In Exelon, the Seventh Circuit held that exchanges by Exelon Corporation (“Taxpayer”) of nuclear power plants for long-term leasehold interests in power plants located in other states were not exchanges qualifying for like-kind exchange treatment under Code Section 1031. According to the court, the Taxpayer did not acquire the benefits and burdens of ownership but rather received an interest more in the nature of a loan, which was not like-kind with the relinquished real property.
The IRS issued notices of deficiency for tax years 1999 and 2001. The tax deficiency for 1999 was in excess of $431 million. On top of that, the Service imposed a 20% accuracy related penalty under Code Section 6662(a) that exceeded $86 million. For 2001, the deficiency was a bit over $5.5 million. Again, for good measure, the Service tacked on a 20% accuracy related penalty of about $1.1 million.
The U.S. Tax Court affirmed both the deficiency assessment and the imposition of accuracy related penalties. Exelon Corp. v. Comm’r, 147 TC 230 (2016). On October 3, 2018, the U.S. Court of Appeals for the Seventh Circuit affirmed the Tax Court. Exelon Corp. v. Comm’r, 122 AFTR 2d ¶2018-5299 (2018).
The saga of Exelon Corporation is a long and complex read, but the morals to the story definitely warrant tax advisors dedicating the time to understand the case.
As reported in my November 2014 blog post, President Obama’s administration wants to limit taxpayers’ ability to defer income under IRC § 1031. In response to former House Ways and Means Committee Chairman David Camp’s proposed Tax Reform Act of 2014, which would have eliminated IRC § 1031 altogether, the Obama administration proposed to retain the code section, but limit deferral with regard to real property exchanges to $1 million per taxpayer each tax year. Personal property exchanges, under the President’s proposal, would go unscathed.
In 2015, President Obama expanded his proposal relative to IRC § 1031 to limit personal property exchanges by excluding certain types of property from the definition of “like kind.” The excluded personal property included items such as collectibles and art. The President’s proposed $1 million real property exchange limitation was left intact.
Fast forward to today. No tax reform legislation has gained enough traction to even come close to being enacted into law. Nevertheless, President Obama’s attack on IRC § 1031 continues. In the administration’s 2017 budget proposal (released a few months ago), the White House expands its quest to limit the application of IRC § 1031. This proposal is identical to President Obama’s original response to former Chairman Camp’s 2014 tax reform proposal, but it goes further. Now, the President is proposing that the $1 million limitation apply to both personal and real property exchanges. In addition, like his 2015 proposal, President Obama wants to exclude certain personal property, collectibles and art, from the definition of “like kind.”
I am not sure any real logic or significant tax policy supports the White House’s latest proposal to limit the application of IRC § 1031. Rather, the proposal appears to be solely aimed at tax revenue generation. According to the Treasury, the proposal, if enacted into law, would increase tax revenues by $47.3 billion over 10 years.
IRC § 1031 is clearly on lawmakers’ radar screens as a means to increase tax revenues. Time will tell whether IRC § 1031 will be repealed or significantly curtailed in its application. Nevertheless, one thing is for sure: IRC § 1031 remains a potential target. Stay tuned!
Actual or constructive receipt of the exchange funds during a deferred exchange under IRC Section 1031 totally kills an exchange and any tax deferral opportunity. Treasury Regulation Section 1031(k)-1(f)(1) tells us that actual or constructive receipt of the exchange proceeds or other property (non-like-kind property) before receiving the like-kind replacement property causes the exchange to be treated as a taxable sale or exchange. This is the case even if the taxpayer later receives the like-kind replacement property. In accordance with Treasury Regulation 1.1031(k)-1(f)(2), a taxpayer is in constructive receipt of money or property if it is credited to his, her or its account; set apart for the taxpayer’s use; or otherwise made available to the taxpayer.
The treasury regulations specifically tell us that security (such as a third party guarantee, letter of credit or mortgage) put in place to ensure a transferee (including the Qualified Intermediary) actually transfers the replacement property to the taxpayer does not constitute actual or constructive receipt of the exchange funds.
Last, where the exchange funds are held in a “qualified escrow account,” no actual or constructive receipt exists by the mere fact that the escrow holds the funds. A qualified escrow account exists if two criteria are met:
Requirement #1: The Escrow may not be established so that the holder of the funds is the taxpayer or a “disqualified person.”
Under Treasury Regulation Section 1.1031(k)-1(k), a disqualified person is:
- Any person or firm that acted as the taxpayer’s employee, attorney, accountant, investment banker or business broker, or real estate agent within two (2) years prior to the transfer of the relinquished property (or when there are multiple relinquished properties, the time period starts at the transfer of the earliest relinquished property). For this purpose, some services are ignored such as services routinely provided by title insurance companies, escrow companies, and financial institutions.
- The attribution rules of IRC Sections 267(b) and 707(b) come into play, but we have to substitute 10% for 50% in applying these rules. So, for example, related persons include: the taxpayer’s spouse, siblings, ancestors, and lineal descendants; a corporation or a partnership owned more than 10% by the taxpayer or a related person; or a trust in which the taxpayer or a related person is a beneficiary or the fiduciary.
Requirement #2: The terms of the escrow must expressly provide that the taxpayer’s rights to the funds are limited.
The taxpayer cannot be allowed to receive, pledge, borrow against or otherwise obtain the benefits of the funds until after the exchange period expires, until after the 45 day identification period where the taxpayer failed the exchange by not identifying any replacement property, or after the time when the taxpayer has received all of the property identified within the 45 day identification period.
Chief Counsel Advice 201320511
Chief Counsel Advice 201320511 raises a not so obvious issue in the area of constructive receipt of exchange funds. An issue that likely occurs often.
In the CCA, Chief Counsel was presented with a taxpayer that was in the equipment rental business. It regularly engaged in Code Section 1031 deferred exchanges to dispose of its rental equipment and to obtain new rental equipment in a tax deferred environment. Machinery and equipment rental businesses, rental car businesses, trucking companies and airlines likely find themselves in this same predicament.
The taxpayer maintained various lines of credit that it used to assist in funding operations during parts of the year and to acquire new rental equipment. The lines of credit, as you may suspect, were secured by the equipment.
Under the exchange agreement, the two specific requirements of a qualified escrow were met, but the Qualified Intermediary was required to pay down the lines of credit with the exchange proceeds and then (through the taxpayer) use the same lines of credit to fund the purchase of the replacement property. Again, one would assume this often occurs in personal property exchanges by taxpayers in related or similar businesses.
The specific issue presented to Chief Counsel was whether the use of the exchange proceeds to pay down the taxpayer’s debt (which may or may not have been directly related to the relinquished property) constituted constructive receipt by the taxpayer of the exchange funds, thereby killing the taxpayer’s opportunity to obtain tax deferral. The taxpayer was getting the benefit of the exchange funds during the time the deferred exchange was ongoing.
Chief Counsel, citing the boot netting rules, concluded in favor of the taxpayer and held no actual or constructive receipt existed. The new debt secured by the replacement property equaled or exceeded the debt secured by the relinquished property which was paid off in the exchange.
Put this Chief Counsel Advice in your bag of tricks. The issue may come up when taxpayers undertake personal or real property exchanges where a line of credit serves as security.
The goodwill of a business can never be exchanged for the goodwill of another business. Goodwill is not like kind property. Treasury Regulation 1.1031(a)-2(c)(2) makes that crystal clear, providing:
The goodwill or going concern value of a business is not of a like kind to the goodwill or going concern value of another business.
Deseret Management Corp. v. Commissioner, 112 AFTR 2d 2013-5530 (Ct. Fed. Cl. 2013), illustrates the fact that goodwill may exist and be intermixed with business assets being transferred in an exchange under IRC Section 1031. The existence of goodwill creates taxable boot.
Whether goodwill exists is a question of facts and circumstances; the possible existence of goodwill cannot be ignored. The issue comes down to expert valuation testimony -- does it exist and what value should be assigned to it?
In the Deseret Management Corp. case, the taxpayer exchanged the assets of a radio station, including the FCC license, for the assets of another radio station. It followed all of the personal property grouping rules. The Service disputed whether goodwill was properly accounted for and the value assigned to goodwill, which would be treated as taxable boot.
The value of the assets being exchanged was $185 million. The parties stipulated that the hard assets had a value of a little over $8.2 million. The taxpayer argued that the remaining $176.8 million or so was mostly, if not all, properly allocable to the FCC license. The Service, on the other hand, asserted that a big chunk of the $176.8 million should be allocated to goodwill or going concern value.
A battle of the experts ensued. Fortunately, for the taxpayer, its experts were more credible than the government’s experts. Only a small amount of the value attributable to the assets was found to account for goodwill. In fact, the court concluded the amount of goodwill or going concern value was “at most, negligible.”
The moral to the story is simple. In an exchange of business assets, you need to carefully consider whether goodwill or going concern value exists. An otherwise tax deferred exchange may be taxable. Careful thought is required. Also, a qualified appraisal is warranted in order to avoid unwanted surprises down the road.
Deseret Management Corp. serves as a good reminder that goodwill or going concern value could be lurking among the business assets being transferred in a Section 1031 exchange.
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," Hawaii Association of Public Accountants ConferenceLas Vegas, NV, 6.14.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University Tax Conferences in July – Advanced Conference on Subchapter SNew York NY, 7.25.19-7.26.19
- "Tax Law Update for Family Law Practitioners," Oregon State Bar - Family Law Section 2019 Annual ConferenceSunriver, OR, 10.10.19-10.12.19
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19