A Virginia bankruptcy court has issued a decision that should be a major eye-opener for any entity that engages in tax-free exchanges under section 1031 of the Internal Revenue Code.

The court warned that if 1031 exchange agreements are not drafted properly, parties that place exchange funds with a qualified intermediary will be general unsecured creditors if the QI declares bankruptcy. Millard Refrigerated Servs., Inc. v. LandAmerica 1031 Exchange Servs., Inc. (In re LandAmerica Fin. Group, Inc., et al.), No. 08-03147, 2009 Bankr. LEXIS 940 (Bankr. E.D. Va. April 15, 2009).

In Millard, the court concluded that a 1031 Exchange Agreement that provides for the seller to relinquish all right, title, and control over the exchange funds does not establish a trust relationship between the Qualified Intermediary (QI) and the seller—even if the exchange funds are segregated into accounts clearly traceable to the seller. The consequences: the exchange funds will constitute property of a bankrupt QI's bankruptcy estate should the QI seek bankruptcy protection, and the seller will have a general unsecured claim for breach of the exchange agreement.

This means the seller only is entitled to a pro rata distribution of the exchange funds at the conclusion of the QI's bankruptcy proceeding. Accordingly, not only does the seller lose the right to immediate full possession of the exchange funds, but the seller also potentially will incur tax liability for failing to effect timely the 1031 like-kind exchange.

The LandAmerica 1031 Exchange Agreements

The facts giving rise to the Millard decision are as follows: Prior to its bankruptcy petition date, LandAmerica 1031 Exchange Services, Inc. ("LES") entered into three identical exchange agreements as the QI, with Millard Refrigerated Services, Inc. ("Millard") as the seller. The exchange agreements, among other things, required LES to hold the net proceeds from the sale of Millard's property (the "Exchange Funds") in three segregated accounts titled to LES, but containing readily traceable information linking the segregated accounts to Millard.

The purpose of the exchange agreements was to defer Millard's tax liability on the gains realized from the sale of its property pursuant to section 1031, by preventing Millard from constructively receiving the proceeds from the sale while Millard sought out like-kind investment property to purchase within 180 days (the "1031 Exchange").

The exchange agreements governed the parties' rights and obligations in connection with Millard's 1031 Exchange. Specifically, the exchange agreement at issue provided that, "LES shall have sole and exclusive possession, dominion, control and use of all Exchange Funds, including [earned] interest ... [Millard] shall have no right, title, or interest in or to the Exchange Funds or any earnings thereon and [Millard] shall have no right ... to ... otherwise obtain the benefits of any of the Exchange Funds...."

Notwithstanding this provision, the exchange agreements acknowledged that any earned interest in the segregated accounts would be payable to Millard.

At issue in the case was whether the Exchange Funds constituted property of LES' bankruptcy estate available for distribution to all creditors, or whether Millard was entitled to immediate possession of the Exchange Funds, in full, so it could complete its like-kind exchanges.

Bank Account Presumption

In ruling that the Exchange Funds constituted property of LES' bankruptcy estate, the bankruptcy court first acknowledged the presumption under federal bankruptcy law that property held in a bank account titled in the name of the debtor is presumed to be property of the estate. In this case, while the segregated accounts holding the Exchange Funds contained information making them traceable to Millard, the accounts, nonetheless, were titled to LES.

Based on the legal title of the segregated accounts and the fact that the exchange agreements conveyed complete dominion and control over the accounts to LES, the court held that Millard had to rebut the presumption that the Exchange Funds contained in the segregated accounts were property of LES' estate.

To rebut the presumption, Millard had to show that it retained some right to the funds recognized under applicable state law—here, Virginia law. Millard argued that LES was holding the Exchange Funds in trust for Millard's benefit to facilitate the 1031 Exchange, and Millard never relinquished that beneficial interest. In support of its argument, Millard noted that the Exchange Funds were maintained in segregated sub-accounts associated with Millard's name and taxpayer identification number, that LES incurred no risk of loss that is commonly associated with ownership interests, and that Millard retained the benefits of accrued interest earned on the Exchange Funds.

The court disagreed with Millard's assessment. Under Virginia law, an express trust is only created by either using express language to that effect in the agreement, or under "circumstances which show with reasonable certainty that a trust was intended to be created." In this case, the court never examined the circumstances of the situation because it determined that the language in the exchange agreement unambiguously did not create a trust.

No Trust Created

The court acknowledged that, while the use of the word "trust" in the agreement is not a necessity, the absence of the word anywhere in the agreement is notable. More importantly, however, the court found that the language of the agreement evidenced the parties' intention not to create a trust. For example, Millard conveyed exclusive possession, dominion, control and use of the Exchange Funds to LES, while at the same time disclaimed any right, title or interest in the Exchange Funds. This conveyance of control combined with the disclaimer of rights was inconsistent with the establishment of a trust.

The court noted that while the Internal Revenue Code prohibits Millard from taking constructive possession of the Exchange Funds to effect a 1031 Exchange, nothing in the code requires Millard to disclaim all interests in the Exchange Funds. On the contrary, the code contemplates a qualified trust pursuant to which the seller retains beneficial interests in the exchange property as one of the four possible safe harbors a seller can use to effect a qualifying like-kind exchange.

Additionally, the exchange agreement imposed no fiduciary duties whatsoever on LES, a hallmark for the establishment of a trust. Instead, the agreement provided that LES would not undertake any duties not expressly set forth in the exchange agreement, including any duties implied or imposed by operation of law. Accordingly, the court held it would be improper to infer a fiduciary duty in this case.

Finally, the exchange agreements contained integration clauses. As such they were complete agreements, and because they were unambiguous, the court's assessment of the parties' relationship under the agreements was limited to the four corners of the documents; extrinsic evidence to modify or alter the terms of the agreements would not be considered. The court quickly dismissed Millard's alternative argument that the exchange agreements created a "resulting trust" by holding that a resulting trust cannot be recognized where the applicable agreements so clearly evidences an intent not to create a trust relationship.

After noting that the Exchange Funds in the segregated accounts were entirely and completely vulnerable to attachment and levy by third-party creditors of LES, the court concluded that the Exchange Funds were property of LES' bankruptcy estate, subject to distribution among all creditors.