Come Fly With Me
What is a like-kind exchange? Many would respond that it is a transaction by which a company exchanges one real property that it has used in its trade business for another property that will also be used by the company in its trade or business.
Generally speaking, this response would be correct. However, it would also be incorrect in limiting its description to real properties. In fact, many items of tangible personal property, including, for example, vehicles and equipment, may be “swapped” – for other vehicles or equipment, as the case may be – as part of a like-kind exchange, provided the requirements therefor, as set forth in the Code and regulations issued thereunder, are satisfied.
The IRS office of chief counsel recently issued an advisory that reviewed a like-kind exchange in which a company exchanged one aircraft for another. Specifically, the IRS considered whether the company held the relinquished aircraft and the replacement aircraft “for productive use in a trade or business” within the meaning of the like-kind exchange rules. The aircraft, which were leased by the company to a related entity that was partially owned by the same individuals who owned the company, were the company’s only operating assets and did not generate an economic profit for the company. [CCA 201601011]
The gain realized from the conversion of property into cash, or from the exchange of property for other property differing materially in kind from the relinquished property, is treated as taxable gain because the exchanging taxpayer has changed the fundamental nature of the taxpayer’s property interest and of the taxpayer’s relationship to such property.
By contrast, the Code provides an exception from the general rule requiring the recognition of gain upon the exchange of property if property held for productive use in a trade or business is exchanged solely for property of a like-kind to be held for productive use in a trade or business.
Whether the property is held for productive use in a trade or business is a question of fact. The manner in which the relinquished property is held at the time of the exchange controls, not the manner in which it was held when acquired. Similarly, replacement property is held for productive use in a trade or business if it is so held at the time of its acquisition.
“Boss! The Plane!”
Partnership P (“P”) owned multiple aircraft which were leased to Partnership O (“O”). O was the primary business entity of the “O group” of entities, which included P and other entities. O’s business activities involved air travel, particularly by its executives. For both business and legal reasons, the aircraft were owned by P, an entity separate from the main business entity, O, and were leased to O. The aircraft were the only operating assets of P, but P also owned interests in other entities in the O group of entities.
The aircraft were principally used by two of O’s senior executives: A and B. A and B used the aircraft variously for business purposes and for personal purposes. Thus, the aircraft served a business purpose for O both in terms of business travel and as an employment perk for its senior executives. To the extent A and B used the plane for personal purposes, they included the required amount in gross income as compensation. A and B, who owned interests in O, also owned 50 percent each of P.
In Year 1, P exchanged the relinquished aircraft for replacement aircraft. Both the relinquished and replacement aircraft were leased to O. The lease payments for the relinquished aircraft approximated the fair market rental value of the aircraft, whereas the lease payments for the replacement aircraft were below market. Nevertheless, in both cases, the lease payments were designed to cover the aircraft’s carrying costs, and were not designed to generate meaningful economic profit.
The IRS initially asserted that P did not hold either the relinquished or replacement aircraft for productive use in a trade or business. In determining whether the planes were “held for productive use in a trade or business” (as required by the Code), the IRS contended that the two entities (P and O) should be examined solely on an entity by entity basis, not as a single business unit, and that the profit motive of one entity (O) should not be attributed to the other entity (P), even though the two entities were closely related.
The IRS concluded that P did not hold the aircraft for “productive use” in a trade or business, stating that P’s intercompany activity with O did not demonstrate a profit motive.
The IRS Reconsiders
The office of chief counsel acknowledged that the rent P charged O for the use of the relinquished property and the replacement property was insufficient for P to make an economic profit on the aircraft rental to O.
It also observed, however, that many businesses hold and use property in a way that, if the use of the property were viewed as a separate activity, does not and could not generate profit. Nevertheless, the property itself is held for productive use in that business.
The Business Structure
The IRS pointed out that businesses, for any number of good business reasons, choose to hold property (like aircraft) in a separate entity.
In the present case, O, which operated a legitimate business enterprise, required private aircraft to be available to its senior executives, both for business travel and as an employment perk. However, for business and legal reasons, the aircraft were owned not by O but by P, a related entity.
The chief counsel’s office noted that if O owned the aircraft, or was the sole owner of P, it is unlikely the IRS would have raised the issue of whether the aircraft were held for productive use in a trade or business.
It went on to state that if the IRS were to disallow like-kind exchange treatment based merely on the entity structure presented, many businesses would be forced to structure their transactions in inefficient and potentially risky ways, from a business perspective, to achieve such treatment.
Thus, the entity structure in the present case could not be used as grounds for determining that the aircraft failed to qualify as property held for productive use in a trade or business.
Chief counsel stated that O operated a legitimate business enterprise and required private aircraft to be available to its senior executives. For business and legal reasons, O structured its affairs so that the aircraft were owned through P, and leased to O for an amount not intended to generate a profit for P. On these facts, the IRS determined that the aircraft were held for productive use in a trade or business for purposes of the like-kind exchange rules.
Thus, P’s lack of intent to make an economic profit on the aircraft rental did not establish that the aircraft failed the “productive use in a trade or business” standard of the like-kind exchange rules.
The “Personal” Use
In addition, the chief counsel noted that A’s and B’s use of the property for personal purposes was not relevant in determining whether P held the aircraft for productive use in a trade or business.
More accurately, the opinion should have stated that because such “personal use” was treated as compensation paid by the business to A and B, it constituted a business use from P’s and O’s perspectives.
We often tell clients that the “tax tail should not wag the business dog” (or something like that – those of you who know me well also know that no idiom, or variation thereon, is safe from being mangled in my hands).
The advisory opinion described herein recognized that there are circumstances in which it may be prudent for a single business to structure its holdings or operations in a certain way for bona fide business, non-tax-motivated reasons. Provided the requirements for like-kind exchange treatment are otherwise satisfied, the taxpayer-business should not be punished for having structured its operations, property holdings, and intercompany transactions in a way that is advantageous from a business or legal perspective, notwithstanding the fact that such transactions, when viewed in isolation, may not generate a profit.
That being said, it is worth observing that certain facts raised by the IRS in the advisory do present legitimate tax concerns: P charged O below-market rent for the replacement aircraft; A and B, rather than O (or all of O’s partners), owned P.
Query, should the IRS be able to apportion or allocate the income and deductions between O and P in a way that “clearly reflects” arm’s-length dealing?
If the facts were developed further, would we find that the O group family of entities and their owners frequently failed to act at arm’s-length with respect to one another? In that case, might this result in a tax treatment different from the treatment claimed by P and O, or A and B?
Would the facts support a finding that P was not a valid partnership, but a sham entity? If P were a sham entity, then A and B, and not P, would be the owners of the aircraft. In that case, the IRS’s analysis and conclusion may have been different. Indeed, the advisory’s acknowledgement that the structure chosen by the taxpayers was based on bona fide business grounds may not have been forthcoming. After all, if the principals ignored the separateness of their own business entities, then so might a potential creditor or claimant.
As always, the best way for related parties to avoid surprises that may arise from their business dealings with one another, is to treat with one another on as close to an arm’s-length basis as possible. But, as Zorba the Greek said, “On a dead man’s door, you can knock forever.”