What’s the first thing that comes to mind when you hear that someone has engaged in a like-kind exchange? Real property, right? A taxpayer who owns a rental building with commercial and/or residential tenants exchanges the building for another rental property, usually as part of a deferred exchange. Or, a taxpayer that owns a building in which it conducts an operating business exchanges that building for another in a different location.

A recent IRS ruling, however, serves as a reminder that like-kind exchanges are not just for real properties. After all, why should the “dirt lawyers” have all the fun?

Like-Kind Exchange Basics

Generally speaking, the gain that is realized from the conversion of property into cash, or from the exchange of property for other property differing materially either in kind or in extent, is treated as income. The amount realized from such a sale or exchange is the sum of the money received plus the fair market value of any other property received.

The Code provides an exception from the general rule requiring the recognition of gain upon the sale or exchange of property. Specifically, no gain will be recognized if property held for productive use in a trade or business or for investment is exchanged solely for property of a like kind to be held for productive use in a trade or business or for investment. Property held for investment may be exchanged for property held for productive use in a trade or business, and vice versa.

However, this exception to gain recognition does not apply to certain enumerated properties, each of which is an item of intangible property (e.g. partnership interests).

Like-Kind Intangibles?

In general, “like-kind” refers to the nature or character of the properties to be exchanged, and not to their grade or quality. One kind or class of property may not be exchanged for property of a different kind or class without triggering gain recognition.

Additional rules apply for determining whether personal property has been exchanged for property of a like kind or class. Personal properties of a like “asset class” or “product class” are considered to be of a like kind for purposes of the non-recognition rule.

However, no like classes are provided for intangible personal property. An exchange of such properties qualifies for non-recognition of gain only if the exchanged properties are of like kind.

Whether one intangible personal property is of like kind to another generally depends on the nature or character of the rights involved and also on the nature or character of the underlying property to which the intangible property relates.

The Properties Exchanged

Corp. was a member of an affiliated group of which Parent was the common parent. Corp. had two types of agreements: the Dual Activity Agreements and the Single Activity Agreements. The agreements were with Parent, and with certain parties unrelated to Parent.

Under the Dual Activity Agreements, Corp. had rights to manufacture and distribute AA, a group of Products of various different brand names. Products were non-depreciable tangible personal property. The Dual Activity Agreements granted Corp. the right to manufacture and distribute AA within Territory 1, Territory 2, or Territory 3.

Under the Single Activity Agreements, Corp. had rights to distribute BB, another group of Products of various different brand names that were different from AA, within the same three territories.

Just like Corp., Company had two types of agreements: the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements. These agreements had the same set of counterparties as Corp.’s agreements.

The Replacement Dual Activity Agreements granted Company the right to manufacture and distribute AA within Territory 4 or Territory 5.

The Replacement Single Activity Agreements granted Company the right to distribute BB within these two territories.

For good business reasons, Corp. and Company entered into an exchange agreement, pursuant to which Corp. was scheduled to enter into two exchanges with Company.

In the first exchange, Corp. would simultaneously exchange its Dual Activity Agreements for Company’s Replacement Dual Activity Agreements as one exchange group. In the second exchange, Corp. would simultaneously exchange its Single Activity Agreements with Company’s Replacement Single Activity Agreements as another exchange group.

Corp. represented that:

• The rights under the Dual Activity Agreements and the Single Activity Agreements were held by Corp. for productive use in a trade or business;
• The rights under the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements would be held by Corp. for productive use in a trade or business; and
• To the best of its knowledge, the proportionate values of the manufacturing and distribution rights were roughly similar across both the Dual Activity Agreements and the Replacement Dual Activity Agreements.

The IRS’s Ruling

The IRS noted that an exchange of intangible personal property qualifies for non-recognition of gain only if the exchanged intangible properties are of a like kind. Whether intangible personal property is of a like kind to other intangible personal property generally depends on (i) the nature or character of the rights involved (e.g., a patent or a copyright) and (ii) the nature or character of the underlying property to which the intangible personal property relates.

The IRS illustrated the application of this rule with the following examples:

 

• Example 1: Taxpayer K exchanges a copyright on a novel for a copyright on a different novel. The properties exchanged are of a like kind.
• Example 2:  Taxpayer J exchanges a copyright on a novel for a copyright on a song. The properties exchanged are not of a like kind.

The Dual Activity Agreements and the Replacement Dual Activity Agreements were intangible properties that granted rights related to the manufacturing and distribution of AA. Because Corp. and Company would simultaneously exchange the agreements, the only issue was whether they were of a like kind. This depended, according to the IRS, on the nature or character of the rights involved and on the nature or character of the underlying property to which the agreements related.

The Dual Activity Agreements and the Replacement Dual Activity Agreements were both in the nature of AA manufacturing and distribution agreements.

Manufacturing and distribution, the IRS said, are two distinct business activities and the rights to each would not, absent some close connection between these activities, be of a like kind.

However, the IRS noted that, for economic and historical reasons, manufacturers of AA have long acted as distributors of AA. The inclusion of both business activities in the Dual Activity Agreements and Replacement Dual Activity Agreements reflected the underlying economics and longstanding historical relationship between the two.

Though not completely inseparable, manufacturing and distribution of AA was frequently best performed by a single entity as part of an integrated business process. Additionally, the manufacturing and distribution rights granted under the agreements could only be exercised in conjunction with each other under the agreements.

It was represented that proportionate values of the manufacturing rights and the distribution rights were roughly the same across all of the Dual Activity Agreements and Replacement Dual Activity Agreements.

Accordingly, although manufacturing and distribution were business activities of a different nature or character, the close economic and unique historical connection between the manufacturing and the distribution of AA demanded that they be treated as two aspects of a single business activity where the rights to manufacturing and distribution were contained within the same integrated agreement.

The terms of the agreements were broadly and substantially similar in granting rights to manufacture and distribute AA. Each agreement granted rights and created obligations related to a single business activity, the integrated manufacturing and distribution of AA.

The differences in the length of the term, renewable periods, geographical territories covered, quality control provisions, marketing activity obligations, restrictions on manufacturing and distribution of similar products, and termination events varied among the Dual Activity Agreements and the Replacement Dual Activity Agreements. These differences, however, were insubstantial, relating as they did to the grade or quality of the rights rather than to their nature or character.

Consequently, the nature or character of the manufacturing and distribution rights in the Dual Activity Agreements and Replacement Dual Activity Agreements were of a like kind.

The IRS next considered whether the underlying property subject to the Dual Activity Agreements and the Replacement Dual Activity Agreements was itself of a like kind. The underlying property to which the intangible rights to manufacture and distribute related was AA, a group of Products that shared substantially similar manufacturing and distribution processes. AA included Products with different brand names, appearances, ingredients, packaging, and marketing strategies. Nevertheless, all AA products were manufactured using a substantially similar process in facilities of a common design, and were distributed in a substantially similar manner to a largely common set of customers who resold them to end customers who, in turn, used each of the products of AA for a substantially similar purpose.

Any differences among AA that were relevant to manufacturing or distribution were differences in grade or quality, and not differences in nature or character. Accordingly, the underlying property to which the intangible rights granted by the Dual Activity Agreements and the Replacement Dual Activity Agreements related was of a like kind.

Similarly, the IRS found that the nature or character of the Single Activity Agreements and the Replacement Single Activity Agreements were of a like kind, and that the underlying property subject to the Single Activity Agreements and the Replacement Single Activity Agreements was of a like kind.

The IRS thus concluded that the rights under the Dual Activity Agreements and under the Single Activity Agreements to be transferred by Corp. were of a like kind with the rights under the Replacement Dual Activity Agreements and the Replacement Single Activity Agreements to be transferred by Company, and that no gain would be recognized by Corp. on the exchange of rights under the Agreements.

Planning for Dispositions?

What’s the first thing that comes to mind when you hear that the owners of a business are planning to sell the business or substantially all of its assets? An exchange for cash and maybe an installment note, right?

In some cases, the selling owners may be willing to accept some degree of equity in the buyer, whether in the form of stock in a corporation or an interest in a partnership or LLC, depending upon the buyer.

What about an exchange for other property in-kind? It’s not something that happens frequently in the world of closely-held businesses (other than real estate – back to those dirt lawyers, damn it), but there may be situations where the sale of a business can be structured, in part, as a like-kind exchange.

As the above ruling illustrates, it will behoove a seller and its advisers to be mindful of the like kind exchange rules.