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Eight Circuit Rejects Like-Kind-Exchange Structured to Avoid Related Party Restrictions.

(Parker Tax Publishing March 16, 2015)

The Eighth Circuit found that a construction equipment seller entered into like-kind-exchanges involving unnecessary intermediaries to avoid related party restrictions. The court upheld a district court determination disallowing nonrecognition treatment. North Central Rental & Leasing, LLC v. U.S., 2015 PTC 67 (8th Cir. 2015)

Background

Butler Machinery Company ("Butler Machinery") sells agricultural, mining, and construction equipment for manufacturers, primarily Caterpillar, Inc. ("Caterpillar"). In 2002, Butler Machinery formed subsidiary North Central Rental & Leasing, LLC ("North Central") to take over rental and leasing operations. Although considered separate entities, Butler Machinery and North Central are closely related and are ultimately controlled by Daniel Butler and his family.

Less than two months after formation, North Central instituted a like-kind-exchange (LKE) program. Under that program, North Central sold its used equipment to third parties, and the third parties paid the sales proceeds to a qualified intermediary, Accruit, LLC ("Accruit"). Accruit forwarded the sales proceeds to Butler Machinery, and the proceeds went into Butler Machinery's main bank account. At about the same time, Butler Machinery purchased new Caterpillar equipment for North Central and then transferred the equipment to North Central via Accruit. Butler Machinery charged North Central the same amount that it paid for the equipment. The LKE program allowed North Central to trade used equipment for new equipment and, in the process, defer tax recognition of any gains or losses from the transactions.

Butler Machinery's use of LKE transactions facilitated favorable financing terms under which Butler Machinery was given up to six months from the date of the invoice to pay Caterpillar for North Central's new equipment, essentially giving Butler Machinery an interest-free loan for up to six months.

From 2004 to 2007 North Central claimed nonrecognition treatment of gains from 398 LKE transactions pursuant to Code Sec. 1031. These transactions frequently resulted in significant sales proceeds which would be placed in Butler Machinery's accounts, giving it unfettered access to the funds until the payments to Caterpillar became due.

The IRS determined that North Central structured the transactions to avoid the related-party exchange restrictions under Code Sec. 1031(f), and disallowed nonrecognition treatment. In response, North Central brought suit in the District Court of North Dakota, alleging the LKE transactions were entitled to nonrecognition treatment. After the district court sided with the IRS, North Central appealed to the Eighth Circuit Court.

Analysis

Under Code Sec. 1031(a), no gain or loss is recognized on the exchange of property held for the productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment ("like-kind exchange"). However, Code Sec. 1031(f) generally prohibits this nonrecognition treatment where a taxpayer exchanges like-kind property with a related person, and either party disposes of the exchanged property within two years of the exchange. In addition, Code Sec. 1031(f)(4) broadly prohibits nonrecognition treatment for any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of Code Sec. 1031(f).

The Eighth Circuit drew attention to the comparative complexity of the transactions, noting that prior cases in both the Eleventh Circuit and the Ninth Circuit had determined that LKEs were structured to avoid the purposes of Code Sec. 1031(f) in part because of their unnecessary complexity and unnecessary parties involved in the transaction. Each of the transactions involved an intricate interplay between at least five parties: North Central, Accruit, Butler Machinery, Caterpillar, and the third party who bought North Central's used equipment. Although North Central, Caterpillar, and the third-party customer were indisputably necessary for the sales and purchase transactions to occur, the court believed Butler Machinery and Accruit were not.

The court questioned why Butler Machinery was involved in the transactions at all as North Central had acknowledged that Butler Machinery functioned as a passthrough for both the cash and the property. North Central proffered several alternative reasons for Butler Machinery's involvement, including that it made the transactions administratively easier and more efficient.

However, the court dismissed those arguments, noting that North Central could have placed the orders with Caterpillar directly; injecting Butler Machinery into the transactions added unnecessary inefficiencies and complexities, including additional transfers of payment and property. Instead, the court believed the more plausible explanation for Butler Machinery's involvement was that it financially benefitted from what amounted to six-month, interest-free loans under the financing terms.

The court found Butler Machinery was not necessary to the transactions yet possessed significant, unearmarked cash proceeds as a result of the transactions.

The court found that Accruit was also an unnecessary party as Butler Machinery and North Central could have exchanged property directly with each other. This unnecessary layer of complexity supported finding that the exchanges were structured to sidestep Code Sec. 1031(f), because if Butler Machinery and North Central exchanged the property directly with each other, they, as related parties, would have to hold the exchanged-for property for two years before the exchanges could qualify for nonrecognition treatment.

Because North Central could have achieved the same property dispositions via a much simpler method, the Circuit Court believed the transactions took their peculiar structure for no purpose other than to avoid Code Sec. 1031(f) and upheld the district court's determination, denying like- kind-exchange treatment for the transactions.

For a discussion of like-kind-exchanges, see Parker Tax ¶113,100. (Staff Editor Parker Tax Publishing)

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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