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Originally published on Forbes.com.

The IRS chalked up a big win in Tax Court against energy company Exelon. Exelon had already provided for interest and state income tax adjustments and had not recognized $539 million in tax benefits from the disputed transaction.  Exelon had expected to prevail on penalties, though.  No such luck. Oops there goes another $87 million. Exelon has a market capitalization of $31.6 billion, so they can probably handle it.  I am concerned though that this decision could have implications for more ordinary taxpayers who use triple net drugstore deals to shelter gains, but we will save that for the end.

Like-kind Exchange

The issue was the validity of a like-kind exchanges (1031) in 1999 when Unicom (of which Exelon is a successor due to merger) sold its fossil fuel plants to Edison Mission for $4.8 billion.  The main thing was gain deferral from 1031, but there is also continuing depreciation, the rent leveling rules, deduction for transaction costs, and, be still my beating heart, original issue discount – not to mention the penalty fight and that the decision makes 50% of the Big 4 look bad.  (PwC dreamed the thing up and Deloitte did the key appraisal).

Code Section 1031 allows for the tax deferred exchange of property of like-kind that is used in a trade or business or held for investment.  It is well known in real estate circles, because all real estate is considered like-kind to all other real estate, making real estate exchanges a virtual sub-industry, but there are many other applications, such as leased automobiles, airplanes and heavy equipment.  Power plants not so much.

You Can’t Exchange For Just Anything

There are various classes of property that are excluded from 1031 like interest in partnerships, securities or evidences of indebtedness and choses in action (whatever they are). So if what Unicom wanted was essentially some really secure bonds, it was out of luck on two grounds, but PwC had a plan.  What if Unicom could find some power plants that would behave like bonds or even better allow Unicom to use the bulk of the cash on whatever.  That was the plan.

This had to all be done pretty quickly because once the $4.8 billion was in the hands of the exchange facilitator, property had to be identified within 45 days and closed within 180 days.  There were several replacement properties, enough so that the decision is just about some of them that will stand in for the others.

Being in the power industry had an advantage in that many of the players are not for profit, making them tax indifferent.  What Unicom directed the exchange facilitator to buy were power plants owned by not for profits which were then leased back to them.  The leases were structured so that there were very strong incentives for the sellers to buy their plants back at the end of the lease.

Some Numbers

Here is how the numbers went on one of the examples used by the Court, “the Spruce transaction” with CPS, a municipal gas and electric utility of the City of San Antonio, Texas.  Unicom’s exchange facilitator paid CPS $725 million for a “head-lease” to last 65 years.  Since the plant had an estimated useful life of 52 years remaining according to Deloitte], this was effectively buying it.  There was then a “sub-lease” back to CPS for a single rental payment of $557,329,539 for 31.5 years.  At the end of the sub-lease, CPS had a cancellation option that allowed it to get clear ownership of the plant back for $733,849,606.  This was funded by a payment to AIG of $88,995,790. (You need just shy of 7% to get from here to there in 31.5 years. Thirty-year Treasuries were yielding 6.63% on January 1, 2000.)

Frankly, I’m having a little trouble tying out the numbers as they are discussed in the case.  It indicates that CPS got to keep $88 million of which it paid $12.3 million to the City of San Antonio.  There seems to be an extra $8 million floating around, but I’m not going to lose sleep about that.  The point is that Unicom gets 77% of the cash laid out for the replacement property right away.  It picks up the $557 million in rent income ratably over 31.5 years.  The portion that is unearned is deemed to be a loan from CPS which produces interest deductions.  (That’s the rent leveling rules under Code Section 467).  The carryover basis from the old power plant continues to produce depreciation deductions.

Another Way To Look At It

As the IRS saw it.  The arrangement with CPS was not a purchase and leaseback.  It was a loan to CPS. So Unicom recognized gain on the sale of its power plant and picks up interest income under the original issue discount rules.  (You can read about OID here).  That is the way the Tax Court saw it also.

The structure of the cashflows in the Spruce transaction guaranteed the return of 76.9% of petitioner’s initial investment just six months after the closing date in the form of rent prepayment under the Spruce sublease. During that period, CPS obtained credit enhancements to secure the payment of the rent. The rest of petitioner’s investment was either used to pay the accommodation fee to CPS in the form of the NPV benefit or set aside pursuant to the Spruce CPUA to secure the payments of the stipulated loss value during the period of the Spruce sublease or the payment of the purchase option price at the end of the sublease. CPS obtained credit enhancement and insurance for the CPUA from AIG, and the interest rate risk was also insured.

The other test transactions were flawed in different ways, but flawed nonetheless.

We hold that the Wansley and Scherer transactions fail the substance-over-form inquiry because petitioner did not acquire the benefits and burdens of ownership of the Scherer and Wansley stations. It was reasonably likely at the time the MEAG transactions were entered into that MEAG or its cotenants would exercise the purchase options at the end of the sublease term. Accordingly, we do not need to consider the risks and benefits to petitioner of the remaining headlease periods. We agree with respondent that the MEAG transactions most closely resemble financial arrangements.

Penalties?

But this was a deal designed by PwC backed up by Deloitte appraisals and opinions of over 300 pages by Winston & Strawn. How can there be penalties with such fantastic due diligence going on?]   That is an interesting discussion, but I have decided to just pick out the amusing bits.

There was testimony from the Unicom tax department people.

With respect to the review by Unicom’s own employees of the analysis and conclusions provided in the Winston & Strawn legal opinions, Mr. Roling testified that he did not get beyond the first seven of several hundred pages of the opinion, and Unicom’s internal tax personnel also did not review the legal analysis in the draft opinions. Mr. Berdelle, however, testified that he did read the Winston & Strawn tax opinions in their entirety.

What Number Did You Have In Mind?

Here is the problem they faced.  In order for the economics of this deal, other than tax benefits, to work there did not have to be an actual power plant involved.  After all, Unicom is getting 77% of the money back in six months and there is an insurance company guaranteeing that they will get more than 100% of the money in a little over thirty years and probably not by coincidence the timing is such that they could defer the back end money with another 1031 deal.

So with those contractual guarantees, the power plant Unicom bought from CPS could have been a fourth grade science project coil of copper wire with a magnet that lit a tiny light bulb and the economics would have worked the same.  That would have been going too far though, which is why Winston & Strawn wanted Deloitte to do an appraisal to show there was a real $700 million-plus power plant there and to project what CPS might or might not do in 30 years.

There is an old accounting joke in which the client asks prospective accountants what two plus two is. Most of them say four and are given the bum’s rush.  The fellow who gets the job strokes his chin and says “What number did you have in mind?”

It is true that Winston & Strawn provided a very favorable tax opinion on the test transactions, notwithstanding the obvious inconsistency of the return provisions and the projected plant capacity factor at the end of the respective subleases. Yet we are not persuaded that Winston & Strawn’s tax opinion can serve as a shield for petitioner under the circumstances. We believe that petitioner fully recognized that a plant with a capacity factor of 82%—the minimum rate at which the Spruce station had to be running when returned by CPS upon expiration of the sublease—would be worth significantly more than the same plant with a capacity factor of 58%—the capacity factor used in the Deloitte appraisals

It is true that Mr. Roling and other employees of petitioner besides Mr. Berdelle had only cursorily read the opinion package prepared by Winston & Strawn. This fact on its own might be sufficient to demonstrate a failure by petitioner to exercise ordinary and reasonable care in entering into the transaction and preparing the related tax returns. However, considering that petitioner (1) was a sophisticated taxpayer, (2) claims to have read the Winston & Strawn tax opinions in their entirety, (3) knew or should have known that Winston & Strawn’s tax opinions based on the Deloitte appraisal reports were flawed, (4) was apprised of the risk that the proposed transactions might be classified as corporate tax shelters and registered them as such with the IRS around the same time it entered into the test transactions, and (5) proceeded with the transactions anyway, we find that petitioner disregarded the applicable rules and regulations. At a minimum, petitioner carelessly disregarded the rules and regulations by failing to “exercise reasonable diligence to determine the correctness of a return position.” See sec. 1.6662-3(b)(2), Income Tax Regs. Moreover, petitioner’s use of Winston & Strawn’s tax opinions—flawed as the opinions were because of Winston & Strawn’s interference with the independence of the appraisal reports that undergirded them—was misguided. We cannot condone the procuring of a tax opinion as an insurance policy against penalties where the taxpayer knew or should have known that the opinion was flawedA wink-and-a-smile is no replacement for independence when it comes to professional tax opinions.

Does This Have Implications For More Ordinary Mortals?

If you cash out of rental property at what to you and me might seem like a significant gain, say a couple of million, one of the options you will be offered is a triple net deal that you can exchange into.  For some reason, I don’t understand, drug stores are big.  On the LoopNet website, for example, you can find scores of CVS buildings for sale.  At the top of the list for whatever reason is one in Billings MT.  It costs $10,469,112 which represents a capitalization rate of 5.25%.

Here’s the thing.  The building is 13,225 square feet on 1.4 acres which works out to $791.62 per square foot.  Here is some interesting information from buildingsguide.com

An average commercial steel building costs between $16 and $20 per square foot, including building package (I-Beams, purlins, girts etc.) , delivery, foundation and the cost of construction. Since many retail & commercial buildings require additional finishing like insulation or façade customization, the cost may rise to $30 or $40 per square foot (SF). Insulating a commercial steel building is a necessary expense but is also a very good investment. In addition to moderating the temperature in a steel building, insulation can improve the acoustics by damping sound. It can also equate to significant energy cost savings.

Let’s be sports and call it $100 per square foot and round it up to 15,000 square feet.  That gives us $1,500,000 for the building.  Is land in Billings MT worth $6 million per acre?  This is all very back of the envelope, but it seems that what is really for sale there is not mainly some commercial real estate in Billings MT, but rather a CVS bond and that what is going on with this whole sub-industry is retailers like CVS using triple net leases to tap into the pool of 1031 money that is out there.

This would seem like idle speculation were it not for the fact that in order to lower its property taxes CVS has made this very argument in court – and prevailed. In the Indiana Tax Court decision in the case of Shelby County Assessor CVS we have

Indiana law requires “careful consideration to make sure that only the value of the real estate is assessed and not some other business or investment interest.”

The Indiana Board noted that this difference was consistent with CVS’s claim that it used sale-leaseback transactions to sell more than just the ownership rights in its properties; rather, it used those types of transactions as a means to generate additional business capital from investors.

Nobody seems to have taken note that the Indiana Tax Court is, in effect ruling, that the poor schnook who exchanged into that building had quite a bit of taxable boot, if the logic is followed through.

Other Coverage

Exelon issued a Form 8-K that discusses the economic impact of the decision.  That was picked up in Crain’s Chicago Business in the story “Exelon loses big in Tax Court” in which he writes

Under the court ruling, ]Exelon must pay the IRS $1.2 billion in taxes owed and another $260 million in penalties and interest. It will be able to deduct interest payments in the future, making the ultimate net hit to the company’s balance sheet $1.1 billion.

That is inaccurate.  I have not fully parsed this because I am more of a tax geek than a GAAP geek, but much of the liability is already on Exelon’s balance sheet, which you can see from reading the tax provision in the 10-K.  The only earnings hit is probably from the penalties, which while still a number is less than a billion. For whatever it is worth Exelon’s] stock price went up yesterday.  Go figure.

Vidya Kauri has a nice summary in Law360.

The indefatigable Lew Taishoff will not miss a regular Tax Court decision on a billion-plus gain and weighed in with 1031 And All That not long after the decision hit the Tax Court website.

Now how about good-faith Section 6664 reliance on experts? Exelon hired a squadron of them.

But the appraisal done by the Big Four accounting firm was flawed, and Exelon’s in-house team should have known that the assumptions upon which it was based were faulty. And the white-shoe lawyers told the accountants what to say.

Ed Zollars has something on Current Federal Tax Developments.

I had had some hope of breaking this story, but my business partner, who is also my life partner, thought with October 15 breathing down our necks I needed to be focusing on what Bob Flach calls the GD extensions.The trials of being a tax blogger who holds onto his day job