The New Hampshire Department of Revenue (DRA) has recently developed a new audit tactic that could cost taxpayers a lot of money.
The Single-Member LLC (SMLLC), an entity disregarded for Federal tax purposes, has become a popular planning tool for acquiring and holding real estate. A SMLLC is generally taxed as a sole proprietorship, and accounted for on Schedule C or E of the Client’s federal tax return. The State of New Hampshire requires each such entity to file a separate Business Profits Tax (BPT) return.
As the popularity of Section 1031 Exchanges grew, taxpayers began acquiring replacement property in the name of a newly-formed SMLLC directly, despite the fact that the relinquished property had been held differently. Beyond liability protection, taxpayers began using the SMLLC to acquire Tenant-In-Common (TIC) investments, which were made popular by the IRS issuance of Rev. Proc. 2002-22. Under this ruling, an investor could sell their relinquished property in New Hampshire, which was held in any number of ways (corporate, individual, trust, etc.), and take a fractional interest in replacement property located somewhere else in the country, for example an undivided interest in a signature building, shopping center, medical facility, and the like.
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 New Hampshire. Enter the 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 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 relinquished property must get the replacement property. However, certain types of entities were “Disregarded” by the 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 taxpayers mentioned above owe NH Business Profits Taxes on their completed exchanges.
For anyone effectuating 1031 exchanges in New Hampshire, special care must be taken. Be sure to consult a qualified intermediary such as All States 1031 Exchange Facilitator, LLC who is familiar with all the rules.
