The U.S. Bankruptcy Court for the Eastern Division of Virginia recently ruled that funds held by a Qualified Intermediary (“QI”) in connection with a tax-deferred exchange under IRC Section 1031 constitute property of the QI’s bankrupt estate.In Millard Refrigerated Services, Inc. v. LandAmerica 1031 Exchange Services, Inc., the bankruptcy court held that the relationship between the QI and Millard Refrigerated Services, Inc. (“Millard”) was that of debtor and creditor and not of trustee and beneficiary as Millard contended.

Millard entered into three identical exchange agreements (“Exchange Agreements”) with LandAmerica Exchange Services (“LES”) in October of 2008. At Millard’s request, LES agreed to open segregated client sub-accounts under a master control account that LES maintained at Citibank.

Each of the three sub-accounts were associated with Millard’s name and taxpayer identification number however the accounts were titled in the name of and controlled by LES. LES alone had the ability to move funds into or out of the accounts and was the only signatory on the accounts.

Additionally, each of the Exchange Agreements signed by LES and Millard provided, in part: “. . . LES shall have sole and exclusive possession, dominion, control and use of all Exchange Funds, including interest, if any, earned on the Exchange Funds. . .”

The court held that the facts in the case mandate a presumption that the exchange funds are the property of the LES bankruptcy estate and that for Millard to successfully rebut that presumption, Millard must show that it retained some right in and to the funds.

Millard pointed to the facts that (1) LES was required, under the terms of the Exchange Agreements, to place the funds in segregated sub-accounts that were associated with Millard’s name and tax identification number; (2) Millard had negotiated to retain the benefit of accrued interest on the funds; and (3) there was no imposition of risk of loss on LES that would commonly be associated with ownership. Millard argued these facts proved that it never gave up its equitable ownership in the funds and that LES was holding the funds in trust for Millard’s benefit.The court looked to state law to determine whether the funds could be excluded from the LES bankruptcy estate because of the existence of either an express trust or a resulting trust. The Exchange Agreements were governed by Virginia law. Under Virginia law an express trust is created where there is an affirmative intent to create a trust which can be established either by express language between the parties or circumstances that show, with reasonable certainty, the intent of the parties was to create a trust.

The court did not find any express language or use of the terms “trust”, “trustee”, or “beneficiary”; therefore, the burden fell to Millard to demonstrate that the intention of the parties was to create a trust.Contrary to Millard’s assertion that the parties intended to create a trust, the court held that the language in the Exchange Agreements actually showed the parties’ intention not to create a trust. According to the court, Millard conveyed all control, dominion, and exclusive possession of the funds to LES in addition to disclaiming all right, title, and interest in and to the funds. The court concluded that the parties’ intention to not create a trust could be gleaned from the fact that they chose to utilize only 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 multiple safe harbors to secure the transferee’s obligation to deliver replacement property which include the use of a separate qualified escrow or qualified trust. While the terms and conditions of the safe harbors must be satisfied separately, they are not mutually exclusive.

Millard and LES did not have a separate trust agreement and did not avail themselves of the safe harbor provisions for a qualified trust arrangement. The court found that there was no express trust created in Millard’s three 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 LES bankruptcy estate.

Copy of?the?Memorandum of Opinion: 2009_04_15_memorandum_opinion-millard-v-landamerica

Next Week, Part II: What does this mean for taxpayers entering into like-kind exchanges?