Edges of Acceptable Tax Planning
What does it look like?
September 9, 2010
The 11th Circuit affirmed the application of section 1031(f)(4) to a like-kind exchange that was structured by a corporation to avoid the purposes of the related party rule of section 1031(f). Ocmulgee Fields, Inc. v. CIR, No. 967-07 (11th Cir. 8/13/2010), aff'g, 132 T.C. No. 6 (2009). After an earlier similar ruling in Teruya Bros. Ltd v. CIR, 580 F.3d 1038 (9th Cir. 2009), the outcome is not too surprising. However, the case is worth studying because it illustrates how tax planning can go off track when anti-abuse rules are underestimated. This illustration has increased significance now that we have a super anti-abuse rule in the form of the codified economic substance doctrine (section 7701(o)).
Corp. X transferred its property to a qualified intermediary (QI), which sold the property for cash. The QI used the cash to buy the exchange property from Corp. Y, which was related to X under the definition of the section 1031 related-party rule. QI transferred the Corp. Y property to Corp. X, which claimed nonrecognition of the $6 million gain on the disposition of its property. Corp. Y reported the $4 million gain on its property sold to the QI. The 11th Circuit held that Corp. X had violated the purposes of section 1031's related party rule, applied the anti-abuse rule of section 1031(f)(4), and so required X to recognize its $6 million gain.
A review of the state of the law in 2004 when this transaction occurred suggests a high likelihood that the Internal Revenue Service (IRS) would attack it; the taxpayer reported it on the "Related Party Exchange Information" form. What went wrong in the taxpayer's planning of this exchange? Perhaps nothing. The Tax Court relieved taxpayer of the $403,172 penalty because its accountant thought the plan would work. Therefore, taxpayer took a reasonable chance and deferred its tax liability for about six years, albeit at a substantial interest cost. But the taxpayer was interested in more than penalty relief, because it appealed to the 11th Circuit, which affirmed. Therefore the taxpayer must have relied heavily on what the court found to be "speculative and unquantified" future tax detriments that it argued offset the immediate, quantifiable, and large tax savings. That was a mistake.
It is hard to tell whether those detriments were considered in advance or products of hindsight. It is more likely that the taxpayer did not think the anti-abuse rule was directly aimed at these facts because it put too much stock in the legislative history being all inclusive, and it missed Rev. Rul. 2002-83, 2002-2 C.B. 927. That ruling, which did predate the transaction, describes almost identical facts and finds them to violate the anti-abuse rule. However, the Tax Court charitably said the ruling did not leave the issue "free from doubt" in waiving the penalty.
The 1989 legislative history talked about "transactions that do not involve the shifting of basis between properties" and said "A disposition includes indirect dispositions of the property, such as by means of the disposition of the stock of a corporation or interests in a partnership that owns the property." Literally neither of those things happened in the facts of the case. But the court was willing to go farther in finding the purposes of the subsection.
On its face section 1031(f) is aimed at Corp. X swapping property with Corp. Y, followed by either one selling the property received within two years. If that occurs the gain not recognized on the exchanged is recognized in the year of the sale. Those were not the facts of taxpayer's case. But section 1031(f)(4) says the rule also will apply to any transaction structured to avoid the purposes of the subsection.
At first read the related party rule seems to be aimed at an exchange that is a delaying tactic intended to obscure a second disposition of the exchanging taxpayer's property. How can such a rule apply to a QI exchange where the exchanged property is going to be immediately sold? It doesn't, which suggests a second reading is required.
Two things should tip off a broader purpose:
The purpose of the rule is not to accelerate gain when the rule applies the unrecognized gain is recognized at the time of the second disposition. The purpose of the rule is to prevent a taxpayer from using section 1031 to switch the basis of high basis property held by a related party for low basis property held by the taxpayer.
Example: Both X and Y rely on section 1031 and Y later sells X's low basis property for no gain because Y swaps its high basis in the property it originally held into X's low basis property.
But on the facts of the case there was no basis shifting. Rather Y recognized its gain using its basis and X did not try to dispose of the property it received from Y, which takes the former basis of the property sold to the third party.
Teruya Bros. Ltd v. CIR, 580 F.3d 1038 (9th Cir. 2009) ruled that a similar transaction was structured to avoid the purposes of the related party rule because the taxpayer could have just swapped the properties with the related party and if it sold the property the related party rule would have been triggered without resort to the anti-abuse rule. Ocmulgee followed Teruya's reasoning.
The wisest takeaway is that taxpayers should warily view anti-abuse rules as if they were poisonous snakes. Admittedly, the anti-abuse rule in section 1031(f)(4) is particularly onerous. It does not say the Treasury can write regulations covering transactions that avoid the purposes of the subsection, but that the subsection applies in those cases, leaving the scope of a section's purposes to the field agent.
A broader and more worrisome lesson is that the economic substance doctrine could have produced a similar ruling. The court did not believe the taxpayer had any business purpose, or stood to gain non tax profit from substituting the QI exchange for a direct exchange with the related party; and the court refused to net the tax benefit down by the speculative tax detriments. However, taxpayers should argue that that Ocmulgee is very different form an economic substance doctrine case for the reason that Congress stated its intent for the purposes of the statute to be enforced in the statute itself.
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Jasper L. Cummings, Jr., JD, is of counsel in the Raleigh office of Alston & Bird LLP. He practices in the areas of corporate taxation and has served as Associate Chief Counsel (Corporate), IRS. He can be reached at 919-862-2302.