Recent California Ruling on Drop and Swaps

Near the end of 2016, the California Board of Equalization issued a ruling on a 1031 exchange transaction involving a limited liability company that distributed its interests down to the members prior to a sale in order for one of the members to complete a 1031 exchange – a “drop and swap”. The Board of Equalization agreed with the Franchise Tax Board challenging an exchange using the substance over form theory expressed in the Chase and Court Holding cases. The Board determined that the sale should be attributed to the LLC, not the individual members, therefore disallowing the exchange, and upheld the assessment of penalties. The decision cites language from Court Holding’s decision that “[a] sale by one person cannot be transferred for tax purposes into a sale by another by using the latter as a conduit through which to pass title.” 

The Board cited several cases in its opinion and discussed factors such as who negotiates the sale, who enters the purchase agreement, who signs the documents, the amount of time that passes between the negotiation and the sale, and the motivation behind the distribution out to the members/partners prior to the sale. The facts in this case, including a determination that the LLC held itself out as the seller to the buyer, broker, escrow company, and the bank, led the Board to find that the taxpayors “merely stepped into the shoes of [the LLC] after the sale was already pending its completion.”

The Board’s decision is a reminder that prior planning is essential when exchangors are contemplating a drop and swap transaction.

The ruling is In re Giurbino and can be found here.