Taxpayer characterized its sale of its power plants followed by purchase/leaseback transactions with tax exempt entities as a Section 1031 Exchange. The IRS rejected this characterization and assessed taxes and penalties.

Taxpayer is a public utility engaged in generation, transmission and distribution of electricity in Northern Illinois. In order to competitively adjust to the deregulation of the electric utility market, the taxpayer determined that it would be more advantageous to sell certain fossil fuel power plants rather than to continue to operate them. The plants were sold for 4.813 billion dollars and the company earned 1.6 billion in taxable gains on the sale. In order to retain as much of the proceeds to reinvest in its remaining assets in its nuclear power plants, the Taxpayer entered into a strategy designed by its advisors, including Price Waterhouse, to defer the 1.2 billion of the gain arising from the sale of two of its six plants and preserve as much of its cash as possible.

The Taxpayer entered into an agreement to acquire a long term leasehold interest in power plants owned by two separate tax exempt utilities and, in turn, subleased the power plants back to the original owners for a shorter sublease period. The original price paid for the head lease was based on an appraisal prepared on behalf of the taxpayer (roughly equal to the value of the exchanged assets sold) and the rent due to the taxpayer on the sublease was paid in full within six months of the sublease, equal to roughly 76.8 % ¹ of the original purchase price. At the expiration of the shorter sublease, the original owners could either transfer control over to the taxpayer to operate the plants, or the original owners could pay a cancellation fee to the taxpayer to terminate their interest in the longer head lease, for an amount equal to 12.1 %² of the original payment on the head lease. The original owners would keep 11.1%³ of the proceeds for their own purposes.

The lease contained certain conditions and terms which required that the sublessees provide financial guarantees to ensure in the event of default, bankruptcy or other conditions that the lessor would be financially insulated from any risk of loss, either as to the physical assets or its operations. Upon termination of the sublease, the sublessee was liable either (1) to turn over the operating assets in a substantially equivalent physical condition as upon the beginning of the lease term, with an operational manager; or (2) to reacquire the head lease.

The Tax Court held that the purchase/lease back arrangement was properly characterized as a loan rather than a purchase since (1) the taxpayer was not at risk for the operational or physical condition of the assets; (2) the terms of the lease ensured that the sublessee would reacquire the head lease at the termination of the sublease; and (3) the transaction involved a circular flow of funds which did not require the counterparties to advance additional funds and returned to the taxpayer the funds it originally advanced. As such, the taxpayer did not meet the requirements of Section 1031 exchange that the taxpayer acquire an eligible asset within the statutory time limits of the exchange.

The taxpayer was not entitled to rely upon the tax opinions provided by counsel because the taxpayer should have known that the tax opinions relied on an appraisal that was substantially flawed and not consistent with the true economics and underlying understanding of all the parties to the transaction.

The taxpayer shared the benefit of the reduced taxes with the parties to the transaction in the form of reduced rents and, if the purchase price option was not exercised at the end of the term of the sublease, the transaction would result in a substantial loss to the taxpayer.

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¹Texas Power Plant
²Texas Power Plant
³Texas Power Plant