Lease of Aircraft at Loss to Related Entity Did Not Disqualify Section 1031 Exchange Treatment on Exchange

An aircraft is held in a partnership and then leases that aircraft to a related entity for both business use and for personal use of two key officers.  Those key officers are also the owners of the partnership and hold interests in the related entity.  The entity to which the aircraft is leased includes, as required under the IRC, the appropriate portion of any personal use of the aircraft in the compensation of the key officers. 

When the partnership traded in one aircraft and acquired another, the question arose regarding whether the exchange qualified for treatment under the like kind exchange rules of IRC §1031.  Specifically, Chief Counsel Advice 201601011 looked at whether the aircraft in this situation were held for productive use in a trade or business in order to qualify for treatment under IRC §1031.

The agents who examined the transaction argued that the aircraft failed that test.  The agents looked at IRC §183 (the “hobby loss” provision) based on how the leases were structured.  As the advice described the terms:

In Year 1, P exchanged the relinquished aircraft for the replacement aircraft.  Both the relinquished and replacement aircraft were leased under a so-called “dry” lease, under which the lessee provides flight crew and other services pertaining to the aircraft.  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 memorandum summarized the agents’ position as follows:

The field’s position is that P did not hold either the relinquished or replacement aircraft for productive use in a trade or business.  Because the term “held for productive use in a trade or business” is not defined in the Code or Regulations, the field relies on § 183 and accompanying cases and regulations to determine whether P held the aircraft for productive use in a trade or business. See, e.g., Treas. Reg. §§ 1.183-2(b) and 1.1831(d)(1); Campbell v. Commissioner, 868 F. 2d 833 (6th Cir. 1989), aff’g. in part and rev’g. in part T.C. Memo 1986-569.  In addition, the field contends that, in making the evaluation under § 183, entities should be examined solely on an entity by entity basis, and the profit motive of one entity should not be attributed to another entity, even if the two entities are closely related. See, e.g., United States v. Basye, 410 U.S. 441 (1973); Moline Properties v. Commissioner, 319 U.S. 436 (1943); Polakof v. Commissioner, 820 F. 2d 321 (9th Cir. 1987), cert. denied, 484 U.S. 1025 (1988).  Using the standards under § 183, the field concludes that P did not hold the aircraft for productive use in a trade or business.

However the National Office disagreed with this view.  The memo notes that “[f]or both business and legal reasons, the aircraft are owned by P, in an entity separate from the main business entity, O, and leased to O.”

The memo takes the position that IRC §183’s rules are not appropriate to apply against the partnership standing alone.  The memo notes:

The facts indicate that the rent P charges O for use of the relinquished property and the replacement property is insufficient for P to make an economic profit on the aircraft rental to O.  However, many businesses hold and use properties in a way that, if the use of the property were viewed as an activity, do not and could not generate profit.  Nevertheless, the property itself is held for productive use in that business.  Thus, P’s lack of intent to make an economic profit on the aircraft rental does not establish that the aircraft fails the productive use in a trade or business standard of § 1031.  In addition, we agree with the field that A’s and B’s use of the property for personal purposes is not relevant in determining whether P holds the aircraft for productive use in a trade or business.

The memo goes on to explain that the existence of significant non-tax reasons for having the aircraft in a separate entity is an important issue in this case.  As the memo notes:

Moreover, it is important to point out that businesses, for any number of reasons, opt to hold property, especially aircraft, in a separate entity.  In the present case, O, which operates a legitimate business enterprise, requires 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 are owned not by O but by P, a related entity.  If O owned the aircraft, or was the 100 percent owner of P, we doubt that the field would have raised the issue of whether the aircraft were held for productive use in a trade or business.  Were we to disallow § 1031 treatment based on the entity structure presented here, businesses would be forced to structure their transactions in inefficient and potentially risky ways to achieve § 1031 treatment.   Thus the entity structure in the present case should not be used as grounds that the aircraft fails to qualify as property held for productive use in a trade or business. [Emphasis added]

However the National Office memo did point the examining agents to the fact that the below market rent issue might create other issues in this case, noting:

We are sensitive to two facts raised by the field: P charges below-market rent for the replacement aircraft and A and B, rather than O, own P.  While these facts do not disqualify the property from being held for productive use in a trade or business for purposes of § 1031, it may be that other tax provisions such as § 280F or 482 may apply to disallow tax benefits or impose a tax treatment different from the treatment claimed by P, O or A and B.

The sections cited by the memo would be a potential limitation where property is used for non-business purposes under IRC §280F and the issue of the proper allocation of income and deductions between related taxpayer under IRC §482.  So while the exchange may not be at risk, the taxpayers may find other issues will be raised in the exam due to this structure