Eighth Circuit Denies Like-Kind Exchange Treatment to Taxpayer Attempting to Avoid Related Party Rules of Section 1031(f)

In North Central Rental & Leasing, LLC,[1] the Eighth Circuit Court of Appeals determined that the taxpayer, North Central Rental & Leasing, LLC (“North Central”) had improperly claimed non-recognition treatment under Section 1031 with respect to gains from certain property exchanges.

Butler Machinery Company (“Butler Machinery”) sold agricultural, mining and construction equipment for manufacturers, primarily Caterpillar, Inc. (“Caterpillar”).  Prior to 2002, Butler Machinery conducted a rental and leasing business in conjunction with its retail sale business, but in 2002 formed a subsidiary, North Central, to conduct the rental and leasing operations.

Butler Machinery and North Central are closely related and ultimately controlled by the same family.  Daniel Butler and certain of his family members own 100% of Butler Machinery, which in turn owns a 99% interest in North Central, with Daniel Butler owning the remaining 1% of the stock of North Central.  Additionally, Butler Machinery shared building space with North Central, and provided accounting and equipment-ordering functions for North Central and initially paid the wages of North Central’s employees.  Both North Central and Butler Machinery were assigned separate dealer codes by Caterpillar, which enabled each entity to independently purchase its own equipment from Caterpillar.  However, Butler Machinery used its own dealer code to order equipment for both itself and North Central.

Less than two months after Butler Machinery formed North Central, North Central initiated a like-kind exchange program enabling North Central to trade used equipment for new equipment.  Under the like-kind exchange program, North Central sold its equipment to third parties, and the third parties then paid the sales proceeds to a qualified intermediary, Accruit, LLC (“Accruit”).  Accruit would forward the sales proceeds to Butler Machinery, which were deposited by Butler Machinery into its main bank account.  Butler Machinery would then purchase new Caterpillar equipment for North Central and transfer the equipment to North Central via Accruit.

By structuring the like-kind exchange transactions in this manner, Butler Machinery was able to take advantage of favorable financing terms from Caterpillar.  Specifically, Caterpillar advised Butler Machinery before it ever established North Central or the like-kind exchange program that such a transaction structure would enable Butler Machinery to take full advantage of Caterpillar’s “DRIS” payment program.  Among other things, the DRIS payment program gave Butler Machinery up to six months from the date of the invoice to pay Caterpillar for the equipment purchased by Butler Machinery for North Central.  During that six-month time period, Butler Machinery could use the sales proceeds it received from Accruit for essentially whatever purpose it wanted.

In the case, the parties stipulated to focus on a transaction representative of the 398 like-kind transactions at issue in the case.  In the representative transaction, North Central exchanged Truck 1 (the “Relinquished Property”) for Truck 2, Skid Steer 1, and Skid Steer 2 (the “Replacement Property”).  North Central agreed on or before 6/30/2004, to sell the Relinquished Property to a third party for $756,500.  North Central’s adjusted tax basis in the Relinquished Property was $129,372.70.  The third party paid Accruit the $756,500 in sales proceeds and North Central transferred to the third party legal ownership of the Relinquished Property.  On or about 8/13/2004, Butler Machinery identified and purchased the Replacement Property from Caterpillar.  Butler Machinery’s total acquisition price for the new property was $761,065.60.  Butler Machinery then transferred legal ownership of the Replacement Property to North Central through Accruit on 8/27/2004.  On 9/10/2004, Accruit transferred the $756,500 in proceeds from the sale of the Relinquished Property to Butler Machinery.  North Central and Butler Machinery then entered into an “adjustment” note between the two companies to compensate Butler Machinery for the $4,565.60 difference between the $756,500 in sales proceeds and the $761,065.60 that Butler Machinery paid for the Replacement Property.

Consequently, following the transaction: (1) a third party owned the Relinquished Property; (2) North Central owned and held the Replacement Property and an adjusted note reflecting the new $4,565.60 debt to Butler Machinery; and (3) Butler Machinery had the $756,500 of sales proceeds from the Relinquished Property in its bank account and an adjusted note reflecting the $4,565.60 due from North Central.  In this manner, North Central deferred recognizing the $627,127.30 gain it realized from the transaction ($756,500 sales proceeds less $129,372.70 adjusted tax basis) pursuant to Section 1031.  Additionally, Butler Machinery, under Caterpillar’s DRIS financing program, essentially had unfettered use of the sales proceeds from the Relinquished Property for nearly six months before it was obligated to pay Caterpillar for the Replacement Property.

The IRS concluded that North Central structured the transactions in order to avoid the related-party exchange restrictions provided under Section 1031(f) pursuant to the provisions of 1031(f)(4).  The District Court found that the transactions were not entitled to non-recognition treatment and were “structured to avoid the purposes of § 1031(f).”

Under Section 1031(a)(1), taxpayers can defer recognizing gains when they exchange property held for 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.  The like-kind exchange provision distinguishes a taxpayer who conducts a like-kind exchange from a taxpayer who liquidates or “cashes in” on his or her original investment.  In a like-kind exchange, the taxpayer essentially continues his or her original investment via the replacement property.

In order to avoid abuses of Section 1031, in 1989 Congress enacted Section 1031(f).[2]  Section 1031(f)(1) generally prohibits non-recognition treatment for exchanges in which a taxpayer exchanges like-kind property with a “related person” and either party then disposes of the relinquished property or the replacement property within two years of the original exchange.  Furthermore, Congress also enacted Section 1031(f)(4), which broadly prohibits non-recognition treatment for “any exchange which is a part of a transaction (or a series of transactions) structured to avoid the purposes of Section 1031(f).”

In analyzing the transaction, the Eighth Circuit Court of Appeals began by stating that although North Central, Caterpillar and the third party customer were necessary for the sales and purchase transactions to occur, neither Butler Machinery nor Accruit were necessary.  Because North Central already had its own dealer code, it could have placed the exact same equipment orders directly with Caterpillar that Butler Machinery placed with Caterpillar.  The court found that injecting Butler Machinery into the transactions added unnecessary inefficiencies and complexities to the transactions, including among other things, additional transfers of payment and property.  The court found the reason for Butler Machinery’s involvement was that Butler Machinery financially benefitted from what amounted to six-month, interest-free loans under Caterpillar’s DRIS financing program.  The President and CEO of Accruit testified at trial that Accruit would have paid the sales proceeds from the Relinquished Property directly to Caterpillar if the new equipment were not purchased by Butler Machinery.  Consequently, if Butler Machinery was not involved in these transactions, neither Butler Machinery nor North Central would have received the de facto interest-free loan and would not have had unfettered use of the sales proceeds from the Relinquished Property for the six-month period.  Citing decisions by both the Eleventh Circuit[3] and the Ninth Circuit,[4] the court found that a transaction can be treated as structured to avoid the purposes of Section 1031(f) when unnecessary parties participated in the transactions and when a related party ends up receiving cash proceeds (as did Butler Machinery).[5]

As additional support for its decision, the court also found that Accruit was an unnecessary party to the like-kind exchange transactions.  The court provided that Butler Machinery and North Central could have exchanged property directly with each other without Accruit’s involvement.  Again, citing Ocmulgee Fields and Teruya, the court found that a transaction can be treated as structured so as to avoid the purposes of Section 1031(f) if, at least in part, the parties could have completed the transactions without the involvement of a qualified intermediary.  The Court directly noted that if Butler Machinery and North Central were to exchange the property directly with each other, they, as related parties, would have had to hold both the Relinquished Property and the Replacement Property for two years before the exchanges could have qualified for non-recognition treatment.

Based on the foregoing, the court concluded that the transaction had indeed been structured for the purposes of avoiding the related party rules of Section 1031(f), and as such, the taxpayer was not entitled to non-recognition treatment under Section 1031(a) with respect to the 398 exchanges at issue.

 [1] _______ F.3d ______ (CA-8, 2015)

[2] See Omnibus Budget Reconciliation Act of 1989, Pub. L. No. 101-239, §7601, 103 Stat. 2106 (1989).

[3] Ocmulgee Fields, Inc., 613 F.3d 1360 (CA-11, 2010).

[4] Teruya Bros., 580 F.3d 1038 (CA-9, 2009).

[5] Although the taxpayer argued that its case was distinguishable from the Ocmulgee Fields and Teruya Bros. cases because Butler Machinery did not have indefinite access to the sales proceeds from each transaction, the court stated that this did not change its analysis as it could not ignore the significant and continuous financial benefits Butler Machinery derived from the hundreds of de facto interest-free loans.  The court observed that as noted by Starker, 602 F.2d 1341 (CA-9, 1979), “if … taxpayers sell their property for cash and reinvest that cash in like-kind property, they cannot enjoy [Section 1031’s] benefits, even if the reinvestment takes place just a few days after the sale.”  See also, Coleman, 180 F.2d 758 (CA-8, 1950).

About the Author:

Stephen R. Looney is the chair of the Tax department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is a member of the Board of Trustees of the Southern Federal Tax Institute, as well as former Chair of the S Corporations Committee of the American Bar Association’s Tax Section. He is Board Certified in Tax Law by the Florida Bar, as well as being a Certified Public Accountant (CPA).  He may be reached at slooney@www.deanmead.com.