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When Clients Flout the Related Party Rules of Section 1031


In this post, we will go over the basics of Teruya Brothers Ltd. v. Commissioner (2009) and then discuss why CPAs need to pay close attention. Teruya involves the “related party” rules of Section 1031, which are among the most perplexing and least understood. In fact, this case made a major contribution to how these rules operate in reality. 

Feb 18th 2020
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One case every CPA should be familiar with is Teruya Brothers Ltd. v. Commissioner (2009). There are several reasons for this.

One is the sheer magnitude of the mistake made by Teruya and its collaborator in the case, Times Super Market, Ltd (“Times”). Teruya ended up losing millions of dollars in tax deficiencies assessed by the IRS. Furthermore, the type of behavior engaged in by the parties in this case is precisely the kind CPAs should be on the lookout for. If accounting professionals can be diligent in identifying this kind of behavior, they will improve their reputation as ethical businesspeople. 

In this post, we will go over the basics of this important case and then discuss why CPAs need to pay close attention.Teruya involves the “related party” rules of Section 1031, which are among the most perplexing and least understood. In fact, this case made a major contribution to how these rules operate in reality. 

First, the facts of the case:

Teruya owned two pieces of land on which condominium complexes were built. Both condo complexes were leased to separate companies, and Teruya decided to sell them to these businesses. It wanted to defer whatever income taxes would be due from the sales, and so it structured the transactions as “tax-deferred exchanges” under Section 1031. 

In transaction #1, Teruya sold the land to the holder of the condo complex lease, which was an unrelated party. The leaseholder transferred funds to the QI, and the QI then transferred those funds to the seller of the replacement property.

The QI also transferred additional funds to complete the transaction. The seller of the replacement property then transferred title to the QI, and the QI delivered the title to Teruya.

The seller, Times Super Market, Ltd., was a related party, as defined by the tax code, and it was a corporation in which Teruya owned a majority interest. Importantly, the related party seller was able to offset gains from the sale of the replacement property with operating losses.

The facts of transaction #2 were quite similar, except this time, Teruya acquired two replacement properties. In this second transaction, the related party seller also did not recognize any gain from the sales. The related party seller actually realized a loss on one sale, and on the other, it used operating losses to cancel out the gain. 

Section 1031 exchanges involving related parties trigger additional rules and complexity. Subsection 1031(f) contains the “special rules” for related-party transactions. Congress implemented this subsection in 1989 to combat abusive tax avoidance by related parties. Before this, related parties were engaging in abusive “basis shifting,” which means they were swapping properties just prior to a subsequent sale of the low-basis property.

Importantly, these special rules for related parties were created before the rules for deferred exchanges were created. So, analyses for deferred (or “indirect”) related party exchanges can be more complex than those for direct exchanges involving just two (related) parties. 

The Teruya case is one example of an indirect related party exchange that involves an unrelated buyer, a QI and a related party seller. Normally, when a related party exchange is a “direct exchange,” it is governed by the two-year rule found in 1031(f)(1) and the exceptions to this rule found under 1031(f)(2). But, because the Teruya case involves indirect exchanges, the court determined that only the “purpose requirement” under 1031(f)(4) applied.

The purpose requirement states that nonrecognition treatment cannot be granted to either a direct or indirect related party exchange which is structured specifically to avoid federal income tax. In other words, if the court finds that the taxpayer and the related party engaged in creative maneuvering specifically to produce an advantageous tax result, the court can deny nonrecognition.

This is a somewhat subjective analysis, as the court has to determine that the taxpayer “colluded” with the related party to achieve a specific result. In the Teruya case, the court found that the taxpayer and the related party had clearly collaborated to produce a superior tax result.

The court based its conclusion on the fact that both parties were clearly placed in an economically superior condition because of the transactions. Teruya was able to defer substantial gains, and Times was able to use past operating losses to cancel out gains. The parties executed the transaction with prior knowledge that Times would be able to avoid heavy income taxes given its prior losses. This is precisely the type of behavior 1031(f)(4) is designed to combat.

The behavior in Teruya is exactly the sort of behavior contemplated by the purpose requirement under 1031(f)(4). CPAs can do a lot by understanding this purpose requirement and drawing attention to it in circumstances such as those found in this case.

If you see this sort of collaboration to avoid federal income tax, this is a sure sign that the rules are likely being violated. You needn’t have a rock solid understanding of how the related party rules function in all instances. If you can flag this type of behavior, you can go a long way toward building credibility and bringing value to your clients. In the end, Teruya Bros. ended up in a far worse situation financially than if the company had simply cashed out in a traditional sale. 

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