A recent decision touched upon a theme that has been considered in several of our blogs: the “substance over form” doctrine, under which the legal form of a transaction – that would otherwise result in a beneficial tax result for a taxpayer – will be disregarded in order to give effect to its “true” economic substance. The case involved what purported to be a like kind exchange of tangible personal property, which in itself makes the case interesting because so many readers think of such exchanges only in the context of real estate.
A Like Kind Exchange Program
Taxpayer sold equipment for a major manufacturer, “Legs Corp.” Prior to Year X, Taxpayer also conducted a rental and leasing business in conjunction with its retail sales business. In Year X, however, Taxpayer formed Subsidiary to take over Taxpayer’s rental and leasing operations.
Although separate entities, Taxpayer and Subsidiary were closely related and were ultimately controlled by the same family, members of which were board members of both corporations. Taxpayer shared building space with Subsidiary, performed accounting and equipment-ordering functions for Subsidiary, and even initially paid the wages of Subsidiary’s employees, though Subsidiary would eventually reimburse Taxpayer on an allocated basis for the shared services. Legs Corp. assigned separate dealer codes to each entity, which enabled each entity to independently purchase its own equipment from Legs Corp.; however, Taxpayer used its own dealer code to order equipment for both itself and Subsidiary.
At issue in the case was Taxpayer’s like-kind-exchange (LKE) program, which commenced after Taxpayer formed Subsidiary. The LKE program allowed Subsidiary to trade used equipment for new equipment and, in the process, defer tax recognition of any gains from the transactions. Under the LKE program, Taxpayer sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary (“QI”). QI forwarded the sales proceeds to Taxpayer, and the proceeds “went into [Taxpayer’s] main bank account.” At about the same time, Taxpayer purchased new Legs Corp. equipment for Subsidiary and then transferred the equipment to Subsidiary via QI. Taxpayer charged Subsidiary the same amount that Taxpayer paid for the equipment.
Taxpayer’s use of LKE transactions in this fashion facilitated favorable financing terms from Legs Corp. (referred to as “DRIS” financing terms). Legs Corp. advised taxpayer before it established either Subsidiary or the LKE program that such a transaction structure would enable Taxpayer “to take full advantage of [Legs Corp’s] DRIS payment terms.” The DRIS payment terms, among other things, gave Taxpayer up to six months from the date of the invoice to pay Legs Corp. for Subsidiary’s new equipment. During that time, Taxpayer could use the sales proceeds it received from QI for essentially whatever business purposes it wanted. In other words, Taxpayer essentially received an up-to-six-month, interest-free loan from each exchange.
A Like Kind Exchange?
In a representative transaction, Subsidiary agreed on or before June 30, 2004, to sell Truck 1 to a third party for $756,500. Subsidiary’s adjusted tax basis in Truck 1 was $129,372.70 at the time. The third party paid QI the $756,500 in sales proceeds, and Subsidiary transferred to the third party legal ownership of Truck 1.
On or about August 13, 2004, Taxpayer identified and purchased the replacement Legs Corp. equipment, Truck 2. Taxpayer’s total acquisition price for this new property was $761,065.60. Taxpayer then transferred legal ownership of the replacement property to Subsidiary through QI on August 27, 2004. On September 10, 2004, QI transferred the $756,500 in proceeds from the sale of Truck 1 to Taxpayer. Subsidiary and Taxpayer then adjusted a note between the two companies to compensate Taxpayer for the $4,565.60 difference between the $756,500 in sale proceeds and the $761,065.60 that Taxpayer paid for the replacement equipment.
Thus, in the immediate aftermath of the transaction, (1) a third party owned Truck 1; (2) Subsidiary held its replacement property (Truck 2) and an adjusted note reflecting its new $4,565.60 debt to Taxpayer; and (3) Taxpayer possessed the $756,500 in sale proceeds from Truck 1 and an adjusted note reflecting its new $4,565.60 credit to Subsidiary. Subsidiary deferred recognizing the $627,127.30 gain it realized from the transaction (the difference between the $756,500 in sales proceeds from Truck 1 and Subsidiary’s $129,372.70 adjusted basis in Truck 1), claiming the gain was entitled to nonrecognition treatment under IRC §1031. And Taxpayer, per Legs Corp’s DRIS financing terms, had essentially unfettered use of the sales proceeds from Truck 1 for nearly six months before it was obligated to pay Legs Corp for the replacement equipment.
The IRS Disagrees
From 2004 to 2007 Subsidiary claimed nonrecognition treatment of gains from almost 400 LKE transactions pursuant to §1031. The IRS issued determined that the transactions were not entitled to nonrecognition treatment. The IRS concluded that Subsidiary structured the transactions to avoid the related-party exchange restrictions provided under §1031(f). The district court found, among other things, that the transactions were not entitled to nonrecognition treatment because they were “structured to avoid the purposes of §1031(f).” In so holding, the court analyzed Taxpayer’s “receipt of cash in exchange for equipment, together with its unfettered access to the cash proceeds,” as well as the relative complexity of the transactions. The district court ruled in favor of the IRS, and Subsidiary appealed to the Eighth Circuit.
As a general rule, taxpayers must immediately recognize the gain they realize from the disposition of their property. Taxpayers can defer recognizing such gains, however, when they exchange “property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” IRC §1031(a)(1). This LKE exception distinguishes a taxpayer who conducts an LKE from a taxpayer who liquidates or “cashes in” on his or her original investment. With an LKE the taxpayer essentially continues his or her original investment via the like-kind property.
However, after Congress enacted the LKE exception, sophisticated parties exploited the exception in a manner inconsistent with its purpose. Some related entities agreed to structure transactions such that they could actually cash in on their investments while nevertheless claiming nonrecognition treatment under §1031.
Section 1031(f)(1) generally prohibits nonrecognition treatment for exchanges in which a taxpayer exchanges like-kind property with a “related person,” and either party then disposes of the exchanged property within two years of the exchange. Moreover, in an attempt to thwart the future use of more complex transactions that technically avoid the provisions of §1031(f) but nevertheless run afoul of the purposes of the law, Congress also enacted §1031(f)(4), which broadly prohibits nonrecognition treatment for “any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of” §1031(f).
The Court Finds for the Government
The Court began by noting that an exchange may be suspect where it involves unnecessary complexity and unnecessary parties. As discussed above, the transactions each involved an intricate interplay between at least five parties: Subsidiary, QI, Taxpayer, Legs Corp., and the third party who buys Subsidiary’s used equipment. Of course, Subsidiary, Legs Corp., and the third-party customer were indisputably necessary for the sales and purchase transactions to occur. Taxpayer and QI, however, were not.
In fact, Subsidiary acknowledged in its briefing, Taxpayer functioned “as a passthrough of both the cash and the property.” This begged the question of why Taxpayer was involved at all in the transactions. Subsidiary proffered several alternative reasons for Taxpayer’s involvement, including that it made the transactions administratively easier and more efficient. None of these arguments, however, convinced the Court. After all, Subsidiary already had its own dealer code, and it could have placed the exact same equipment orders directly to Legs Corp. Injecting Taxpayer into the transactions added unnecessary inefficiencies and complexities to the transactions, including, among other things, additional transfers of payment and property.
A more plausible explanation for Taxpayer’s involvement, the Court said, was that Taxpayer financially benefitted from what amounted to six-month, interest-free loans under the DRIS financing terms, analyzing “the actual consequences” of the transactions to ascertain the parties’ intent, and noting that related parties should be treated as an economic unit in this inquiry. As discussed above, the DRIS financing gave Taxpayer up to six months to pay its invoices to Legs Corp. In the meantime, the sales proceeds from the relinquished equipment were deposited into Taxpayer’s “main bank account,” and Taxpayer was able to use the proceeds as it pleased.
Taxpayer attempted to downplay the benefit it derived from these de facto interest-free loans by asserting that Subsidiary would have received the same financing terms if it had ordered directly from Legs Corp. The officers of QI, however, testified that QI would have paid the sales proceeds from the relinquished property directly to Legs Corp. if the new equipment were not purchased via Taxpayer. In other words, if Taxpayer was not involved in these transactions, neither Taxpayer nor Subsidiary would have received the de facto interest-free loans.
In sum, though Taxpayer was not necessary to the transactions at issue, it acquired access to significant, freely usable cash proceeds as a result of the transactions. Subsidiary argued that Taxpayer did not have indefinite access to the sales proceeds from each transaction. The Court responded that it simply could not ignore the significant and continuous financial benefits taxpayer derived from these hundreds of de facto interest-free loans.
QI was also an unnecessary party to these transactions. Taxpayer and Subsidiary could have exchanged property directly with each other without QI’s involvement. This extra layer of complexity lent support to the finding that the exchanges were structured to sidestep IRC §1031(f). Notably, if Taxpayer and Subsidiary had exchanged the property directly with each other, they, as related parties, would have had to hold the exchanged-for property for two years before the exchanges could qualify for nonrecognition treatment. Hence, their need for QI.
Repetition is the Mother of Learning?
Related party transactions will be subject to close scrutiny by the IRS. Related party transactions will be subject to close scrutiny by the IRS. Related party transactions will be subject to close scrutiny by the IRS.
It appears that many taxpayers, and some advisers, firmly believe that this basic tenet of tax law does not apply to them – at least until they are selected for audit. But why wait for that? There’s nothing like thoroughly examining a proposed transaction before undertaking it. It is worth the time and expense.