the like. There were also oil and gas interests being offered as Replacement Property.
However, the promoters of these investments, and more importantly the banks who financed them, required each of the up to 35 investors to go into the investment “clean,” with no baggage. A special type of SMLLC was created in Delaware, which had a second, “swing” member whose sole purpose was to veto a bankruptcy filing on the part of the SMLLC. In this way, the bank financing the TIC assured itself that none of the investors could declare bankruptcy, none had any past business liabilities or “baggage,” and none could be sued because the most a creditor could get was an attachment on the investor’s SMLLC interest, not on the underlying property.
Since 2002, hundreds if not thousands of these TIC investments were sold to New Hampshire taxpayers who were exchanging out of old, low basis real estate in this state.
Enter the New Hampshire Department of Revenue (DRA), about April of 2008. It began to use transfer tax information provided to it by the 10 Registries of Deeds to track persons who sold New Hampshire real estate and did not file a Business Profits Tax Return with gain figures indicated that were comparable to the value of the stamps that had been placed on the deeds of conveyance. It appears that transfers of $2 million and above were targeted initially.
Eventually the DRA identified a rather large number of NH taxpayers for the 2007 tax year who sold property, did not file a BPT return (because it was a Section 1031 Exchange), and who did not take the Replacement Property in exactly the same name as was on the deed to the Relinquished Property. The cases divided themselves into two groups: a Voluntary Group of taxpayers who took the new property in an SMLLC to enhance their liability protection going forward, and an Involuntary Group of taxpayers who took the new property in an SMLLC because they were required to do so by the TIC (or Oil & Gas) sponsor.
There has long been an issue in Section 1031 Exchanges called the “Identity of Taxpayer Rule,” which states that for Federal tax deferral to occur in an otherwise valid transaction, the same taxpayer giving the old property must get the new property. However, certain types of entities were “Disregarded” by IRS, namely Grantor Trusts, SMLLC’s and others.
As of April of last year, such is NOT THE CASE in New Hampshire. Only the Grantor Trust is disregarded, which means that the hapless group of taxpayers mentioned above owes NH Business Profits Taxes on their completed exchanges.
This issue first came to our attention when a past client (a member of the Involuntary Group) received a Notice of Assessment for $155,000 from the DRA in November 2008. This person had sold a NH shopping center for a price in excess of $2 million, which was owned by his corporation and purchased 3 TIC investments out-of-state. (Note: The out-of-state issue does not appear to be of concern to the DRA, as it has assessed in-state transactions too.) The TIC sponsor required the investments to be held in Delaware SMLLC’s, and 3 such entities were formed for our client, with his corporation as the sole member of each. His closings were complete in January 2008, and were reported on his 2007 return. Since he took a small amount of “Boot” in the transaction, this was reported on a timely filed NH BPT return. The balance of the exchange was reported on IRS Form 8824 (Like-Kind Exchanges).
Naturally, our Client was concerned and he sought the advice of experienced counsel. They took his case, and approached the DRA in late December 2008. The DRA requested information from the attorney as to how TIC’s were being organized and marketed, and such was provided to it in January 2009.
From what we can gather happened next was that the DRA immediately began to audit BPT returns from 2005, the farthest back the Statute of Limitations would let them search. It made no attempt to discuss its new audit tactic with the attorneys (there were now several, all representing different taxpayers), and several months passed. We know of the 2005 audits because we have heard from some of our past clients. We also received a call from an attorney outside Rochester, NY, whose Client had just received an assessment letter from the DRA of over $500,000 for a NH campground he sold in 2005. We also know of them because another client has just had his 2005 exchange disallowed by NH despite the fact that this client was audited and approved by IRS for the same tax year.
Now the DRA has apparently had a change of heart: It has just offered all of the affected taxpayers a deal. Just pay the tax, and DRA will waive the interest and penalties. None of the parties are expected to settle for this, so the situation continues.
Still on the table is an offer by our Client’s attorney to take his case as a model and litigate it through the DRA and through the courts, if necessary. The reason to pick his particular case is that it has no facts in it other than the Section 1031 Exchange with different names on each side. All parties would be bound by the results of such a case, but for now, the DRA is doing nothing.
To sum up, we strongly suggest that if your Clients wish to do a Section 1031 Exchange, they do so with the same entity or names on both sides. Then, New Hampshire is certain to recognize it. If the Client wants the added liability protection of an SMLLC, have them establish it after the fact, wherever their purchase is located. The TIC sponsors will not like this, and may refuse to sell your Client their TIC product for the reasons stated above.
We are spearheading this pro-bono effort to get the word out about this matter, and would appreciate you sending us any information on the topic that comes to your attention.