Transactions Strutured to Avoid Related Party LKE Rules, Gain Must Be Recognized

The Eighth Circuit rejected a taxpayer’s attempt to structure an equipment like kind exchange (LKE) program to effectively allow a related taxpayer the use of the sales proceeds in the case of North Central Rental & Leasing, LLC v. United States, CA8, 115 AFTR 2d ¶ 2015-494.

The taxpayer originally ran an equipment sales and leasing business (Butler Machinery & Equipment), primarily dealing with Caterpillar, Inc. equipment.  Eventually the taxpayer split the equipment rental and leasing business off into a subsidiary called North Central Rental & Leasing, LLC.  Less than two months after the leasing business was moved into North Central the taxpayer began its LKE program.

The LKE program worked as follows:

Per the LKE 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 Butler Machinery paid for the equipment.

However, there was another set of transactions taking place between Butler Machinery and Caterpillar that was where the taxpayer believed the “magic” took place giving Butler the use of the proceeds for an extended period.

As the Court described the issue:

Butler Machinery's use of LKE transactions in this fashion facilitated favorable financing terms from Caterpillar (referred to as "DRIS" financing terms). Caterpillar advised Butler Machinery before it established either North Central or the LKE program that such a transaction structure would enable Butler Machinery "to take full advantage of [Caterpillar's] DRIS payment terms." The DRIS payment terms, among other things, gave Butler Machinery up to six months from the date of the invoice to pay Caterpillar for North Central's new equipment. During that time, Butler Machinery could use the sales proceeds it received from Accruit for essentially whatever business purposes it wanted, such as paying bills or payroll. In other words, Butler Machinery essentially received an up-to-six-month, interest-free loan from each exchange.

The IRS attacked this arrangement by arguing it was a transaction structured to avoid the related party like-kind exchange provisions of IRC §1031(f), in violation of IRC §1031(f)(4).

That provision provides:

Section 1031(f)(1) generally prohibits nonrecognition treatment for exchanges in which a taxpayer exchanges like-kind property with a "related person," and either party then disposes of the exchanged property within two years of the exchange. Moreover, in an attempt to thwart the future use of more complex transactions that technically avoid the provisions of § 1031(f) but nevertheless run afoul of the purposes of the law, Congress also enacted § 1031(f)(4)—which broadly prohibits nonrecognition treatment for "any exchange which is part of a transaction (or a series of transactions) structured to avoid the purposes of" § 1031(f).

The trial court had ruled in favor of the IRS, finding the structure was one designed to avoid §1031(f) and, as the asset was clearly disposed of during the transaction, a gain on disposal would need to be recognized by North Central.  The taxpayer appealed this ruling to the Court of Appeals.

Unfortunately for the taxpayer, they found no sympathy here either.  The Court noted that the transaction was unnecessarily complex, introducing players whose only reason for being part of the transaction was to avoid §1031(f)(4) related party status or to be able to gain the benefit of using the funds in question, the sort of thing that is not supposed to be possible in a transaction under §1031.

As the Court explained:

As North Central acknowledges in its briefing, Butler Machinery functioned "as a passthrough of both the cash and the property." This begs the question of why Butler Machinery was involved at all in the transactions. Elsewhere in its briefing North Central proffers several alternative reasons for Butler Machinery's involvement, including that it made the transactions administratively easier and more efficient. None of these arguments, however, convince us that the district court clearly erred in reaching a different conclusion. After all, North Central already had its own dealer code, and it could have placed the exact same equipment orders directly to Caterpillar. Injecting Butler Machinery into the transactions added unnecessary inefficiencies and complexities to the transactions, including, among other things, additional transfers of payment and property.

An equally (if not more) plausible explanation for Butler Machinery's involvement is that Butler Machinery financially benefitted from what amounted to six-month, interest-free loans under the DRIS financing terms. See Ocmulgee Fields, 613 F.3d at 1369 (analyzing "the actual consequences" of the transactions to ascertain the taxpayer's intent); Teruya Bros., 580 F.3d at 1045 ("[T]he taxpayer and the related party should be treated as an economic unit in this inquiry."). As discussed above, the DRIS financing gave Butler Machinery up to six months to pay its invoices to Caterpillar. In the meantime, the sales proceeds from the relinquished equipment were deposited into Butler Machinery's "main bank account," and Butler Machinery was able to use the proceeds as it pleased. The value of Butler Machinery's interest-free access to such money should not be underestimated.

The Court cited cases from both the Ninth and Eleventh Circuits that provided one of the key tests for determining if a transaction was structured to avoid the provisions of IRC §1031(f) is if:

  • Otherwise unnecessary parties are part of the transaction and
  • A related party ends up with the cash proceeds

(Ocmulgee Fields, Inc. v. C.I.R., 613 F.3d 1360 (11th Circuit 2010) and Teruya Bros. v. C.I.R., 580 F.3d 1038 (9th Cir. 2009)).

As the appellate opinion concluded:

In short, because North Central “could have achieved the same property dispositions” via a much “simpler means,” it appears “these transactions took their peculiar structure for no purpose except to avoid § 1031(f).” Teruya Bros., 580 F.3d at 1046.

It is interesting to note that the opinion suggests the manufacturer apparently was the party that advised the taxpayer that they should establish this sort of structure, presumably to gain the tax advantages of the LKE structure (thus gaining "full advantage" of the financing program). 

Advisers can be put into a tough position in such cases to “push back” against a deal that sounds too good to be true—the client will claim that they are being told by an apparently authoritative entity that “this works” and “everybody is doing it” and won’t often take well to an advisers’ alternative view that the structure simply runs afoul of various provisions of the tax law.

Nevertheless, advisers have a responsibility to independently review any such assertions regardless of their source.  CPAs in particular are subject to Ethics ¶1.130.020 in the AICPA’s Code of Professional Conduct that prohibits CPAs from subordinating their professional judgment to that of a third party.  “Going along” with a transaction simply because the client’s supplier says they have research that backs up a position isn’t good enough—the CPA has a responsibility to the client to review the position and determine if he/she agrees with the conclusions reached.

Obviously the advisers in this case may have done so, concluding that there was, in their view, sufficient support for this position (that’s not an issue discussed in this opinion).  Merely not prevailing in court isn’t necessarily proof of subpar work—tax work involves a lot of “grey” areas.  As long as the client understands when a position is not one that is a slam dunk but rather involves positions that may or may not survive a court challenge the CPA is fine to advance an aggressive position (though it’s very important the client understand this is a grey area).

But the temptation is there to quietly go along with the third party and not raise questions, especially as the adviser grows concerned the client might shop for a “less thorough” adviser and take its business elsewhere.  CPAs must fight succumbing to that temptation to be truly valuable to their clients—and to comply with the requirements of professional standards.