[Federal Register Volume 72, Number 53 (Tuesday, March 20, 2007)]
[Proposed Rules]
[Pages 13055-13058]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-4968]


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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