Borden, Bradley T.

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Brooklyn Law School: BrooklynWorks

Brooklyn Law School BrooklynWorks Faculty Scholarship 2018 Effect of IRS Nonacquiesence on Tax Planning and Reporting Bradley T. Borden Follow this and additional works at: https://brooklynworks.brooklaw.edu/faculty  Part of the Tax Law Commons BRADLEY T. BORDEN is a Professor ofLaw at Brooklyn Law SchooLLike-Kind Exchange CornerEffect of IRS Nonacquiesenceon Tax Planning and ReportingBy Bradley T Bordenhe IRS lost its challenge of the nonrecognition treatment of a non-safe-harbor Code Sec. 1031 reverse exchange in BartellEst.' The IRS hadthe option of appealing the decision to the Ninth Circuit, but instead itissued an Action on Decision ("AOD") stating that it does not acquiesce to theTax Court's decision.2 This column considers what effect, if any, the IRS actionshould have on taxpayers and their advisors.Recall that in Bartell, the taxpayer entered into an agreement with a facili-tator, pursuant to which the facilitator took title to property. The taxpayerintended for that facilitator-held property to be replacement property in afuture Code Sec. 1031 exchange. While the facilitator held the property, thetaxpayer oversaw construction of a building on it. Seventeen months afterthe facilitator took title to the property, the taxpayer sold other property andthen took title to the facilitator-held property to complete a Code Sec. 1031exchange. Relying upon a benefits-and-burdens analysis under Grodt &3McKayRealty, Inc., the IRS took the position that the taxpayer became the owner ofthe property when the facilitator took title.' The Tax Court rejected that po-sition and, relying on Ninth Circuit precedent (the circuit to which the casewould be appealable), adopted a formalistic interpretation of tax ownershipfor Code Sec. 1031 transactions with facilitators. Based upon that formalisticinterpretation, the court held that the facilitator was the tax owner of theproperty while it held title to the property.The AODThe AOD nicely summarizes the IRS's views on this issue and provides aninteresting study of IRS legal analysis. First, the IRS takes issue with the TaxCourt's reliance upon case law that was decided before the issuances of Reg.§ 1.1031(k)-1, which contains the qualified-intermediary and other safe harborsfor deferred multiple-party exchanges. Those regulations also provide that theydo not apply to reverse exchanges.4 Notably, because those regulations providesafe harbors, they do not attempt to overturn prior law. The IRS correctly statesthe law provided in Bartell: "a third-party exchange facilitator 'need not assumethe benefits and burdens of ownership of the replacement property in order to betreated as its owner for section 1031 purposes before the exchange.'@ 2018 CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 17JANUARY-FEBRUARY 2018LIKE-KIND EXCHANGE CORNERSecond, the IRS recognizes that in Rev. Proc. 2000-371 ithas taken the same position the Tax Court takes (disregardsbenefits and burdens to determine the tax owner), butonly if the facilitator holds property for no more than 180days. The IRS recognizes that if the Rev. Proc. 2000-37safe harbor does not apply then "the proper treatment ofany transactions entered into by or between parties, willbe made without regard to the provisions of this revenueprocedure." The Tax Court in Bartelldid not indicate thatit considered the Rev. Proc. 2000-37 safe harbor to applyin favor of the taxpayer. In fact, the court recognizes thatthe revenue procedure was published after the Bartell tax-payers undertook the transaction. It also quoted languagefrom the revenue procedure that the IRS recognizes thatreverse exchanges may be accomplished outside its safeharbor and that the revenue procedure did not intendany inference regarding the federal income tax treatmentof such transactions.The IRS lost its chalenge of thenonrecognition treatment of anonsafe harbor Code Sec. 1031reverse exchange in Ba rtell Est.Third, the IRS cites D. DeCleene6 as authority for itsposition that the Tax Court decided Bartell incorrectly.The Tax Court expended considerable ffort to addressthe IRS's contention that DeCleene should apply to theBartell facts. The Tax Court distinguished the two cases.In DeCleene, the taxpayer had acquired property and latertransferred title to that property to a facilitator that con-structed improvements on the property, and the taxpayerthen reacquired the now improved property. The TaxCourt held that the exchange in DeCleene was an exchangewith the taxpayer's self. The Tax Court in Bartellconcludedthat the DeCleene holding did not apply to a transactionif the facilitator acquired title to property from a thirdparty, as opposed to the taxpayer.Fourth, the IRS states that it will not follow Bartell.It affirms its position that the benefits-and-burdens testshould apply to determine who owns property for purposesof Code Sec. 1031 for transactions that do not satisfy theRev. Proc. 2000-37 requirements. The IRS concludes itsAOD with a bewildering statement: "Taxpayers that useaccommodating parties outside the scope of Rev. Proc.2000-37 have not engaged in an exchange if the taxpayer,rather than the accommodating party, acquires the benefitsand burdens of ownership of the replacement propertybefore the taxpayer transfers the relinquished property."One should understand that the IRS's purpose in issuingthe AOD is to state its belief that the Tax Court did notcorrectly decide Bartell, but this categorical statement ofthe IRS's understanding of the law is misplaced. The TaxCourt's ruling is a precedential statement of the law. Thediscussion below will address this matter in greater detail.Finally, the AOD provides in all caps that it "is not to berelied upon or otherwise cited as precedent by taxpayers."The Effect of the AODThe IRS's categorical statement in the AOD is neither anaccurate description of the law nor legally binding, but itsnonacquiesence may have an in terrorem effect on sometaxpayers and advisors. Taxpayers and their advisors mayshy away from structuring transactions that are similar tothe Bartellexchange, fearing that doing such a transactioncould, at a minimum, result in the IRS challenging itstreatment as a Code Sec. 1031 exchange. They may alsofear that such a challenge would result in costs to opposethe IRS challenge, that the IRS could successfully convincea court to rule contrary to Bartell, and that perhaps penal-ties could be imposed. This discussion first considers howtaxpayers who have reported Bartell-like transactions asCode Sec. 1031 exchanges might react, if the IRS were tochallenge such aposition. It then considers how a taxpayerwho is contemplating a Bartell-like transaction mightaccount for the AOD in deciding whether to pursue it.Finally, it shows that penalties should not be imposed ona taxpayer who structures Bartell-like transactions andreports it as a Code Sec. 1031 exchange.If the IRS challenges a Bartell-like transaction thata taxpayer has already entered into, then the taxpayerhas Bartell to rely upon to defer its tax treatment of thetransaction. If the case is being heard by the Tax Court,the taxpayer should take comfort that the court thatdecided Bartell will rule on its case. The Tax Court willmost likely rely upon Bartell as precedent. If the appealof the Tax Court decision would be to a court other thanNinth Circuit, the taxpayer may worry that the othercircuit would not rely upon the Ninth Circuit cases citedin Bartell, but the contrary result is more likely. Circuitcourts recognize that decisions of other circuits "do ofcourse have weight as authority with us even when theyare not our own decisions."' Thus, other circuits are morelikely than not to rely upon the Ninth Circuit cases citedin Bartell, and a taxpayer should confidently oppose theIRS if the IRS challenges its nonrecognition of treatmentof a Bartell-like transaction.18 JOURNAL OF PASSTHROUGH ENTITIES JANUARY-FEBRUARY 2018A taxpayer in the planning phase of a Bartell-like transac-tion may entertain various alternative courses of actions.One alternative would be to acquire the replacementproperty outright, understanding that the acquisitionwould disqualify the property from serving as replacementproperty. If the taxpayer planned to dispose of relinquishedproperty and did not have other potential replacementproperty in mind, the acquisition would mean that gainrealized on the subsequent disposition of relinquishedproperty probably could not qualify for Code Sec. 1031nonrecognition." Thus, the cost of an outright acquisitionwould be the tax paid on gain that might have otherwisebeen deferred.The taxpayer may consider other structures that mightallow it to transfer the relinquished property as part of aCode Sec. 1031 exchange. For instance, a related partycould acquire the taxpayer's relinquished property andhold it until a third party acquires the property. Thetaxpayer could then use the proceeds from the sale ofthe property to the related party to acquire the replace-ment property immediately following the transfer ofrelinquished property to the related party. Several privateletter rulings grant Code Sec. 1031 nonrecognition tosuch transactions.' Such transactions accomplish the sameend result achieved through the Bartell structure, but theIRS has privately sanctioned the related-party structure.The related-party structure may not be feasible in allsituations. For instance, the relinquished property maybe subject to a loan with favorable terms, and transfer-ring it to a related party could place the loan in default,which would allow the lender to call the loan. In sucha situation, the taxpayer must weigh whether using theBartell-like structure provides sufficient benefit to offsetthe threat that the IRS may challenge the taxpayer's CodeSec. 1031 nonrecognition treatment of the transaction.In considering the threat that the IRS may challenge thetreatment, the taxpayer should consider its alternatives andthe cost and benefit of each alternative. The first alterna-tive is to avoid the Bartell-like transaction and pay tax onthe disposition of property. The cost of that alternative isthe tax paid.The other alternative is to adopt the Bartell-like transac-tion. The taxpayer will incur transaction costs to set upthe structure, so the potential tax savings will have to besufficient to offset those costs. The taxpayer could alsoincur costs to oppose an IRS challenge, if the IRS auditsthe transaction and raises the matter on audit. The BartellAOD may increase the likelihood that the IRS will raisesuch a matter on audit, but there is no apparent reason toexpect it to increase the likelihood that the IRS will audita taxpayer solely because it does a Bartell-like transaction.For demonstration purposes, assume no penalties wouldbe imposed for treating a Bartell-like transaction as aCode Sec. 1031 exchange (which, as discussed below, is areasonable assumption). If the IRS audited the taxpayer'sreturn and challenged the reporting position, the taxpayercould simply pay the tax at that point and be done withit, and the taxpayer would have to pay no more than theamount of the deferred tax. Thus, the taxpayer can do acost benefit analysis comparing the cost of structuring aBartell-like transaction and reporting the disposition ofproperty as a Code Sec. 1031 exchange with the cost ofreporting it as a taxable transaction and paying the taxcurrently. Generally, the cost of taking Code Sec. 1031treatment will be less than the cost of paying the tax, asillustrated by a simple example.f the IRSchallengesan BartetmlitaeCod Sct 1o exchat I th t axpayer hasalread enee int, then the tapaeohas? Bo tl tly-pot 'ef ts taxotraten f the trnsctonAssume a taxpayer would defer $200,000 of taxes bystructuring a Bartell-like transaction and reporting it as aCode Sec. 1031 exchange. If the taxpayer does not takeCode Sec. 1031 treatment, it would pay the $200,000currently. Assume that it will cost $20,000 to structurethe Bartell-like transaction. The total cost of doing theBartell-like transaction would equal the $20,000 transac-tion costs plus the expected cost of paying the deferredtax. The expected cost of paying the deferred tax equalsthe $200,000 deferred tax multiplied by the probabilityof paying the deferred tax. If the expected cost of thedeferred tax is less than $180,000, the cost of doing theBartell-like transaction (sum of $20,000 transaction costplus the expected cost of the deferred tax) would be lessthan $200,000. Thus, if the probability of paying thedeferred tax is less than 90 percent, the cost of doing theBartell-like transaction will be less than the cost of pay-ing the tax currently. At the time a taxpayer must decidewhether to do a Bartell-like transaction, the probabilityof tax being imposed on the transaction will rarely begreater than 90 percent. Consequently, the cost of doinga Bartell-like transaction in this hypothetical most likelywould be less than paying the tax currently.For a taxpayer who has already paid the transaction costsand must decide whether to report the transaction as aQ 2018 CCH INCORPORATED AND ITS AFFILIATES. ALL RIGHTS RESERVED. 19JANUARY-FEBRUARY 2018LiKE-KIND EXCHANGE CORNERCode Sec. 1031 exchange, the cost of taking the reportingposition would simply equal the expected cost of payingthe tax. The probability of paying the deferred tax willbe less than 100 percent-there will always be a chancethat the IRS will not audit the return or raise the matteron audit. Thus, the cost of paying the deferred tax if thetaxpayer does the Bartell-like transaction will always beless than the cost of not doing the transaction and merelypaying the tax.The AOD does not change this type of cost-benefitanalysis. The AOD suggests the IRS will challenge theCode Sec. 1031 treatment of any Bartell-like transac-tions that it becomes aware of, but the probability ofit becoming aware of such transactions is less than 100percent, and most likely considerably less than 100percent. At the time the taxpayer must decide whetherto do the Bartell-like transaction, the expected cost ofpaying the tax will always be less than the cost of payingthe tax and should be less than the cost of paying thetax and transaction costs to structure the transaction.While taxpayers cannot take the likelihood of audit andthe matter being raised on audit into account in deter-mining whether a substantial-understatement penaltywill be imposed,0 the law does not prohibit them fromconsidering those factors when determining the expectedcost of a reporting position."The IRS does not have a legal basis to impose a penaltyon a Bartell-like transaction because substantial authoritysupports the application of Code Sec. 1031 nonrecog-nition to such transactions. The substantial-authoritytest consists of the weight-of-authority method and thewell-reasoned method.12 The weight-of-authority methodrequires comparing weight of authority that supports areporting position to the weight of contrary authority. ForBartell-like transactions, the weight of authority support-ing the application of Code Sec. 1031 is the Tax Court'sBartell decision. That decision is directly on point, so itis strong authority. The negative authority is the AOD.1It is also directly on point, but it is not legal precedent,and the arguments in the AOD were rejected by the TaxCourt in Bartell, so the AOD is not as strong as the TaxCourt decision.14In the absence of certain types of authority, a taxpayermay argue a well-reasoned construction of the statutecan provide substantial authority.1 5 This well-reasonedmethod favors the taxpayer's position at least as much asit favors the IRS's position in the AOD. The Tax Courtrelied upon case law that elevates form over substance inCode Sec. 1031 exchanges to hold in favor of the taxpayer.In the AOD, the IRS makes references to its safe harborsin regulations and a revenue procedure, treating thosesafe harbors as substantive law that overrules earlier caselaw. That is poor legal reasoning and should be rejected.IRS safe harbors are, by definition, expansive in favor oftaxpayers. They indicate the types of transactions thattaxpayers may engage in without IRS challenge. Safeharbors provide no guidance beyond their prescribedscopes. Arguing by negative inference that actions outsidea safe harbor violate law or that a safe harbor can overridelegal authority that governs activities that extend beyondthe scope a safe harbor is an inappropriate application ofthe safe harbor.Taxpayers doing Bartell-like transactions can alsoshow that the acquisition of the replacement propertyand disposition of the relinquished property are partof an integrated transaction. That showing would helptaxpayers overcome prior negative authority and wouldcomply with an IRS private ruling requiring grantingexchange treatment to an integrated acquisition anddisposition of property." Even if the taxpayer is treatedas the owner of the property for tax purposes, one couldmake a compelling argument that the integrated acquisi-tion of replacement property and transfer of relinquishedproperty should be treated as an exchange.1 7 It is theintegrated-transaction argument that might weigh moststrongly against those who believed that a benefits andburdens test should apply to the ownership question.1Under the integrated-transaction theory, the transactioncould qualify as a Code Sec. 1031 exchange, even if theexchanger is the tax owner of the property. The Bartellcourt might have adopted the integrated-transactionapproach explicitly, if the transaction had evidence ofintegration in the absence of a facilitator taking title tothe property. Thus, the well-reasoned argument supportsthe taxpayer's nonrecognition position.Both the weight-of-authority and well-reasonedmethods favor taxpayers doing Bartell-like transactions.Based upon those methods, the position that CodeSec. 1031 applies to Bartell-like transactions would, ata minimum, more likely than not, be upheld. Becausethat level of authority exceeds the substantial-authoritythreshold,9 substantial authority supports applyingCode Sec. 1031 nonrecognition to Bartell-like transac-tions. Thus, neither the IRS nor courts can impose asubstantial-understatement penalty on taxpayers whotreat Bartell-like transactions as qualifying for Code Sec.1031 nonrecognition. That being the case, a Bartell-liketransaction will often cost less than paying tax that aBartell-like structure would defer.Continued on page 5620 JOURNAL OF PASSTHROUGH ENTITIES JANUARY-FEBRUARY 2018

Effect of IRS Nonacquiesence on Tax Planning and Reporting

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Effect of IRS Nonacquiesence on Tax Planning and Reporting

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