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IRS Agent Erred in Applying Hobby Loss Rules to "Productive Use" Test for Like-Kind Exchange.

(Parker Tax Publishing January 26, 2016)

The IRS Office of Chief Counsel advised that a partnership that exchanged an aircraft for a replacement aircraft held the property for productive use in a trade or business for purposes of Code Sec. 1031. The Chief Counsel's Office disagreed with a revenue agent's analysis that used Code Sec. 183 hobby loss rules to reach the opposite conclusion, finding those rules inapplicable. CCA 201601011.


Under the facts in CCA 201601011, a partnership referred to as "P" owns multiple aircraft which are leased to a partnership referred to as "O." O is the primary business entity of a group of entities, which includes P. The entities' activities involve air travel, particularly by its executives. For both business and legal reasons, the aircraft are owned by P, a separate entity, and leased to O. The aircraft are the only operating assets of P.

The aircraft are principally used by two of O's senior executives for both business and personal purposes. To the extent the executives use the plane for personal purposes, they include the required amount in income as compensation.

In the year at issue, P exchanged the aircraft ("relinquished aircraft") for a replacement aircraft. Both the relinquished and replacement aircraft were leased under a so-called "dry" lease, under which the lessee provides flight crew and other services pertaining to the aircraft. The lease payments for the relinquished aircraft approximated the fair market rental value of the aircraft whereas the lease payments for the replacement aircraft were below market. In both cases, the lease payments were designed to cover the aircraft's carrying costs and were not designed to generate meaningful economic profit.

An examining agent during an audit of the partnership took the position that P did not hold either the relinquished or replacement aircraft for productive use in a trade or business. Because the term "held for productive use in a trade or business" is not defined in the Code or regulations, the agent relied on the hobby loss rules in Code Sec.183 and accompanying cases and regulations to determine whether P held the aircraft for productive use in a trade or business. Using the standards under Code Sec. 183, the agent concluded that P did not hold the aircraft for productive use in a trade or business.

The IRS Office of Chief Counsel (IRS) was asked whether P held the aircraft "for productive use in a trade or business" within the meaning of Code Sec. 1031 where the aircraft were P's only operating assets and did not generate an economic profit for P.


Code Sec. 1031(a)(1) provides that no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.

Code Sec. 183 applies to limit the deductions of an individual or an S corporation engaging in an activity without a profit motive.

The IRS determined the aircraft owned by P served a business purpose for O both in terms of business travel and as an employment perk for its senior executives, and advised that the aircraft were held for productive use in a trade or business for purposes of Code Sec. 1031.

The IRS stated that there was no authority suggesting that the standards of Code Sec. 183 should be used to evaluate whether property is held for productive use for purposes of Code Sec. 1031 and consequently did not agree with the examining agent that Code Sec. 183 should be used to evaluate whether the aircraft are property held for productive use in a trade or business.

Although the rent P charged O for use of the aircrafts was insufficient for P to make an economic profit, the IRS noted that many businesses hold and use properties in a way that, if the use of the property were viewed as an activity, do not and could not generate profit. Nevertheless, the IRS said, the property itself is held for productive use in that business, and P's lack of intent to make an economic profit on the aircraft rental did not establish that the aircraft failed the "productive use in a trade or business" standard of Code Sec. 1031.

The IRS also pointed out that businesses, for any number of reasons, opt to hold property, especially aircraft, in a separate entity. In the instant case, the IRS said, O required private aircraft to be available to its senior executives (both for business travel and as an employment perk), and for business and legal reasons the aircraft were owned by a related entity. Were it to disallow Code Sec. 1031 treatment based on the entity structure in the instant case, the IRS said, businesses would be forced to structure their transactions in inefficient and potentially risky ways to achieve Code Sec. 1031 treatment.

OBSERVATION: The IRS's analysis only extended to the "productive use in a trade or business" requirement of Code Sec. 1031. The IRS did not advise on whether the exchange met the other requirements to be considered a tax-free like-kind exchange.

The IRS noted that while two facts raised by the examining agent - that P charged below-market rent for the replacement aircraft and that the senior executives, rather than O, owned P - did not disqualify the property from being held for productive use in a trade or business for purposes of Code Sec. 1031, other tax provisions such as Code Sec. 280F or Code Sec. 482 might apply to disallow tax benefits or impose a tax treatment different from the treatment claimed by the partnerships or the senior executives. The IRS also said its conclusion was based on the assumption that P was a legitimate partnership, and if P is a sham entity then the senior executives would be the owners of the aircraft, and its analysis and conclusion would likely be different.

For a discussion of tax-free like-kind exchanges, see Parker Tax ¶113,100. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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