Evaluating and making a choice of "no entity" for real property held for investment or lease.

• Author: Wagner, E. John, II

The choice of entity for real property held for investment or lease is dependent upon many factors. As a general rule, clients wish to have a workable structure--one requiring only the level of sophistication or complication necessary to achieve certain goals. In some situations, this requires a choice of no entity at all, and a structure treated as a co-tenancy for federal income tax purposes (a "tax co-tenancy") is appropriate. This article discusses some of the federal estate and income tax advantages of tax co-tenancies, and then analyzes structures under state law that may be treated as tax co-tenancies.

Advantages of Tax Co-tenancies

The reasons why taxpayers may choose a tax co-tenancy are too numerous, and too dependent upon a particular taxpayer's circumstances, to comprehensively list here. A few recurring reasons why taxpayers chose tax co-tenancies include the following:

* No separate tax return. Each tax co-tenant is treated as the owner of an undivided fractional interest in the property. Consequently, each co-tenant will report a fractional share of the items of income or deduction on the co-tenant's tax return. Because a partnership tax return is not required, a tax co-tenancy may also reduce the probability of audit.

* Separate like-kind exchanges. Notwithstanding the low individual capital gains rates, many clients still wish to defer capital gain upon the sale of property by entering into a like-kind exchange under Code [sections] 1031.(1) For this purpose, a tax co-tenancy allows the owners to reinvest in separate replacement properties. In contrast, partnership interests are excluded from like-kind exchange treatment,(2) making successful like-kind exchanges of partnership property into replacement properties held by different partners difficult or impossible.(3)

* Automatic step-up in basis upon death of tax co-tenant. When a tax co-tenant dies, the basis of the decedent's interest is automatically stepped up to its fair market value.(4) Thus, in contrast with property held through a partnership, it is not necessary to make a Code [sections] 754 election to obtain this favorable tax treatment for appreciated property held in a tax co-tenency.

* Other federal income tax advantages. Tax co-tenants may make separate elections for depreciation and depletion and enjoy other federal income tax advantages associated with separate ownership.

* Estate and gift tax valuation discounts. The determination of appropriate valuation discounts for minority interest and lack of marketability for federal estate and gift tax purposes is a facts and circumstances inquiry,(5) and arguably more resembles an art than a science. Although many believe limited partnerships generate the largest valuation discounts, courts have applied reasonable valuation discounts to co-tenancies, generally rejecting the IRS' arguments that such discounts should be limited to the cost of partition.(6) Taxpayers should be wary, however, that the specialized valuation regime under the federal estate tax for co-tenancies featuring survivorship rights under state law may obviate the advantages of such valuation discounts.(7) As a result, taxpayers seeking valuation discounts with respect to tax co-tenancies are advised to hold title under a structure that does not feature survivorship rights.

Classification as a Tax Co-tenancy

If it is determined that a tax cotenancy is in the taxpayers' best interests, then a form of ownership under state law must be chosen that will be respected as such for federal tax purposes. Not surprisingly, most taxpayers attempt to accomplish this end through one of the co-tenancy arrangements available under state law ("state law co-tenancies").(8)

In the case of the federal estate and gift taxes, rights under state law should generally control the valuation of interests transferred by a decedent or donor. Accordingly, valuation discounts for lack of marketability or control generally are determined based upon the rights transferable under state law in an arms-length transaction.(9) The classification of a state law co-tenancy for federal income tax purposes is more complex because it is not merely a function of the form of ownership under state law.(10) In some circumstances, a state law co-tenancy will be treated as a tax partnership, thus making the federal income tax advantages of a tax co-tenancy unavailable. Therefore, if taxpayers hold property in a state law co-tenancy, it still is necessary to engage in an independent inquiry to determine whether the state law co-tenancy is also a tax co-tenancy or whether the taxpayers instead own the property through a tax partnership.(11)

Code [subsections] 761(a) and 7702(a)(2) define a tax partnership as "a syndicate, group, pool, joint venture or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not a corporation, trust, or estate." Treasury Regulations provide a more descriptive test, focusing upon whether "the participants carry on a trade, business, financial operation, or venture and divide the profits therefrom."(12) Taken together, the Code and Treasury Regulations present a two-part test, with each part constituting a necessary condition to the existence of a tax partnership. First, two or more persons must carry on a business or similar activity. Second, there must be a sharing of profits. Under this formulation, the absence of either should preserve the classification of a state law co-tenancy as a co-tenancy for federal income tax purposes.

Case law has generally approached the inquiry more broadly, looking to a multiplicity of factors to determine whether taxpayers subjectively intend to form a...