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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