In the general course of business the sale of property that results in a gain is subject to capital gains tax. A taxpayer who wishes to avoid payment of capital gains taxes may be able to structure the transaction as an exchange instead of a traditional sale. Under Section 1031 of the Internal Revenue Service Code, transactions that qualify as an exchange are tax-deferred for the purpose of capital gains tax. A Section 1031 Exchange involves the exchange of “like-kind” property held for use in trade, business, or investment.
Section 1.1031(f) Related Party
The financial benefits offered by structuring a transaction as a Section 1031 Exchange also led to taxpayer abuse in years past. For example, prior to amendments passed in 1989, taxpayers were able to “act[ing] in concert to exploit the non-recognition treatment and carry over basis provisions to minimize their tax liability but still cash in on their investments.” Ocmulgee Fields, Inc. v. C.I.R., 613 F.3d 1360, 1364 (11th Cir. 2010). Recognizing the rampant abuse of the system, Congress amended Section 1031 to limit the ability of related parties to claim Section 1031 treatment and then cash out on their investment shortly thereafter. Sub-section (f) of Section 1031 prevents related parties from claiming non-recognition and then cashing out within the two year period immediately following the exchange. There are, of course, exceptions to the general prohibition preventing related parties from claiming Section 1031 treatment. The recent case of North Central Rental & Leasing, LLC v. United States (D. N. Dakota. 2013) offers some insight into how narrowly the courts construe those exceptions.
Tax Court Summary
In summary, North Central involved a taxpayer, Butler Machinery, that was in the business of selling construction equipment and machinery. Butler created a subsidiary, North Central, to conduct equipment rental and leasing. Prior to the creation of North Central, Butler did its own rental and leasing in-house. Taxpayer testified that North Central was created for a number of reasons, one of which was to take advantage of the tax deferrals offered by entering into Section 1031 exchanges. Butler has a working relationship with Caterpillar that encouraged Butler to create a Like-Kind Exchange, or LKE, program with Butler’s subsidiary North Central. Caterpillar indicated to Butler that Butler would still be able to take advantage of Caterpillar’s 180 day grace period, known as the DRIS program, if it instituted a LKE program. A typical transaction involved North Central conveying equipment (“Truck A”) to a Accruit, a Qualified Intermediary (“QI). The QI then sold Truck A to an unrelated third-party. Butler purchased replacement equipment (“Truck B”) from Caterpillar. The QI used funds from the sale of Truck A to purchase Truck B from Butler and then transferred Truck B to North Central. This would leave North Central with the replacement property, a third-party with the relinquished property, and Butler with the proceeds that could be used for anything since the bill to Caterpillar was not due for six months.
In essence, this created a situation where Butler ordered replacement parts as part of a LKE from Caterpillar but was not required to pay Caterpillar for six months. Therefore, funds received by Butler from North Central were not required to go directly to Caterpillar but could be used by Butler for anything. Furthermore, while a third party was part of the exchanges, Butler clearly orchestrated the transactions and served as the source for replacement property. The taxpayer claimed that the transactions were eligible exchanges because a third-party was involved. The taxpayer also pointed to the use of a QI to show intent to enter into an eligible Section 1031 exchange. The Court referred to the court in Teruya Bros., Ltd. v. C.I.R., 580 F.3d 1038, 1046 (11th Cir. 2009), which found that a transaction can be disqualified from non-recognition even when a QI is used “if the qualified intermediary’s involvement in the transactions . . . served no purpose besides rendering simple–but tax disadvantageous–transactions more complex in order to avoid § 1031(f)’s restrictions.” Instead of the role played by the third-party or the QI, the Court focused on Butler’s role throughout the transactions. See Ocmulgee, 613 F.3d 1360; Teruya, 580 F.3d 1038.
Tax Court Outcome
The Court also found that the transactions were structured to avoid the purpose of Section 1031(f) because both Butler and North Central effectively “cashed-out” on their low-basis property – exactly what sub-section (f) was enacted to prevent. The purpose of Section 1031 is to allow a taxpayer who has essentially done nothing more than shift an investment to avoid a tax obligation. Here, however, the taxpayer did not simply shift an investment and therefore should not be afforded the benefit of non-recognition.
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