Originally published on Forbes.com.
A sketchy 1031 exchange getting slammed is not that big a deal. A deficiency north of $400 million and an $87 million penalty – That’s a big deal. And then there is the penalty being assessed even though both PwC and Deloitte were involved in structuring the deal. PwC designed it and Deloitte did the key appraisals. That’s the biggest 2 of the Big 4. That’s what made the 2016 Tax Court decision in the case of Exelon Corporation irresistible when I wrote about it. Also, I think the logic of the decision threatens a 1031 mini-industry, but as far as I can tell nobody else has picked up on that thought. This week’s news is that the Seventh Circuit has upheld the Tax Court decision. Lew Taishoff broke the story with 1031? Not Hardly, but he graciously gives me credit for alerting him to the decision. Mr. Taishoff’s summary might be all that you need.
The Transactions
In 1999, Unicom, a predecessor to energy company, Exelon, decided to sell its fossil fuel plants and use the money to upgrade its nuclear plants. It sold the fossil-fuel plants for $4.8 billion, which was more than $2 billion more than it had anticipated. (The appellate decision consigns the entity complications that you find in the Tax Court decision to a footnote – (“As did the parties, we refer to Exelon, its predecessors and subsidiaries collectively as “Exelon.””) Seems to me you make 2 billion extra, you have a little party and feel good when you pay the extra taxes. That’s how I felt when I had my biggest year. But a public company has a duty to its shareholders, I guess, so the siren song of PwC must have seemed irresistible.
Why not set up a like-kind exchange for a couple of power plants that you don’t actually need or want? You pay some money to not-for-profit power plant operators (and your clever advisors) and you will end up with more cash after-tax than you otherwise would have had. They were dealing with billions of dollars and power plants so there were complications. A lot of the argument for the legitimacy of the transaction, which you can listen to here turned on how likely it was that Exelon would take over and start operating the plants in thirty years.
Could This Work For You?
Nonetheless, if you ever sell real estate for north of a couple of million, you are likely to hear about a similar option that is pretty well prepackaged for you. It will be a retail outlet (drugstores are pretty common) that is subject to a very long lease with lots of renewals. The replacement cost of the property is a fraction of the present value of the lease stream, so what you are essentially exchanging for is a CVS or Walgreen’s bond with some downside protection. If the IRS ever decided to go after these deal, CVS, itself, has already made the IRS argument in a local property tax case, in which CVS prevailed.
CVS believed that the use of the subject property’s contractual rent in the income approach was not appropriate. Indeed, through its expert witnesses, CVS stated that it typically uses sale-leaseback transactions as financing tools; consequently, the lease payments it makes to its lessors pursuant to its leases do not reflect merely the value of the real estate, but rather the broader business value of CVS itself.
To demonstrate this point, CVS presented evidence showing that twenty-four vacant CVS, Walgreens, RiteAid, and Eckerd Drug stores (nine in Indiana and fifteen throughout the country) were in the process of being marketed to “second-generation tenants” for rent at approximately $10.00 per square foot. Thus, explained CVS, the $10.00 per square foot figure represented the actual value of the subject property’s real estate. In turn, CVS explained that the “spread” between that figure and the subject property’s contractual rent of $27.20 per square foot represented the investor’s expected return on its investment in CVS.
The Exelon case is more extreme in that they were not relying on the creditworthiness of the tenant utilities but rather had pretty much had all the money in escrow.
To reach this conclusion, the court first analyzed the parties’ rights and obligations during the sublease term for each transaction. In doing so, it concluded that Exelon “did not face any significant risks indicative of genuine ownership” during that period. In particular, the court found that the transactions’ “circular flow of money” precluded Exelon from having any real investment in the plants, despite using its own funds (as opposed to borrowed funds in a traditional SILO) to finance the headlease payments. In addition, the court found that each sublease allocated all costs and risks associated with the plants to the sublessees, and that each transaction’s defeasance structure left Exelon able to “fully recover its investment” in the unlikely event of either a lessee bankruptcy or an early termination of the sublease.
Next, the court reviewed the parties’ options at the end of the sublease terms and found that there was a “reasonable likelihood” that the lessees would each exercise its purchase option, meaning Exelon’s profit was fixed at the onset of each transaction, and thus Exelon did not acquire any benefits or burdens of ownership. The court rejected Exelon’s reliance on the properties’ residual values to establish genuine ownership. In particular, the court, agreeing with the government’s expert, found that Deloitte’s appraisals of the future fair market value of the plants at the end of the sublease terms were too low. As a result, it rejected Exelon’s argument that the sublessees were not “economically compelled” to exercise the purchase option.
The drug store deals are a lot riskier, so there is that.
The Penalty
The penalty is interesting, because Exelon really had top notch advice in crafting the transaction – Winston & Strawn, PwC and Deloitte.
PwC estimated that the tax deferral allowed under § 1031 would provide an after-tax yield of 20%. PwC explained to Exelon that the transactions would be similar to maintaining a typical debt private placement, and that the fundamental risks for Exelon would be the credit of the lessee and the federal tax risk that the IRS would not respect the form of the transaction. PwC explained that the credit risk would be addressed through the transactions’ “defeasance strategy,” and the tax risk would be mitigated by obtaining an appraisal and other expert opinions to support the conclusion that the fixed purchase option was not “practically compelled.” Prior to making its pitch to Exelon, PwC had assisted other clients to implement SILO transactions, including as part of its “Like-Kind Exchange Program.”
Part of the problem was a little odd. Teamwork is usually thought to be a good thing, but not in this sort of a situation.
The tax court also rejected Deloitte’s appraisals because it found that Winston had interfered with the integrity and independence of the appraisal process by providing Deloitte with the wording of the conclusions it expected to see in the final appraisal reports. As did the tax court, we reject Exelon’s argument that Winston was merely providing the existing guidance and tests on the issue of what is considered to be a lease. Winston’s December 29, 1999, letter to Deloitte contained a detailed list of specific conclusions that Winston needed in order to issue the necessary tax opinion. Deloitte’s conclusions mirrored those in Winston’s letter almost word for word. The evidence certainly supports the tax court’s decision to reject Deloitte’s appraisals.
That effort to keep the story straight was the weak point in the penalty defense, since there was evidence that Exelon knew what was going on.
Exelon continues to argue that the Deloitte appraisals were not tainted by Winston’s input. More importantly, it argues that even if the appraisals were tainted, Exelon had no way of knowing that and cannot be penalized for its reliance on Winston’s opinions. The record is replete, however, with evidence that Exelon knew full well that Winston was supplying Deloitte with the necessary conclusions. Both Walter Hahn and Robert Hanley of Exelon were copied on the emails sent by Winston first to Stone and Webster and then to Deloitte. Indeed, it was Hahn who concluded that most of the requested conclusions were items for Deloitte, and sent the list of Winston’s necessary appraisal conclusions to Deloitte multiple times.
There is a lesson there for tax planners. Despite its efficiency, e-mail, with multiple copies might not always be the optimal way to communicate, particularly when you are trying to get your story straight. The zeal of the lawyers to have the appraisal language “just so” (because God knows CPAs can’t write) contributed to the client going out of pocket an extra $87 million (plus interest).
Other Coverage
My new policy on “other coverage” is not to provide links to stuff that is behind a paywall of any sort, so I am leaving out a couple. As noted above Lew Taishoff pretty much broke the story for the thrifty crowd. Crain’s Chicago Business had Appeals Court affirms ruling that Exelon dodged taxes to tune of $1 billion. “Dodged taxes” that sounds pretty harsh.
The decision may finally close the books on an aggressive maneuver the company used to dramatically lower its tax bill on a highly lucrative coal-plant sale nearly two decades ago.
Jack Townsend at Federal Tax Crimes had a pretty passionate piece on the decision. I feel obligated to bowdlerize it. The blanks refer to a byproduct of livestock management that is used as fertilizer – Another ———Tax Shelter Rejected With Slight Penalty. His summary is worth quoting in full:
1. That tax shelter, that’s ————–! That reasonable cause, that’s ————.
2. The taxpayer, as in many and most ———– tax shelters, hoped to create indecipherable smog by complex documents that, in the final analysis when deciphered, meant that the taxpayer did not enter the type of transaction for which Congress intended the benefits claimed. Lawyers get a lot of money by trying the hide the true economic effect of transactions in unnecessary complexity. And, taxpayers are willing to hire them to do so because those taxpayers, not themselves unsophisticated, think they are buying (i) indecipherable fog or (ii) at least insurance from penalties. But, when the IRS deploys the resources to get to the real deal rather than the paper deal, nothing of tax substance is found. The taxpayer thus just lost the audit lottery as to the tax and the penalty.
3. I am still amazed that these complex transactions which, known to all involved, are nothings from which large tax benefits are claimed do not attract criminal investigation and prosecution. But, our country’s politicians and thus its administrators are in thrall of large taxpayers and their major law and accounting firms who feel themselves entitled to play games with their tax obligations. Only by increasing the costs of such games beyond a potential 20% accuracy related penalty if caught will corporate behavior change, particularly in an era of declining IRS resources. In this environment where the likelihood of getting caught is decreasing, the penalties ought to increase for those who are caught.
Stop holding back, Jack. Tell us how you really feel.