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Buchanan Ingersoll & Rooney PC, Washington, DC
In Morton v. U.S., No. 1:08-cv-00804-LMB (Fed. Cl. 4/27/11), the U.S. Court of Federal Claims found that the taxpayer's various business entities operated as a unified business enterprise and, therefore, the taxpayer could impute the business activities of one entity to his other entities. However, the court declined to grant summary judgment on deductions for expenditures and the validity of a like-kind exchange because the record did not establish business use of the property in question. The decision is important because the court seemed to hold that the businesses were the alter ego of the taxpayer. Additionally, this decision is important because the court rejected the IRS's contention that the accidental (and immediately corrected) receipt of the sale proceeds by the taxpayer was sufficient to nullify the like-kind exchange on purely procedural grounds.
Taxpayer, the co-founder of successful restaurants, hotels and casinos, which were marketed under a single brand name, was the sole or majority shareholder of several S corporations that operated various aspects of Taxpayer's business endeavors. For the years at issue, Taxpayer frequently traveled on an airplane owned by one of the S corporations; often accompanied by various friends and family members. Taxpayer claimed business deductions with respect to expenses incurred on certain trips he characterized as business trips. Taxpayer argued that he was permitted to apply the expenses of an asset owned by one entity towards other entities because Taxpayer and his various entities operated as a "unified business enterprise."
Deduction for Business Expenses
Under §162, a taxpayer may deduct "ordinary and necessary business expenses paid or incurred…in carrying on any trade or business." Additionally, under §§167 and 168, a taxpayer is allowed a depreciation deduction for "property used in the trade or business" if the taxpayer was "engaged in [an activity] for profit" under §183. A taxpayer will be deemed to be engaged in an activity for profit if the taxpayer is "involved in the activity with continuity and regularity and that the taxpayer's primary purpose for engaging in the activity [is] for income or profit." 1
The U.S. Court of Federal Claims stated that in order to determine whether Taxpayer was allowed to deduct expenses for the airplane use, it must analyze (i) whether the law permitted Taxpayer to treat multiple companies as a "unified business enterprise" for purposes of a tax deduction, and (ii) if so, whether Taxpayer had substantiated the business expenses he attempted to deduct. Citing Campbell v. Comr., 2 the court emphasized that "[t]he entire economic relationship and its consequences are what determine profit motive" under §183. Upon a review of the record, the court concluded that the various entities were intertwined financially and the activities of one entity were clearly in furtherance of the other entities of similar ownership. Thus, the court held that the entities formed a unified business enterprise that operated for profit-making purposes. Further, the court distinguished the cases cited by the IRS, Deputy v. du Pont, 3 and Moline Properties, Inc. v. Comr., 4 principally on the grounds that they were decided before the creation of the S corporation and a taxpayer has a different relationship to an S corporation. The court seemed to indicate that all of Taxpayer's entities were "alter egos" of Taxpayer. Based on the foregoing analysis, the court granted summary judgment to Taxpayer on this issue.
The U.S. Court of Federal Claims then turned to whether the evidence showed that the airplane expenses were for legitimate business purposes. The court noted that Taxpayer did not maintain systematic records of the airplane passengers and their reasons for being on the particular trips, and, therefore, the court could not definitively determine whether his characterization of the trips as business or personal in meetings with his accountant were sufficiently contemporaneous as to be conclusive. Accordingly, the court declined to grant summary motion on the issue of the business or personal characterization of the travel expenses incurred during Taxpayer's use of the plane. Moreover, the court also declined to grant summary motion on whether depreciation deductions were allowed because this determination was dependent on substantiating the business usage of the airplanes.
During one of the years at issue, Taxpayer also sought to exchange the airplane for a newer airplane in a qualified like-kind exchange under §1031. Under §1031 and the treasury regulations thereunder, no gain or loss is recognized when business or investment property is exchanged solely for other business or investment property of like kind in nature or character, though not necessarily of grade or quality. In order to take advantage of the nonrecognition provisions of §1031, a taxpayer must satisfy a number of technical requirements. Under §1031(a)(3), where like-kind property is not simultaneously exchanged, the replacement property must be identified within 45 days and received within 180 days after transfer of the relinquished property. Generally, Regs. §1.1031(k)-1(a) provides that if the taxpayer actually or constructively receives money before the taxpayer actually receives the replacement property then gain or loss must be recognized. However, Regs. §1.1031(k)-1(g)(4) provides a safe harbor that prevents a taxpayer from actually or constructively receiving money if the following requirements are met: (i) the taxpayer assigns his rights under the sales contract to a qualified intermediary, (ii) the taxpayer gives written notice of the assignment to all parties on or before the sale of the relinquished property and (iii) the taxpayer limits his rights to receive, pledge, borrow or otherwise obtain the benefits of the money held by the intermediary. Taxpayer entered into agreements with a qualified intermediary and an escrow agent to effectuate the exchange; however, the escrow agent accidentally, and in contravention of the escrow agreement, wired funds from the escrow account to the S corporation owning the plan. The funds were returned the following day.
The U.S. Court of Federal Claims concluded that the accidental transfer followed by an immediate return of funds did not constitute actual or constructive receipt. The court noted that Taxpayer was bound by the contract and legally was required to return the funds to the proper account. Although the court determined that Taxpayer's actions met the requirements of the safe harbor, the court declined to grant summary judgment on this issue because Taxpayer had not yet introduced sufficient evidence that the airplanes were actually used for "productive use in a trade or business."
In finding that Taxpayer's actions met the requirements of the safe harbor for a §1031 exchange, the court noted that Taxpayer should not be penalized for another's mistake when he complied with all the steps to validly effect a deferred like-kind exchange over which he had control. Interestingly, the court recognized that the safe harbor provided very specific requirements that had to be complied with in order to receive the benefits thereof, the court seemed to apply a common sense approach in refusing to apply the rules so rigidly that Taxpayer would lose all benefits through the actions of another party even though Taxpayer had complied with the rigid requirements over which he had control.
While the court's decision brought a welcomed common sense approach to the §1031 requirements, the holding that the various businesses operated as an alter ego of Taxpayer is certainly controversial and will probably be appealed. The court stated that the development of S corporations changed individuals' relationships with corporations and that an S corporation is essentially the individual owner(s). Although S corporations are pass through entities for federal income tax purposes, the court went beyond that in calling the S corporation an alter ego of the shareholders.
For more information, in BNA's Tax Management Portfolios, see Maule, 505 T.M., Trade or Business Expenses and For-Profit Activity Deductions, and Levine, 567 T.M., Taxfree Exchanges Under Section 1031, and in BNA's Tax Practice Series, see ¶1510, Like-Kind Exchanges and ¶2110, Trade or Business Expenses — General Requirements.
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