Part of the 1031 XChange Index - Originally Published 7/1/2009 at STEC

The U.S. Bankruptcy Court for the Eastern District of Virginia ruled in late April that funds held pursuant to tax-deferred exchange agreement under IRC Section 1031by a Qualified Intermediary in a Chapter 11 filing are property of the bankrupt estate. Millard Refrigerated Services, Inc. v. Landamerica 1031 Exchange Services, Inc., APN 08-03147-KRH, U.S. Bankruptcy Court, Eastern District, Virginia, Richmond Division. The bankruptcy court ruled that the relationship between the Qualified Intermediary and the Taxpayer claimant was that of debtor and creditor and not of trustee and beneficiary contended by the plaintiff.

A 1031 Exchange allows a taxpayer to defer the payment of tax that otherwise would be due upon the realization of a gain on the disposition of business or investment property through the use of a Qualified Intermediary. In the typical transaction, a taxpayer desiring to structure a transaction as a qualifying exchange assigns its rights as seller under a contract for the disposition of business or investment property to a qualified intermediary pursuant to the terms of a written exchange agreement. The purchaser of the relinquished property transfers the net sales proceeds directly to the qualified intermediary who holds the funds for the completion of the exchange. Under Internal Revenue Code Section 1031, the exchanger must identify like-kind replacement property within 45 days. The taxpayer has a maximum of 180 days to close on the replacement property after the conveyance of the relinquished property. The qualified intermediary, in theory, purchases the replacement property and then transfers the replacement property to the taxpayer, but in most instances, the actual conveyances are accomplished by direct deeding among the respective parties. If the replacement property is not identified or the replacement property purchase is not completed within these time periods, the qualified intermediary then pays the net sales proceeds realized from the sale of the relinquished property to the taxpayer.

In this case, the Qualified Intermediary invested certain of the exchange funds it received from its customers in the ordinary course of its business. Some of the exchange funds received by the Qualified Intermediary were invested in the form of auction rate securities that are now illiquid as a result of the rapid economic decline experienced in late 2008 that left these credit markets frozen. As a result, the Qualified Intermediary does not have the liquidity to fund all of its exchange obligations within the Section 1031 time limits.

This case was one of over 85 adversary proceedings that have been brought by former customers of the Qualified Intermediary in connection with its Chapter 11 bankruptcy case. They assert that the exchange proceeds deposited into the Qualified Intermediary's bank accounts are held in trust for their benefit and should be returned to them. On the Petition Date, the Debtor had approximately 450 uncompleted exchange transactions pursuant to separate exchange agreements. The Debtor employed two primary types of exchange agreements: "(a) agreements that included language contemplating that the applicable exchange funds would be placed into an account or sub-account associated with the relevant customer's name (the "Segregated Account Agreements"); and (b) agreements that did not include this "segregation" language (the "Commingled Account Agreements")." Only 50 of the uncompleted exchange transactions involved Segregated Account Agreements. The Court entered a protocol order in January of 2009 staying litigation in all but five of these proceedings. Each of the selected cases were allowed to proceed on an expedited basis, presented legal and factual issues common to the other adversary proceedings. The plaintiff's proceeding was selected to be the representative case for customers with segregated exchange agreements.

The plaintiff entered into three separate exchange agreements with LandAmerica Exchange Services in October of 2008, and the Qualified Intermediary opened segregated client sub-accounts in the plaintiff's name and taxpayer Identification number under a master control account that the Qualified Intermediary maintained and controlled. The opinion set out a fairly detailed summary of the cash management procedures of the Debtor and apparently found them significant as refuting the plaintiff's arguments. Suffice it to say that the procedures were solely for the purpose of allowing the Debtor to rake off a significant return from the funds entrusted to its care for its own benefit. There is nothing in the record the Court presents to suggest that the plaintiff knew about, approved of or consented to the debtor's use of the skimmed earnings.

The plaintiff contended that the facts showed that under the terms of the Exchange Agreements the Qualified Intermediary was required to place the funds in segregated sub-accounts in the plaintiffs' name and tax identification number, the plaintiff was entitled to the accrued interest, and there was no imposition of risk of loss on the Qualified Intermediary commonly associated with ownership. It argued that all of the exchange funds should be turned over to it outside of the bankruptcy pro rata distribution system. The plaintiff contended that facts proved that it never relinquished its equitable right in the funds and that the Qualified Intermediary was holding the funds in trust for its benefit. The Creditors' Committees and the Debtor argued that the exchange funds were held by the Qualified Intermediary pursuant to the terms of exchange agreements between the parties and were assets of the Debtor. The Creditors' Committees asserted that under the provisions of the exchange agreements, the plaintiff disclaimed all "right, title and interest" in the exchange funds and provided the Qualified Intermediary with exclusive rights of "dominion, control and use" over them. They argued that this evidenced the clear intention of the parties not to create a trust arrangement. The court held that the facts in the case mandate a presumption that the exchange funds are the property of the Qualified Intermediary's bankruptcy estate and that for the plaintiff to successfully rebut this presumption, it must show that it retained some right in and to the funds.

The court analyzed state ( Virginia ) law to determine the existence of an express or constructive trust that would mandate that the funds should be excluded from the bankruptcy estate. Under Virginia law, an express trust is created only where there is an affirmative intent to create a trust and the requisite intent can be established by express language between the parties or by circumstances that clearly demonstrate the intent to create a trust. Clearly, the court would not find any such express language or use of the terms "trust", "trustee", or "beneficiary" in any typical exchange agreement and did not here. The court held that the language of the Exchange Agreements actually showed the parties' intention to not create a trust.  

 
The court also found it significant that the plaintiff chose to use the Qualified Intermediary safe harbor to the exclusion of the other safe harbors available to them under Treasury Reg. 1.1031(k)-1(g). The Treasury Regulations permit the use of a separate qualified escrow or qualified trust to secure the transferee's obligation to deliver replacement property. While the terms and conditions of the safe harbors must be satisfied separately, they are not mutually exclusive. In this instance a separate qualified trust arrangement was not employed. Thus, the Court found that there was no express trust created in these exchanges.
 
Additionally, the court held that the parties' intentions were clearly discernible by the terms of the Exchange Agreements and that the parties evidenced their intention not to create a trust and the funds were considered part of the Qualified Intermediary bankruptcy estate.

The treasury regulations governing exchanges sanctioned by Internal Revenue Code Section 1031 require that the taxpayer must abrogate all control over the exchange funds until the exchange is completed. The court notes: "'If the taxpayer actually or constructively receives money or property in the full amount of the consideration for the relinquished property before the taxpayer actually receives like-kind replacement property, the transaction will constitute a sale and not a deferred exchange, even though the taxpayer may ultimately receive like-kind replacement property.' Treas. Reg. § 1.1031 (k)-1(f). However, the abrogation of control required by the treasury regulations does not require the taxpayer to relinquish all right, title and interest to the exchange funds as the parties to these Exchange Agreements (as hereinafter defined) contracted for Millard to do. See DeGroot v. Exchanged Titles, Inc. (In re Exchanged Titles, Inc.), 59 B.R. 303, 306 (Bankr. C.D. Cal. March 27, 1993) ("for the purpose of the exchange . . . there was no need for [the accommodator] to acquire ‘real' interest in the . . . property . . . to make the exchange qualify under the statute. . . .'") (citation omitted); Cook v. Garcia, No. 96-55285 1997 WL 143827, at *1 (9th Cir. 1997) ("A taxpayer need not abandon all equitable interests in the proceeds . . . for a transaction to qualify as a non-taxable event under section 1031."). This negates Millard's argument that the disclaimers contained in Section 2 of the Exchange Agreements were included only because the treasury regulations required them to be included."

The Court goes on to observe: "Treasury Regulation Section 1.468B-6, 26 C.F.R. § 1.468B-6,8 establishes rules concerning the taxation of exchange funds held by exchange facilitators. The default rule established by the treasury regulation is that where the exchange funds exceed $2 million, they will be treated for tax purposes as a loan from the taxpayer to the qualified intermediary. Treas. Reg. § 1.468B-6(c)(1); Treas. Reg. § 1.7872-5(b)(16). There are, however, four safe harbor exceptions to this default rule. One of those safe harbors provides that if a qualified intermediary holds the exchange funds in a segregated account established under the taxpayer's name and identification number, then the qualified intermediary need not take into account items of income, deduction, and credit attributable to the exchange funds. Treas. Reg. § 1.468B- 6(c)(2)(i)-(ii).9 Under this exception exchange funds held in sub-accounts are treated as separate accounts even though they may be linked to a master account. Treas. Reg. § 1.468B-6(c)(2)(ii)."

While the court uses this analysis to support its conclusion that the funds belong to the Debtor's estate, there is a fundamental fallacy in its logic. If the funds were not so segregated, they would be treated for tax purposes as a loan. Had that been the case here, the Court's conclusion would be correct. But, the Treasury regulations provide that where the account is segregated and all interest attributable pursuant to the account is payable to the taxpayer, the exchange funds will not be treated as being loaned to the Qualified Intermediary.  If the money were loaned to the Qualified Intermediary, the interest would be attributed to it and taxed as income of the Qualified Intermediary. Clearly the IRS considers the funds to be the taxpayer's and the income taxed as such where the account meets this standard. As the taxpayer took the steps to prevent that treatment, it militates more to demonstrate the intent of the parties to treat the plaintiff as retaining an equitable interest in the funds. The court also observes that the Treasury Regulations say that the "‘determination of whether the taxpayer is in actual or constructive receipt of money or other property before the taxpayer actually receives like kind replacement property is made as if the qualified intermediary is not the agent of the taxpayer.' This further suggests that the intent of the Internal Revenue Service is to treat the funds as NOT those of the taxpayer."

Nonetheless, in this case, the Court determined that "the facts mandate a presumption that the Exchange Funds are the property of the Qualified Intermediary bankruptcy estate. The Exchange Funds were derived from the proceeds of the sale of the Relinquished Properties that Millard had assigned to the Qualified Intermediary. The Exchange Funds were transferred from the third party purchasers of these Relinquished Properties directly into the bank account of the Qualified Intermediary by the closing agents. The transferred funds remained in the bank accounts of the Qualified Intermediary through the Petition Date. Millard never had any ability to withdraw the funds. The accounts were under the complete control of the Qualified Intermediary. Only the Qualified Intermediary had the ability to disburse or withdraw the funds. As the Qualified Intermediary maintained the exchange funds in bank accounts in its name and under its control, the money is presumably property of the Qualified Intermediary bankruptcy estate. (citations omitted)"

In order to rebut this presumption, the plaintiff contended that the Qualified Intermediary was temporarily holding the Exchange Funds on its behalf solely for the purpose of facilitating the exchange, that it never parted with its equitable interest, that the Qualified Intermediary was required to place the Exchange Funds in segregated sub-accounts associated with its name and taxpayer identification number and that the Qualified Intermediary was holding the Exchange Funds in trust for its benefit.

This may be considered a tactical error. Clearly under state law in Virginia (and likely elsewhere), the plaintiff and debtor did everything possible to avoid a trust relationship so that the agent control issue would not make the debtor unqualified under the Treasury regulations. The Court notes that "not only is there an absence of any language that the parties intended to create a trust, but there is language in the Exchange Agreements that actually evidences an intent not to do so. Millard, in the Exchange Agreements, conveyed exclusive possession, dominion, control and use of the Exchange Funds to the Qualified Intermediary. It also disclaimed any right, title or interest in and to the Exchange Funds. That conveyance combined with that disclaimer is inconsistent with the establishment of a trust. Under a trustee beneficiary relationship, the trustee holds legal title in the trust property and the beneficiary holds an equitable interest in the trust property." and "Further evidence that the parties did not intend the Exchange Agreements to create a trust can be found in the parties' agreement to limit the duties of the Qualified Intermediary to those expressly contained in the Exchange Agreements. A trust necessarily requires the establishment of fiduciary duties." …" Fiduciary duties create a special relationship of trust and good faith that goes beyond the duties set forth in an ordinary contract between commercial parties." (citations omitted)

The court properly concludes:  "The Exchange Funds are not excluded from property of the estate pursuant to 11 U.S.C. § 541(d) because of the existence of an express trust or as a result of the imposition of a resulting trust. The plain, unambiguous language of the Exchange Agreements clearly establishes that it was not the intent of the Qualified Intermediary or Millard to create an express trust. As the Exchange Agreements were integrated contracts, Millard cannot use parol evidence to prove the existence of an express trust"

It seems that in arguing the issue of "trust", the attorneys may have overlooked the most obvious argument...Why was the Qualified Intermediary holding funds and for whom? Trust law is totally irrelevant and the Court and the parties seem confused on this issue. In the typical transaction a taxpayer desiring to structure a transaction as a qualifying exchange, must limit control of the funds in every respect under the Treasury regulations. In no way do the regulations require the taxpayer to cede a claim of beneficial ownership in those funds. This discussion and conclusion exhibit the failure of the Court to grasp the fundamental nature of tax deferred exchanges in modern commerce. Simply put, Internal Revenue Code Section 1031 exchanges are an IRS approved procedure for deferring tax on the disposition of business property when it is being replaced by like kind property. They can simply not be considered true exchanges as the transactions are generally structured.  They are simply dressed up as exchanges with the IRS blessing to comport with archaic language and the IRS requirements to conform transactions accordingly. Every taxpayer considers the money in all exchange accounts as belonging to them, as do all revenue agents, as do all Qualified Intermediaries. What the IRS is concerned about is control of the funds not ownership of them. The language in the exchange agreements that the court focused on as relinquishing ownership, is included to reinforce the taxpayers' total lack of control of these funds in order to avoid constructive receipt and recognition of gain. If you were to ask any participant prior to this decision; "Whose money is it?" the answer would invariably be "The Taxpayer's."

Yet, not all equitable interests are trusts. A bank account can be said to be analogous to an exchange account. The bank holds the funds in the taxpayer's name pursuant to the terms of a contract. The bank controls these funds irrespective of the accounting or characterization of them as agreed to between the parties. When the time, circumstance and conditions of the contract provisions call for payment, and only then, can and will payment be made. It can be fairly said that the funds themselves are legally owned by the bank and that the depositor only has an equitable interest that, by contract, entitles the depositor to delivery. That equitable interest is solely contractual in nature. The fact that the account is in the Debtor's name and the Debtor only has control of the account does not in itself determine who the equitable owner is. An equitable interest is an interest held under an equitable title that indicates a beneficial interest in property and that gives the holder the right to acquire formal legal title. Not all equitable title is held under trust theory. A classical example of such an interest arising out of contract is that of an equitable lien. A document, may by its form, purport to make an absolute transfer of the ownership of property and yet be found, in substance, to be a security instrument. In the real property context, this may be referred to as an equitable mortgage or equitable lien.

The court acknowledges this principle as being applicable to the bankruptcy estate where it cites as follows: "Section 541(d) of the Bankruptcy Code creates a limitation on the otherwise broad definition of property of the estate. That section provides in pertinent part that: ‘property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate under sub-section (a)(1) or (2) of this section only to the extent of the debtor's legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.'" Where the court goes astray is in assuming that a trust relationship is the only form of equitable ownership and forgets that Equity incorporates the legal principles supplementing the strict rules of law where their application would operate harshly, in order to achieve fairness. Some would simply call it common sense.