Two-member LLC as disregarded entity.

• Author: Noles, Susana
• Position: Taxation

Letter Ruling 9911033, addressing classification of a two-member limited liability company (LLC) as a disregarded entity for purposes of a Sec. 1031 exchange, may have a broad impact on general tax planning for disregarded entities, and perhaps implications for the check-the-box regulations.

As a result of market conditions in recent years since the downturn in real estate values, lenders' requirements have become more stringent, increasingly relying on bankruptcy-remote entities as a form of insurance against a borrower's declaration of bankruptcy. For taxpayers seeking to structure a tax-free exchange under Sec. 1031, this demand creates an obstacle by calling for an entity other than the relinquished property's owner to receive the replacement property, because Sec. 1031 requires that the owner of the property relinquished receive the replacement property.

The taxpayer in the letter ruling was able to satisfy both the lender's demand for an "insurance policy" through the use or a bankruptcy-remote entity, as well as the taxpayer's own requirements under Sec. 1031 for a tax-free exchange. In the ruling, the trustees of a grantor trust (trust) wished to exchange a parcel of real estate owned by the trust for another property of their choosing in a Sec. 1031 exchange. The trustees assigned all their rights in a contract to sell the property (relinquished property) to a qualified intermediary (intermediary) (as defined in Regs. Sec. 1.031-1(g)(4)). It was intended that the intermediary would acquire a like-kind property (replacement property) and transfer it to the trust in a transaction qualifying for tax-free treatment under Sec. 1031 (a)(3).

The trustees intended to finance the replacement property through a loan. The lender, as a condition for making the loan, insisted that the legal title to the replacement property be held by a bankruptcy-remote entity. Accordingly, to secure the loan, the trust formed a state LLC under an LLC agreement between the trustees and Member2, a corporation wholly owned by the trust. A representative of the lender was appointed to Member2's board of directors. The intermediary was instructed by the trustees to transfer the replacement property directly to the LLC rather than to the trust.

Under the LLC agreement, the trust has sole authority for making decisions on behalf of the LLC, with certain exceptions delineated in the LLC agreement. The trust is allocated 100% of the LLC's profits, losses and credits...