IRS memorandum addresses application of like-kind exchange rules and aircraft held for trade or business use

In a recent Internal Legal Memorandum (ILM 201601011) to the field, the IRS National Office determined that an aircraft was held for productive use in a trade or business for purposes of applying the Section 1031 nonrecognition provisions. The only activity of the partnership at issue was to lease the aircraft to a related party that used the aircraft in its business activities. These business activities were mainly carried out by two executives who each owned interests in the related party and together owned 100% of the partnership.

The partnership in the ILM exchanged an aircraft for a replacement aircraft and applied Section 1031. The lease payments for the relinquished aircraft were fair market rental value, and the lease payments for the replacement aircraft were below market. For both aircraft, the lease payments were intended to cover the carrying costs of the aircraft and not to generate meaningful economic profit.

The field determined that the taxpayer did not have a valid Section 1031 exchange because the partnership did not hold the replacement or relinquished property for “productive use in a trade or business.” This term is not defined in the Internal Revenue Code or regulations, and so the field looked to apply Section 183, which applies to limit the deductions of an individual or an S corporation engaging in an activity without profit motive. The IRS National Office concluded that there was no authority that would suggest that the standards of Section 183 should be used to evaluate whether property is held for productive use for purposes of Section 1031.  

Instead, the National Office looked to the fact that many businesses hold and use properties in a way that do not and could not generate profit. Even in that situation the property is still held for productive use in the business. Additionally, the National Office pointed out that many businesses, for any number of valid nontax reasons, opt to hold property (including and especially aircraft) in a separate entity, and this should not preclude the partnership from being able to take advantage of Section 1031. They National Office reasoned that the taxpayer shouldn’t get a different answer if the aircraft or the partnership had been owned 100% by the related party.

Accordingly, the memo concludes that the replacement and the relinquished aircraft are eligible for Section 1031 because they meet the requirement that they be held for productive use in a trade or business.

Interestingly, the memo includes an assumption about whether the leasing partnership should be respected as a partnership for U.S. federal income tax purposes. It appears that the field did not raise the issue of whether the partnership is a valid partnership and not a sham entity, but the memo notes that if the partnership is a sham entity, then the two senior executives, and not the partnership, are the owners of the aircraft. The memo explains that “[i]n that case, our analysis would be different than provided below and the conclusion may be different as well.” Thus, though the memo assumes that the partnership is a valid partnership, the memo seems to suggest that there may be a question about whether there are situations in which, based on the facts, the leasing partnership faces a risk of not being respected as a valid partnership.

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