Developers, like everyone else, try to find ways to minimize their tax liability. Developers will often attempt to use related parties (typically a Limited Liability Company (LLC) and an S corporation) to structure the sale of land in such a way to convert part of their appreciation from ordinary income to capital gain income. In a recent court case, one development company tried to use this tax strategy and failed after the Court ruled in favor of the IRS.
- A group of individuals created an LLC (Concinnity) and purchased 300 undeveloped acres of land in Montana for $1.4M.
- The same group of individuals also incorporated Elk Grove Development Co. (Elk). Concinnity entered into 81 buy-sell agreements with Elk for the sale of a portion of the land.
- After the land was sold, Concinnity reported long-term capital gains on its Schedule D, Capital Gains and Losses.
The IRS contends that the land sale produced ordinary income. Concinnity argued the sale produced capital gains because they held the land for investment.
A capital asset is defined as property held by the taxpayer but does not include property held by the taxpayer primarily for sale to customers in the ordinary course of their trade or business. In this instance, "primarily" means "of first importance" or "principally". The Court relied on the relevant factors for evaluating whether a taxpayer held certain properties primarily for sale to customers in the ordinary course of business.
Nature of Property Acquisition: The IRS contended that Concinnity acquired the land to divide and sell lots to customers for profit based on two documents.
- The first, Concinnity's initial Federal income tax return, where the form identified its principal business activity as "development" and its principal product or service as "real estate".
- The second is an affidavit filed by Concinnity in its second year of existence that stated Concinnity is a developer and Concinnity entered into 81 buy-sell agreements for the sale of a portion of the property.
The important issue related to this factor was the purpose for which the property was held, vs. the purpose of the acquisition. Although intentions can change during the course of holding property, there was no evidence to support this and the Court concluded that Concinnity failed to show they held the land for investment purposes.
Frequency and Continuity of Sales
More frequent and substantial sales of real property indicate sales in the ordinary course of business. The IRS contended that Concinnity had at least one customer, Elk, and potentially others, evidenced by the affidavit referencing 81 buy-sell agreements. It is not known how many and often sales occurred. Since the burden of proof fell on Concinnity and the record was unclear, this factor weighed in favor of the IRS.
Nature and Extent of Business
The only documents in the record indicated that Concinnity brokered deals, found additional investors for the development project, secured the water and wastewater systems, and guaranteed performance on certain aspects, thus aiding and participating in the development of the land.
Activity of Seller About the Property
Concinnity had to prove that they did not spend large portions of its time actively participating in the sale of the land. Since the record is unclear whether Concinnity sought out individual purchasers, purchasers sought out Concinnity, or Concinnity sold only to Elk, this factor weighed in favor of the IRS.
Extent and Substantiality of the Transaction
While the IRS contended that Elk was principally incorporated (with the same owners as Concinnity) to evade Federal income taxes and Concinnity and Elk should be viewed as the same entity, the Court found that the "identical ownership" of the two entities didn’t mean that Elk should be disregarded. The Court determined that Elk's activity constituted a valid business purpose for their existence since a portion of the land was retained by Concinnity. However, since Elk purchased the land from Concinnity at an inflated price, the Court concluded that the transaction did not occur at an arm's-length. Had there been a land appraisal to support the related party sale, this factor could have favored Concinnity.
The Court ruled that Concinnity failed to carry the burden of proof and did not prove the IRS's determinations were erroneous.
Although this particular Court case didn’t address all the other factors, the Pritchett Court case enumerated other factors that are also relevant in determining whether property is held primarily for sale to customers in the ordinary course of business. Such other factors include the extent to which improvements, if any, were made to the property and the listing of property with brokers. None of the Pritchett factors are conclusive standing alone, but rather all of the factors taken as a whole govern. Keep in mind these Pritchett factors to minimize your tax liability on future deals.
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