[Federal Register: March 20, 2007 (Volume 72, Number 53)]
[Proposed Rules]
[Page 13055-13058]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr20mr07-20]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-113365-04]
RIN 1545-BD19
Escrow Accounts, Trusts, and Other Funds Used During Deferred
Exchanges of Like-Kind Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Proposed Rulemaking; Revised Initial Regulatory Flexibility
Analysis.
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SUMMARY: This document contains a revised initial regulatory
flexibility analysis relating to proposed regulations under section
468B of the Internal Revenue Code on the taxation and reporting of
income earned on escrow accounts, trusts, and other funds used during
deferred exchanges of like-kind property, and proposed regulations
under section 7872 regarding below-market loans to facilitators of
these exchanges. The proposed regulations affect taxpayers that engage
in deferred like-kind exchanges and escrow holders, trustees, qualified
intermediaries, and others that hold funds during deferred like-kind
exchanges.
DATES: Written or electronic comments must be received by May 4, 2007.
ADDRESSES: Send submissions to CC:PA:LPD:PR (REG-113365-04), room 5203,
Internal Revenue Service, POB 7604, Ben Franklin Station, Washington,
DC 20044. Submissions may be hand delivered Monday through Friday
between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-113365-
04), courier's desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC. Alternatively, taxpayers may submit
electronic comments via the Federal eRulemaking Portal at http://www.regulations.gov
(IRS-REG-113365-04).
FOR FURTHER INFORMATION CONTACT: Concerning the revised initial
regulatory flexibility analysis and the proposed regulations under
section 468B, Jeffrey Rodrick, (202) 622-4930; concerning the proposed
regulations under section 7872, David Silber, (202) 622-3930;
concerning submission of comments, Kelly Banks, (202) 622-3628 (not
toll-free numbers).
SUPPLEMENTARY INFORMATION: On February 7, 2006, a partial withdrawal of
notice of proposed rulemaking, notice of proposed rulemaking, and
notice of public hearing was published in the Federal Register (71 FR
6231). The initial regulatory flexibility analysis included in that
notice of proposed rulemaking concluded that the number of transactions
involving small businesses that will be affected and the full extent of
the economic impact on small businesses could not be precisely
determined and requested additional comments. This notice revises the
initial regulatory flexibility analysis included in that notice of
proposed rulemaking in response to comments provided in writing and at
a public hearing. These comments asserted that the analysis did not
adequately define the industry, determine the number of small
businesses affected, describe the economic impact of the proposed
regulations on small businesses, or discuss alternatives to the
proposed rules that were considered and the bases for conclusions
reached. The IRS and the Department of the Treasury have worked closely
with the Small Business Administration's (SBA) Office of Advocacy
(Advocacy) to obtain additional information from the affected industry
to identify and quantify the small businesses affected and to determine
the likely economic impact of the proposed regulations on small
businesses. In a letter dated August 3, 2006, the president of the
leading industry association for qualified intermediaries (QI), wrote
that the association ``believes we have or can develop information that
would be helpful in this [impact-study] effort,'' and volunteered to
provide this information to the IRS. The industry association surveyed
its members based on questions developed by the IRS and the Department
of the Treasury, and submitted a summary of the survey responses for
consideration. The association, which according to its Web site has
over 300 member companies (not all of which are QIs), received
approximately 130 responses. Seventy-one respondents indicated they
engage in the QI business exclusively, which represents 22 percent of
the estimated number of 325 full-time QIs in the industry (as discussed
in this notice, not all of which are small businesses). The summary of
the survey responses submitted did not address a substantial number of
the issues important to evaluating the effect of the proposed
regulations on small business. The summary of the survey responses is
available at http://www.IRS.gov/regs. This notice seeks additional
comments and reiterates questions that will assist in assessing the
economic impact of the proposed regulations on small businesses in the
QI industry and in considering reasonable alternatives. The survey
information provided is discussed in this revised initial regulatory
flexibility analysis and will be considered further in the development
of final regulations.
Revised Initial Regulatory Flexibility Analysis
Reasons for Action and Succinct Statement of the Objectives of, and
Legal Basis for, the Proposed Rule
The proposed regulations are issued under the authority of section
7805, section 468B(g) (which provides that nothing in any provision of
law shall be construed as providing that an escrow account, settlement
fund, or similar fund is not subject to current income tax and that the
Secretary shall prescribe regulations providing for the taxation of
such accounts or funds whether as a grantor trust or otherwise), and
section 7872.
Section 1.468B-6 of the Income Tax Regulations was included in
proposed regulations issued in 1999 under section 468B(g) (the 1999
proposed regulations), and provided rules for the current taxation of
income of a qualified escrow account or qualified trust used in a
section 1031 deferred exchange of like-kind property. The 1999 proposed
regulations included a facts and circumstances test to determine
whether the taxpayer (the transferor or exchangor of the property), the
QI, or a transferee is the owner of the assets in a qualified
[[Page 13056]]
escrow account or qualified trust and must take into account all items
of income, deduction, and credit (including capital gains and losses)
of the account or trust. The 1999 proposed regulations further provided
that, if a QI or transferee is the owner of the assets transferred, the
transaction may be characterized as a below-market loan from the
taxpayer to the owner to which section 7872 may apply. Under this
proposed rule, if a QI or transferee is the owner of the assets, the
transaction is a loan to which section 7872 generally applies if the
loan is below-market.
Comments received on the 1999 proposed regulations reflected
differing interpretations of the 1999 proposed regulations and
disagreement on the proper rules for taxing these transactions. Some
commentators interpreted the 1999 proposed regulations as allowing a QI
to ``own'' the funds held in connection with the deferred like-kind
exchange and never characterize the arrangement between the taxpayer
and the QI as a loan.
Rules based on a facts-and-circumstances test are inherently
difficult for taxpayers to apply and for the IRS to administer, and are
subject to inconsistent application. Therefore, the 2006 proposed
regulations eliminate the facts and circumstances test and propose
specific rules that determine whether the income of an escrow account,
trust, or fund used in a deferred like-kind exchange is taxed to the
taxpayer or to an exchange facilitator, which is a QI, transferee, or
other party that holds the exchange funds. These rules are intended to
provide greater certainty for taxpayers, enhance administrability, and
ensure consistent treatment of taxpayers.
Description and Estimate of the Number of Small Businesses to Which the
Proposed Regulations Will Apply
The 2006 proposed regulations affect exchange facilitators that
hold exchange funds for taxpayers engaging in deferred exchanges of
like-kind property. Exchange facilitators may be large or small
businesses (including individuals operating as sole proprietors). For
this purpose, the SBA size standards set forth at 13 CFR 121.201 for
North American Industry Classification System (NAICS) code 531390
(other activities related to real estate), define a business with
annual gross receipts of up to $2 million as a small business. There is
no NAICS code associated specifically with exchange facilitators or
QIs. Although like-kind exchanges are not limited to real estate
transactions, 70 percent of the respondents to the industry survey
indicated that they use NAICS code 531390. Therefore, notwithstanding
comments criticizing the use of NAICS code 531390 for purposes of
determining the applicable size standard with respect to the 2006
proposed regulations, after consultation with Advocacy, the IRS and the
Department of the Treasury have determined that NAICS code 531390 is
appropriate for this industry. Accordingly, the applicable size
standard for determining what constitutes a small business with respect
to the 2006 proposed regulations is $2 million in annual gross
receipts, the SBA's definition of a small business for NAICS code
531390.
The IRS and the Department of the Treasury estimate that there are
approximately 325 businesses (primarily QIs) that are full-time
exchange facilitators. This estimate is based on information originally
provided by the industry association in connection with the development
of the 2006 proposed regulations. The recent industry survey did not
provide any additional information regarding this number. Seventy-one
of 121 (58.7 percent) respondents to the survey indicated that they are
engaged exclusively in the QI business, although it is unclear how many
of these are small businesses. Although 84 percent of respondents
reported having annual gross revenues (fees plus net retained interest,
if any) from the QI business of $1.5 million or less (the previous size
standard for NAICS code 531390) for the most recent year, it is unclear
how many of this number are exclusively in the QI business. The survey
also indicated that almost 90 percent of respondents have 10 or fewer
employees (including owners active in the business), and nearly 70
percent have fewer than 5 employees. An estimate of the percentage of
the QI industry that consists of small businesses is difficult to make
based on the available information. The summary of the survey responses
did not correlate information on annual gross revenues reported with
information on the number of respondents engaged exclusively in the QI
business. Nonetheless, it appears that a significant portion of the QI
industry consists of small businesses under the SBA's size standard.
Accordingly, the IRS and the Department of the Treasury continue to
seek information regarding the number of small businesses engaged in
the QI industry. Specific comments are requested from QIs engaged
exclusively in that business indicating whether their annual gross
receipts are $2 million or less, or more than $2 million.
Searches for information through the Department of Commerce and the
SBA disclosed no data collected or maintained on QIs or exchange
facilitators as an industry.
Description of Compliance Requirements and Estimate of the Classes of
Small Businesses That Will Be Affected by the Compliance Requirements
Under the 2006 proposed regulations, exchange funds are treated as
loaned by the taxpayer to the exchange facilitator unless all of the
income earned is paid to the taxpayer. If the exchange funds are
treated as loaned to the exchange facilitator, interest generally is
imputed to the taxpayer under section 7872 unless the exchange
facilitator pays sufficient interest. If a loan between the taxpayer
and the exchange facilitator does not provide for sufficient interest
and the loan is not otherwise exempt from section 7872, interest income
is imputed to the taxpayer at the applicable Federal rate (AFR) (or the
difference between the rate paid and the AFR). Therefore, exchange
facilitators must keep records of the amount of income paid to the
taxpayer and may be required to report the income on Form 1099.
Under section 7872 and the 2006 proposed regulations, if the
exchange funds are treated as loaned from the taxpayer to the QI and
the loan is a below-market loan, income is deemed transferred to the
exchange facilitator as compensation and retransferred to the taxpayer
as interest. The taxpayer's imputed interest income is not offset by a
deduction for the taxpayer's imputed payment to the exchange
facilitator because compensation paid to the exchange facilitator is a
cost of acquiring the replacement property that must be capitalized and
added to the property's basis. The exchange facilitator has income from
the imputed compensation and an offsetting deduction for the interest
deemed paid to the taxpayer.
Seventy percent of respondents to the industry survey reported that
they engage in at least 100 exchange transactions a year. According to
information provided by the industry association from an earlier survey
of its members, over 92 percent of the small business respondents
currently pay to the taxpayer at least 20 percent of the income earned
on exchange funds, including accounts that commingle the exchange funds
of multiple taxpayers. The IRS and the Department of the Treasury
request additional comments providing more specific information to
clarify these results. The information
[[Page 13057]]
available suggests that an overwhelming majority of small businesses
affected by the 2006 proposed regulations currently maintain records of
the amount of income paid to the taxpayer and report the payments on
Form 1099. Therefore, the IRS and the Department of the Treasury
estimate that for most small businesses the 2006 proposed regulations
should not increase significantly the compliance burden associated with
keeping records and reporting income paid to the taxpayer.
Nonetheless, commentators have stated generally that complying with
the 2006 proposed regulations would result in additional recordkeeping
and reporting requirements. Fifty-eight percent of respondents to the
recent industry survey indicated that the 2006 proposed regulations
significantly will increase recordkeeping burdens and accounting costs,
but the survey did not provide quantified data on the amount of any
additional time or cost expected to result from the 2006 proposed
regulations. Comments are requested estimating the annual number of
transactions that will result in an increased recordkeeping and
reporting burden, per transaction, under the 2006 proposed regulations,
as well as the amount of time and additional cost that each additional
recordkeeping and reporting burden would impose.
Commentators also have stated that accounting for individual
taxpayers' earnings in commingled accounts would necessitate additional
labor and system design costs that would fall disproportionately on
small business QIs. The IRS and the Department of the Treasury have not
received specific comments quantifying the effect of these costs on
small businesses. Specific comments are requested estimating the amount
of these costs.
Commentators have asserted that complying with the loan
characterization rules of the 2006 proposed regulations will result in
a substantial revenue loss and cause a large number of small businesses
to fail or to reduce their workforces. They claimed that small business
QIs would be disproportionately affected because the small business QIs
predominantly apply a business model that would place them at a
disadvantage under the 2006 proposed regulations.
In general, commentators have described two business models
employed to facilitate deferred like-kind exchanges:
1. The exchange facilitator segregates the exchange funds in
separate accounts, charges a separate fee for its services, and pays
all earnings to the taxpayer, or
2. The exchange facilitator commingles the exchange funds, pays a
portion of the earnings to the taxpayer and retains a portion of the
earnings, or may retain all of the earnings. Some of these exchange
facilitators also may charge a separate fee for their services. If a
fee is charged, it is likely to be lower than the fee that would be
charged if the exchange facilitator retains no earnings.
Some small businesses offer customers both forms of structuring the
transaction. Comments from and discussions with industry members,
however, have disclosed that the first model is employed most commonly
by large businesses often ``affiliated'' (in the sense of having some
level of corporate relationship and not necessarily within the meaning
of section 1504) with banks. The second model also may be employed by
large businesses but is used widely by independent, small business QIs.
In the recent industry survey, 95.8 percent of respondents indicated
that they are not affiliated with a bank, savings and loan company,
brokerage firm, or similar financial institution.
The earlier industry survey indicated that 96 percent of the small
business respondents retain at least a portion of the interest earned
on the exchange funds. Commentators have stated that if these small
businesses are required to impute interest on the exchange funds,
taxpayers will demand that this interest be paid to them. According to
commentators, to compensate for this loss of revenue these businesses
will be required to change their business practices to pay all income
to the taxpayer and to charge higher fees. Commentators further stated
that absent charging higher fees, paying all interest to the taxpayer
is expected to result in a reduction of revenues ranging from 10 to 80
percent. Specific comments are requested estimating the effect on
revenues or profits of a change in business practices to pay all income
to the taxpayer.
Some commentators have asserted that, in contrast, bank-affiliated
QIs generally pay all the income to the taxpayer under their current
business practices and therefore will not be required to change their
business practices or charge higher fees as a result of the 2006
proposed regulations. These commentators claim that bank-affiliated QIs
are able to pay all the income to the taxpayer and charge fees
commensurate with the fees charged by independent QIs because bank-
affiliated QIs are compensated through the receipt of fees paid by
institutions in which the funds are deposited. Moreover, these
commentators maintain that bank-affiliated QIs indirectly benefit when
funds are deposited with related-party depositary institutions that
invest deposited exchange funds and earn income that is not required to
be paid to the taxpayer under the 2006 proposed regulations. If, as
these commentators claim, bank-affiliated QIs would not be required to
change their business model as a result of the 2006 proposed
regulations, the commentators predict that the 2006 proposed
regulations will cause many small business QIs to be disadvantaged in
competing with bank-affiliated QIs. Specific comments are requested
estimating the number of QIs that would change their business model as
a result of the 2006 proposed regulations.
Significant Alternatives Considered
Various alternatives to the rules contained in the 2006 proposed
regulations were considered. For example, retaining the facts and
circumstances test of the 1999 proposed regulations was considered but
rejected because the test is difficult for taxpayers to apply, lacks
administrability, is subject to misinterpretation, and may result in
inconsistent tax treatment of similarly-situated taxpayers.
Rules that would allow the exchange facilitator and taxpayer to
determine which party will be taxed on the earnings were considered but
regarded as lacking certainty and administrability and violating
established tax principles. Rules that would tax the party that
receives the income (and thus treat only income paid and not income
retained by the QI as the taxpayer's taxable income) were considered
but not adopted. Under some circumstances, a QI's retention of income
earned by an exchange fund is properly characterized as a payment of
compensation by the taxpayer for the QI's services. Therefore, under
the appropriate circumstances, a rule that taxed only the QI on
retained earnings would violate the doctrine of Old Colony Trust v.
Commissioner, 279 U.S. 716 (1929), that a payment that satisfies the
obligation of a taxpayer to a third party is includible in the income
of the taxpayer.
A rule that would treat all the earnings of the exchange funds in
all circumstances as the taxpayer's income was considered but lacked
flexibility and did not conform in all cases to the substance of the
transaction. Other alternatives were considered and not adopted because
they were considered inconsistent with section 7872. In the legislative
history to section 7872, Congress stated that when a service provider
is permitted to retain customer funds without paying interest to the
[[Page 13058]]
customer, and the benefit the service provider derives from the funds
is in lieu of a fee for services, the transaction is a compensation-
related loan under section 7872. H.R. Conf. Rep. No. 861, 98th Cong.,
2d Sess. 1019 (1984) (1984-3 (Vol. 2) CB 272). Moreover, it was
determined that exchange funds are not received in consideration for
the sale or exchange of property (within the meaning of section
1274(c)(1)) or received as a deferred payment on account of a sale or
exchange of property (within the meaning of section 483).
The industry survey indicates that 30 percent of respondents closed
at least half of their deferred like-kind exchange transactions within
60 days or less. Only eight percent completed at least half of their
transactions in more than 150 days. In addition, 42 percent of survey
respondents reported that at least half of their transactions typically
involve exchange funds of $250,000 or less, while about 8 percent of
respondents reported that most of their transactions involve exchange
funds in excess of $1 million. In light of this information, comments
specifically are requested regarding the average duration of exchange
transactions, the average dollar amount of exchange funds, and the
appropriateness and nature of a de minimis rule that would except
certain exchange transactions from the application of section 7872.
If exchange funds are characterized as loaned by the taxpayer to
the exchange facilitator, interest may be imputed if the exchange
facilitator does not pay sufficient interest to the taxpayer. To reduce
the administrative burden of determining imputed interest, the 2006
proposed regulations provide a special AFR, equal to the investment
rate on a 182-day Treasury bill, in lieu of the short-term AFR (which
applies to loans of 3 years or less), to qualify as sufficient interest
for purposes of determining whether interest must be imputed. This
special AFR was intended to be a more accurate measure of a market rate
of interest for these loans than the short-term AFR, and was expected
to result in characterization of fewer transactions as below-market
loans than if the short-term AFR were used. Commentators have stated
that the special AFR is significantly higher than the market rate paid
on funds held for the periods of time that exchange funds typically are
held by QIs. They state, for example, that few if any QIs that pay less
than all the income to the taxpayer pay an amount that is equal to or
greater than the special AFR provided in the 2006 proposed regulations.
Specific comments are requested identifying the rate of return
typically earned by small business QIs on exchange funds, the interest
rate QIs typically pay to taxpayers, and an appropriate rate for
testing exchange facilitator loans for sufficient interest under
section 7872.
Duplicative, Overlapping, and Conflicting Rules
The IRS and the Department of the Treasury are not aware of any
duplicative, overlapping, or conflicting Federal rules.
Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E7-4968 Filed 3-19-07; 8:45 am]
BILLING CODE 4830-01-P