Purported Like-Kind Exchanges Involving Sale-Leasebacks Didn't Meet Section 1031 Requirements

(Parker Tax Publishing September 2016)

The Tax Court held that purported like-kind exchanges involving sale-leaseback strategies were not like-kind exchanges but rather were transactions properly characterized as loans since the transactions did not transfer the benefits and burdens of ownership. In addition, the taxpayer did not satisfy the like-kind exchange requirement of exchanging similar property because it exchanged power plants for an interest in financial instruments. Exelon Corporation v. Comm'r, 147 T.C. No. 9 (2016).

Exelon Corporation is engaged in the production, transmission, and distribution of electricity to residential, commercial, and industrial customers in Northern Illinois. In 1999, it sold its fossil fuel power plants for $4.813 billion and made a profit of $1.6 billion on the sale. In order to shelter the gain, Exelon pursued a series of like-kind exchanges employing sale-leaseback strategies between itself and two unrelated third parties, each a tax-exempt public utility. Exelon fully funded the transactions using the proceeds from the sale of its own power plants. In the transactions, the third parties would lease a power plant to Exelon for a term exceeding the plant's useful life, receiving in turn a lump-sum payment of cash, and Exelon would sublease the power plant back to the tax-exempt public utility. Part of the amount paid to the public utility would be returned to Exelon as a prepayment of the sublease, another part would be set aside for investment and to secure a cancellation option allowing the tax-exempt public utility to purchase back their power plants at the end of the sublease periods, and the remainder would be retained by the tax-exempt public utility and used for their own needs.

Since exercising the cancellation options was expected to be the only economically viable option, the parties to the transactions anticipated that at the end of the sublease periods, the public utilities would exercise their cancellation options and regain ownership of the power stations leased to Exelon. Since Exelon characterized the transactions as like-kind exchanges under Code Sec. 1031, the primary tax benefits that Exelon expected to derive were from the deferral of income tax under Code Sec. 1031 and various deductions related to the replacement properties. Exelon identified appropriate replacement properties, conducted due diligence, and closed the transactions within the timeframes provided for in Code Sec. 1031.

The IRS labeled the transactions as sale-in/lease-out (SILO) transactions and rejected Exelon's assertion that the transactions qualified as like-kind exchanges under Code Sec. 1031. The IRS assessed a 20 percent accuracy-related penalty under Code Sec. 6662 on the grounds of negligence or disregard of rules and regulations with respect to Exelon's tax treatment of the SILO transactions.

The Tax Court held that the agreements between Exelon and the tax-exempt public utilities were not true leases but rather properly characterized as loans since the transactions did not transfer the benefits and burdens of ownership to Exelon. The substance of the transactions, the court said, was not consistent with their form. Further the court noted, Exelon did not satisfy the requirements of Code Sec. 1031 that property of a like kind be exchanged since Exelon exchanged power plants for an interest in financial instruments.

The Tax Court also concluded that Exelon was not entitled to deduct interest or include rental income on its return with respect to the transactions at issue since they were not lease agreements for federal tax purposes under Code Sec. 467. Nor, the court said, could Exelon deduct transaction costs related to its transactions with the public utilities. Instead, such costs had to be included as an additional amount lent to the public utilities.

With respect to the penalties, the IRS found Exelon liable for the assessed accuracy-related penalties on the grounds of negligence or disregard of rules or regulations. The court concluded that Exelon did not show reasonable cause and good faith under Code Sec. 6664(c) and thus did not meet the exceptions for avoiding the penalties.

For a discussion of the requirements for a valid like-kind exchange, see Parker Tax ¶113,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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