In Gagne v. Gagne, 2019 WL 1284883 (Colorado Court of Appeals, Division V, 2019), the appellate court reviewed and approved a trial court’s order to dissolve four LLC real property holding companies owned by a mother and her son, and then swap tenancy-in-common (TIC) interests in those assets so that mother and son would each own a fee interest in two of the four properties.

The facts

Paula Gagne and her son Richard Gagne acquired four apartment buildings in Fort Collins, Colorado. Each building was held in the name of a separate LLC. All funds for the purchase came from Paula. Their agreement called for evenly dividing all profits after Paula received the return of her capital investment. The trial court expressly found that a specific purpose of the investments was to give Richard and his family a livelihood operating the properties through HSI, a real estate management company owned by Richard. Paula and Richard could not get along and, as the trial court found, Paula wrested control of the companies from Richard, ceased doing business with HSI, and engaged in extensive inappropriate self-dealing.

The trial court found that the LLCs could not effectively function because of Paula’s self-dealing and because she had frustrated a fundamental purpose of the LLCs by refusing to do business with HSI. It therefore ordered the LLCs to be liquidated and the properties divided between the parties through an IRC §1031 drop-and-swap transaction.

The court’s calculations

The court’s calculations can be summarized as follows:

  • Equity in the four apartment buildings was $6,071,000. Paula’s unreimbursed capital contribution was $2,025,000, and the remaining equity of $4,046,000 was to be split equally, $2,023,000 each.
  • Paula was found to have misused LLC funds in the amount of $1,257,635.87, but she had fronted $489,000 of her own funds to cover part of the shortfall. The net shortfall was $768,635.87, half of which she was obligated to return to Richard: a credit to him and a debit to her of $384,317.94.
  • Paula was also obligated to pay Richard’s legal fees of $400,000, a further credit to Richard and debit to Paula.
  • As a result, Richard and Paula were entitled to aggregate target equity in the four properties of $2,807,317.94 and $3,263,682.06, respectively.
  • The court allocated two properties to each, with equity values of $2,914,500 and $3,156,500. Richard was found to owe Paula $107,182.06 in cash to balance the transaction.

To accomplish this distribution, the court ordered the LLCs liquidated, making Paula and Richard tenants in common, and then ordered the appropriate TIC interests exchanged between them, with Richard’s $107,182.06 cash balancing the transaction.

The appeal

Paula appealed on numerous grounds. For our purposes, the most important was her argument that a §1031 exchange was an inappropriate way to distribute the property. The appellate court disagreed. Paula argued that even if an in-kind distribution wasn’t barred by the operating agreements, a drop-and-swap wasn’t appropriate because (1) the state LLC act’s provisions allowing in-kind distribution don’t allow it to be accomplished this way; (2) section 1031 doesn’t allow an exchange of limited liability company property; and (3) even if it does, it won’t work here. The court said these arguments “don’t require any extended analysis, because each fails for very straightforward reasons.”

The court rejected the first argument, finding the trial court justified in using a temporary creation of tenancies-in-common and subsequent transfers of those interests between members, because the parties had treated the four LLCs as essentially one business. That finding is interesting because it suggests that facially separate tax partnerships may be considered a super-partnership for certain purposes, including §1031.

On the second argument, the court drew the appropriate distinction. Experts testified that swapping membership interests for each other or for real property can’t qualify for §1031 treatment, but that once the properties are owned by tenants in common, they qualify. The district court therefore ordered a process, involving initial transfers to the members as tenants in common, that allows the parties to take advantage of §1031 if they choose to.

On the third argument, the court noted that Paula pointed to contingencies such as IRS approval, careful planning, and involvement by banks and title companies, but did not argue they were insurmountable. In any event, such an exchange was expressly contemplated by the operating agreement and was merely an option the court was allowing the parties to pursue. Paula said she would suffer negative tax consequences from losing her gain in each LLC, but offered no legal argument in support, nor did she explain how negative tax consequences could be avoided while still winding up the LLCs.

There is a great deal that one would like to see clarified in that last statement. However, the bottom line is that the Colorado appellate court expressly approved a drop-and-swap in this case.

Cautions

Caution should be exercised in relying on this case too strongly, for several reasons. First, it is a state court case focused primarily on the state law issue of what remedies are available to dissolve a limited liability company. It is not a tax case. Second, there are some indications that the tax issues may not have been fully briefed and considered. Third, the case is not yet officially published.

On the other hand, the case is remarkably similar to a situation discussed and approved by the Tax Court in Mason v. Commissioner, T.C. Memo. 1988-273 (1988). Official publication of Gagne is eventually likely, and it may serve as additional weight for the argument that drop-and-swap transactions are an ordinary IRC §1031 planning tool.