Chamber Member Spotlight January 1, 2012

The Reverse Exchange

By Charles Darwin Davidson, Jr.

            Two primary reasons for a reverse exchange are:

1.         Exchanger must purchase replacement property before the sale of relinquished property; and

2.         The purchase price (without making improvements) of the replacement property is not sufficient for a complete deferral of tax.

A reverse exchange is the opposite of a deferred like-kind exchange.  In a reverse exchange, the Exchanger (i.e. a property owner seeking to defer a taxable gain under the non-recognition rules of I.R.C. § 1031) acquires the like-kind replacement property before disposing of the relinquished property.  Prior to Revenue Procedure 2000-37, it was unclear whether reverse exchanges would be given non-recognition treatment by the IRS.

The following is a road map for structuring a transaction under the safe harbor protection of Revenue Procedure 2000-37.

1. The Exchanger must assign its rights under the Purchase Agreement to a newly created entity, the Exchange Accommodation Titleholder (“EAT”).  The EAT and the Exchanger then enter into a “Qualified Exchange Accommodation Agreement”.  This agreement establishes the rights and duties of the EAT and the Exchanger.  The most important duty of the EAT is to take title to the replacement property.  The Exchanger, on the other hand, has the right to lease the replacement property from the EAT and to be designated as the project manager to complete construction of improvements on the replacement property.

1. After the EAT takes title to the replacement property, the Exchanger has forty five (45) days to identify one (1) or more relinquished properties.  The Exchanger must sell the relinquished property within the lesser of one hundred eighty (180) days of the EAT’s purchase of the replacement property or the due date of the Exchanger’s tax return for the year in which the relinquished property is sold.

1. When the Exchanger sells the identified relinquished property, the cash proceeds of the sale go through a qualified intermediary who uses the proceeds to acquire the replacement property from the EAT.  The replacement property is then transferred to the Exchanger.

If properly structured, the Exchanger should have no gain on the sale of the relinquished property and the same tax basis in the replacement property that it had in the relinquished property.  When pursuing these types of transactions, the Exchanger should seek professional tax advice.

Installment Sales and Alternatives

By: Charles Darwin Davidson, Jr.

When an investor must sell real estate but cannot find a cash buyer, he or she may have to settle for installment payments.  Before agreeing to an installment sale, the investor should (1) compare the alternatives (i.e. cash sale, installment sale and §1031 transaction), (2) gauge the risks involved, and (3) determine the overall tax impact of the transaction.

COMPARING THE ALTERNATIVES.

The investor must decide whether the installment sale is better than waiting for a cash buyer, or substantially reducing the price for a quicker cash sale.  The answer will depend on how much cash the installment buyer will pay in the year of sale (less selling expenses, paying off existing mortgages, and taxes) and the interest rate charged on the installment note.  The seller should negotiate for self-amortizing principal and interest payments on the note and resist receiving interest payments only during the term with a balloon payment of remaining principal at maturity.  The §1031 transaction requires a sale of the asset and reinvestment in like-kind property.

GAUGING THE RISK.

The investor must decide whether the price is worth the credit risk and how the risk can be minimized.  An installment seller can minimize risk by following basic underwriting procedures, such as credit checks evaluating the buyer’s financial statements, and verifying the buyer’s legal status and capacity to enter into the agreement.  Beyond these basic credit underwriting precautions, the seller should also require the beneficial owner of the buyer to be personally liable for the loan, obtain additional collateral security, and require a third party’s guarantee.  The §1031 transaction is akin to the cash sale, however the investor accepts the risk of buying a new asset and must perform due diligence.

TAX IMPACT OF THE TRANSACTION.

Seller financing would be unattractive if the seller had to pay a tax in the year of sale on the entire profit:  the tax due could exceed the cash received in the year of sale.  Fortunately, the installment sale rules of Internal Revenue Code §453 generally match the payment of tax on realized gain to the seller’s receipt of cash (achieving deferral of gain).  In addition, to the extent the gain on the sale would place the taxpayer in a higher tax bracket, spreading the gain over a period of years (assuming consistent tax rates) enables the taxpayer to be taxed at the lowest possible rates.  The §1031 transaction has the possibility of deferring any gain on the sale provided the seller’s compliance with the precise rules of like-kind exchanges.

CONCLUSION

Installment sales can be a useful tool for bringing a buyer and seller together.  However, investors in real estate should compare alternatives, gauge the risks involved, and determine the overall tax impact before agreeing to an installment sale.

April 12, 2011

By: Benjamin Kent

An effective way for businesses to reduce the inevitable risk of litigation and inevitable cost of litigation is to utilize an “Arbitration Clause.”  When inserted correctly into an agreement between parties, the “Arbitration Clause” can act as a specific agreed-upon road map to efficiently guide the parties through possible disputes.

Arbitration awards are often decided by an expert, or a panel of experts, who have direct knowledge of the subject that constitutes the dispute.  The decision of the arbitrator(s) is generally final and binding upon the parties to the dispute.  So will the award be effective?  The recent Arkansas Appeals decision in Parks v. Rogers Group, Inc., 2011 Ark.App. 109 (2011) shows that the courts are enforcing arbitration awards.

The Parks case dealt with the interpretation of a lease renewal provision.  The lease contained an “Arbitration Clause,” and was thus brought before an arbitration panel.  An arbitration hearing was held to decide the dispute.  The panel held that the Parks’ could not terminate the lease.  The Parks’ attempted to vacate the arbitration award through the circuit court, which denied the request.  The denial was later affirmed by the Arkansas Court of Appeals.

The Parks’ argued that the arbitrators disregarded Arkansas case law.  The Appellate Court held:

“The court’s role is not to determine if the arbitrators decided the dispute correctly but only whether the arbitrators acted within their jurisdiction. Indeed, our deference is so great that the failure of the arbitrators to follow the law as a court would have done provides no grounds for relief. Mistakes of law or fact are insufficient to set aside an award.”

Whether or not the arbitrators decided “correctly” was not a basis for the court to vacate the arbitration award.

An “Arbitration Clause” can be effective in lease agreements, agreements for the sale of goods, construction contracts, real estate agreements, business organization agreements and employment agreements.

Your Law – Spring 2011

• Understanding Social Security
• It’s Your Health – Take Charge!
• Beyond “I Do”
• Handling Landlord-Tenant Disputes

February 22, 2011

By: J Paul Davidson

The most litigated issue under the Fair Labor Standards Act (FLSA) is whether an employee is an independent contractor or not. This classification is important for several reasons, including the fact an employer is not required to pay overtime wages to an independent contractor under the FLSA. Many employers wrongly believe it is sufficient to simply classify the employee as an independent contractor. That is not so, and a stripper case out of New York illustrates that point and demonstrates the risks associated with misclassifying an employee as an independent contractor.

A Manhattan court in In re Penthouse Executive Club Compensation Litigation recently granted a motion for class certification to a group of adult dancers who worked at a Penthouse Executive Club in New York City. The dancers alleged the Club failed to pay them overtime for working over forty-hours a week in violation of FLSA. The Club argued the dancers were independent contractors and therefore, the Club was not required to pay overtime under the FLSA.

The court was not persuaded at this stage in the lawsuit and proceeded to certify the class of dancers. The court held a plaintiff’s burden in seeking a preliminary class certification is simply to “make a modest factual showing sufficient to demonstrate that plaintiffs and potential plaintiffs together were victims of a common policy or plan that violated the law.”

Misclassification of an independent contractor occurs frequently and unfortunately, carries with it significant risks. This misclassification will not only cost the employer damages for unpaid overtime, but can include damages for unpaid unemployment taxes, workers compensation premiums, payroll taxes, and employee benefits.

Regardless of your business’s current state of compliance, there are ways to minimize its exposure to future litigation, including: (1) restructuring an employer’s relationship and control over its contractors; (2) voluntary reclassification; and (3) employee leasing.

Despite the risks, the use of independent contractors is still a cost effective and valid option for many businesses. Because of the increased litigation in this area of the law professional advice should be sought to properly manage this FLSA risk.

22 November 2010

By: J. Paul Davidson

If you are reading this article, you already know the handbook has become the proverbial sword that can be wielded by either side in litigation. Like most contracts, however, parties are often unaware of the provisions found within their handbook and often fall victim to language and agreements never read or seen before. As analyzed below, that is a foolish mistake.

Courts treat a provision in an employee handbook as a valid and enforceable contract.  In Crain Industries Inc. v. Cass 305 Ark. 566, 810 S.W.2d 910 (1991), the court held a provision found in a handbook constitutes a contract if: 1) the handbook language is sufficiently definite to constitute an offer; 2) the offer has been communicated by dissemination of the handbook to the employee; 3) there has been acceptance of the offer; and 4) consideration has been furnished for its enforceability.

With the court’s validation, employers wisely began inserting more detailed provisions in their handbooks, and one such provision has become an employers most cost-saving provision: mandatory-arbitration. With Crainand the growing popularity of alternative dispute resolution in general, it provided a match made in heaven for the employer. For employees, it was a marriage that forced many to settle disputes in conference rooms rather than courtrooms.

Despite this pro-arbitration movement, the Arkansas legislature placed some restraints on arbitration. For instance, the Uniform Arbitration Act (“UAA”), codified at Ark. Code Ann. § 16-108-201 (2008), prevents arbitration for tort claims, employee-employer disputes and some insurance related claims. Although helpful for employees, employers simply argued around § 16-108-201 by alleging the Federal Arbitration Act (“FAA”) applied because,allegedly, the agreement involved interstate commerce and preempted the UAA. Unlike its counterpart, the FAA has very few restraints on arbitration agreements.

The Arkansas Supreme Court, however, appeared to thwart this arbitration-friendly movement in Arkansas Diagnostic Center v. Tahiri, 370 Ark. 157, 257 S.W.3d 884 (2007). In Tahiri, the court held an employer could not compel its employee to arbitration. Like many employers, ADC argued its agreement involved interstate commerce, was subject to the FAA and therefore valid. To support the argument, the employer argued interstate commerce applied to the agreement because it had, among other things, treated out-of-state patients and paid the employee to travel to out-of-state seminars.

Not persuaded, the Arkansas Supreme Court refused to compel the employee to arbitration. In doing so, the court tapped the brakes on this pro-arbitration movement and protected an employee’s right to the courtroom, at least for now.

29 November 2010

By: Daniel Roda

Most investors have heard of a 1031 Exchange – a tax-deferred exchange of “like-kind” property under Section 1031 of the Internal Revenue Code.  This regulation provides that no gain or loss be recognized on certain property exchanges.  The exchanged property must be “like-kind” and must be held for business or investment, not as inventory or a personal residence.  Additional requirements must be met in terms of timing, structure, and mechanics, however, the concept remains simple:  if you sell a property and purchase a replacement within 180 days and before your next tax return is due, you can attain significant tax advantages with proper planning.

What if you have found a property you want to buy, and you have a “like-kind” property you intend to sell within the next few months, but you aren’t able to sell the old property before you buy the new one?  Can you still get the benefit of a 1031 exchange?  The answer is YES, but properly structuring the transaction, referred to as a “Reverse 1031 Exchange”, is complex.

A 1031 exchange is channeled through a Qualified Intermediary.  This intermediary, an independent entity that facilitates the exchange, does not actually take title to the property being exchanged.  The rights to the sale contracts involved are assigned to the intermediary, and the intermediary holds the funds from the original sale until replacement property is identified and purchased.  In a reverse exchange scenario, a Qualified Intermediary is still utilized, but not until the time comes to sell.

In a reverse exchange, a new entity must be formed.  This new entity’s purpose is to take title – that is, act as the buyer – of the new property.  This new entity is referred to as an Exchange Accommodation Titleholder, or, sometimes, a parking company.  You can lease back the new property while it’s being “parked”, and the new entity can even delegate the right to complete construction during this time.

Once you are ready to sell the old property, the proceeds of sale are channeled through the Qualified Intermediary.  The intermediary then uses those proceeds to purchase the new property from the parking company.  If everything was set up right from the front end, and the IRS regulations are observed throughout, you should incur no taxable gain on the sale of the old property, and have the same basis in the new property.  When contemplating a traditional or reverse 1031 exchange, you should seek the advice of your attorney and your CPA.

4 November 2010

By: Benjamin Kent

One of the main fundamental principles underlying the public policy of any bankruptcy is to allow the Debtor a “fresh start.”  With this in mind, the Bankruptcy Code allows for a Debtor to disclaim from the bankruptcy estate certain types of interests in property, such as a car or home, up to certain values.  Protecting the interests of Creditors is also a fundamental principle in the policy of bankruptcy.  Since providing the Debtor an exemption is essentially depriving a Creditor that value were it included in the estate, the Bankruptcy Code limits the exemptions available to a Debtor in an effort to balance fairness between the two parties.

The Bankruptcy Code allows for a Debtor to give values to his exemptions based on amounts provided to him in the Code.  This property, claimed as exempt, will be excluded from the bankruptcy estate unless a party in interest, or the Trustee, objects within a 30-day period.  What would happen if the trustee did not object to an exemption, but it was later found that the Debtor undervalued that exemption?

The Supreme Court has recently answered this question in Schwab v. Reilly.  In this case, the Debtor gave the value of her claimed exemptions in dollar amounts within the range allowed for by the Code.  Because the exemptions were within the allowable range, the Trustee did not object to these exemptions within the 30-day period.  It was later discovered that the property was worth more than the value to which it was given by the Debtor, and the Trustee moved to recover the value in the estate beyond the dollar value given.  The Court held that where the Bankruptcy Code defines the property which a Debtor is authorized to exempt as an interest, the Trustee is entitled to rely upon the value given and need not object to the exemption in order to preserve the estate’s ability to recover the extra value.

The Court’s decision in this case puts a limit on the value received by a Debtor subject to the rules.  It also shows that a Debtor who wishes to exempt the full market value of an asset should use accurate language in a way that makes the scope of the value clear.  If you have questions about bankruptcy, please contact one of Davidson Law Firm’s qualified attorneys.

Your Law Fall 2010

• You Have Been Laid Off – Now What?
• New Banking Regulations May Affect You
• Supreme Court Update
• Wills and Estate Taxes Are in Flux: What Does That Mean for You?