What is a related party? For tax purposes, a related party is anyone directly linked by blood or bearing a relationship to the taxpayer as described in IRC sections 267(b) or 707(b)(1). For instance an individual who owns more than 50% of a corporation or partnership is related to that entity for tax purposes. Also, a trustee and beneficiary of the same trust are deemed related.

Section 1031 says “no gain or loss shall be 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 a like kind which is to be held in equivalent manner.” Generally speaking, the basis of property acquired in a 1031 exchange is the same as the basis of the property exchanged.

Before 1989 a number of taxpayers used what they affectionately called “basis shifting” to circumvent the intent of the exchange process. In a typical basis-shifting scenario, a taxpayer wanted to sell low-basis property that would generate a high tax bill. To avoid this result, the taxpayer would select another, high-basis property with the same value it owned under a different name and tax ID number. The taxpayer then exchanged or “swapped” the high-basis property for the low-basis property. The property that was sold ended up with a high basis and there was little or no tax consequence.

To stop this type of abusive transaction, in 1989 the IRS added section 1031(f) to the code. The key element of this addition was a required two-year holding period after a transfer of property between related parties. Also included was subsection (f)(4) that says “this section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of section 1031(f).” The rationale was clear: “If a related-party exchange is followed shortly thereafter by a disposition of the property, the related parties have, in effect, ‘cashed out’ of the investment” and are not entitled to nonrecognition treatment.

The added antiabuse rules were similarly clear in one sense: If the taxpayer executed an exchange involving a related party, it could not dispose of the property within two years. However, the ambiguous nature of section 1031(f)(4) created other problems. What type of transaction or series of transactions would the IRS consider “structured to avoid the purposes” of the new rules? Did a distinction exist between selling property to a related party and buying property from a related party? Revenue procedure 2002-83 answers those questions and provides CPAs with clear direction for future related-party transactions.

The revenue procedure used an example of a taxpayer selling low-basis relinquished property through a qualified intermediary to an unrelated third party and then buying high-basis property through an intermediary from a related party. (The use of a qualified intermediary or accommodator was considered immaterial.) The IRS concluded that buying replacement property from a related party violated section 1031(f)(4) because it was part of a transaction structured to avoid the purpose of the related-party rules. The proposed rationale of the abusive nature of this transaction was that the taxpayer was selling low-basis property and receiving in return high-basis property owned by a related party.

This was a similar fact pattern and conclusion of tax advice memorandum (TAM) 9748006, which the IRS issued in 1997, catching many CPAs and taxpayers off guard. In this transaction, a mother and son sold property they co-owned. The mother took her portion of the proceeds and bought property she used as a primary residence. For his part the son set up a 1031 exchange, identifying three potential replacement properties. One was the house his mother had just bought. He was unsuccessful in acquiring the other two properties and subsequently acquired his mother’s home as his replacement property. The IRS surmised the son had sold low-basis property for high-basis property originating from a related party and concluded it to be a failed exchange. Some tax professionals thought the conclusion was inconsistent with section 1031(f) and did not give the memorandum much credence. But it appears the IRS wanted to make a distinction between selling relinquished property and buying replacement property from a related party.

Observation. The IRS now has clarified the ambiguous nature of related-party transactions. A taxpayer may sell the property it is relinquishing to a related party as long as it complies with the two-year holding period. However, the taxpayer may not buy replacement property from a related party. CPAs should be prudent and use caution when a related party is involved in an exchange transaction. Related parties are treated differently and have a unique set of rules. Knowing these rules should eliminate unpleasant surprises.

Prepared by Ronald L. Raitz, CCIM, president, Real Estate Exchange Services Inc., Marietta, Georgia. He serves on the board of directors of the Federation of Exchange Accommodators. His e-mail address is rraitz@rees1031.com .

TWA is a partnership that provides accounting services. In 1994 it negotiated with the taxpayer, Victor Grigoraci, to admit him as a partner. TWA’s other partners were all S corporations owned by accountants who worked at the firm. To avoid being the only partner with personal liability, Grigoraci followed legal advice and also formed an S corporation to become a TWA partner.

Following the admission of Grigoraci’s S corporation as a partner, TWA reported his distributive share of earnings as going to his S corporation. That entity paid Grigoraci a salary, which he reported as self-employment income. He reported the remainder of his share of TWA’s income as non-self-employment income. The IRS held that Grigoraci should have reported all of the TWA income his S corporation received as self-employment income on the grounds he was the true partner. Grigoraci filed suit asking the Tax Court to treat the S corporation as the partner. Thus the income above his salary would not be additional self-employment income.

Result. For the taxpayer. The actual issue before the court was whether determining the identity of the real partner was a partnership item. The code defines a partnership item as one “required to be taken into account for the partnership’s taxable year…to the extent regulations…provide that… such item is more appropriately determined at the partnership level than at the partner level.” The regulations, according to the IRS, mandate that items the partnership takes into account under subtitle A are, by definition, partnership items. The court disagreed. It concluded the regulations provide only a list of such items. The regulations do not say all items taken into account under subtitle A are thus more appropriately determined at the partnership level and are, therefore, partnership items.

In prior cases the courts determined a partnership item to be one that affects the distributive shares of income or loss other partners report. In Katz v. Commissioner, 116 TC 5 (2001), the court ruled that how a partner and his bankruptcy estate had allocated partnership income between them was not a partnership item because the result did not affect the amount of income the other partners reported. Therefore, the identity of who was the true partner of TWA was not a partnership item because it did not affect the other partners.

This decision does not mean determining the existence of a partner is never a partnership item. For example, in Blonien v. Commissioner, 118 TC 541 (2002), determining an individual was a partner was ruled a partnership item since it would change the number of partners, thereby affecting how much income the other partners reported.
This case should help CPAs identify the appropriate test to use to determine the existence of a partnership item. As a general rule, unless the result will affect the income the other parties report, it should not be considered a partnership item.

Victor Grigoraci v. Commissioner, TC Memo 2002-202.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.

Asbestos Removal Costs Deductible
B usinesses may deduct environmental remediation costs currently as repairs if the expenditures keep property in an ordinarily efficient operating condition but don’t materially increase its value or useful life. If the expenditures stop deterioration and appreciably extend the property’s useful life, the costs must be capitalized. Previously, the courts had held asbestos removal costs to be capital expenditures. (See Dominion Resources Inc. v. United States, 2000-2 USTC 50,633; Norwest Corp. and Subsidiaries v. Commissioner, 108 TC 265.) In a more recent case, the court held the cost of cleaning contaminated soil also was a capital expenditure. (See United Dairy Farmers, Inc. v. United States, 2001-2 USTC 50,680.) But sometimes the courts take a different approach.

Cinergy, a public utility, built an addition to its office building in 1972. In doing so it sprayed fireproofing material containing asbestos onto the steel structure. In the late 1980s the material began to flake and crumble if touched or disturbed. In 1990 the company paid a contractor approximately $224,000 to remedy the potential health hazard—even though the amount of asbestos in the air was below the levels set by the Occupational Safety and Health Administration. The contractor removed the asbestos in some parts of the building, while in others it encapsulated the substance. The company deducted the project’s costs as an ordinary repair. The IRS disallowed the deduction claiming it represented a capital expenditure. Cinergy paid the additional tax; however, in 1999 it filed suit for a refund in the Federal Court of Claims.

Result. For the taxpayer. The Court of Claims held the company could deduct the expenditures currently since they (1) had not appreciably increased the value of the building, (2) were only a small percentage of the building’s value, (3) had not substantially increased the building’s useful life and (4) had not allowed the company to use the building in a different way. The court distinguished this case from Dominion Resources, where the asbestos removal permitted the owner to put the building to a different use, thus requiring it to capitalize the expenditures.

The court also contrasted this case with Norwest , where the asbestos removal costs were held to be capital expenditures since the company had incurred them as part of a general plan to rehabilitate and renovate the property. Cinergy incurred removal costs as part of a discrete project whose sole purpose had been to solve the asbestos problem. The remediation only restored value to the property that had existed before the deterioration began.

The court also held that the government’s reliance on United Dairy Farmers was misplaced. In that case a company purchased stores that contained underground gasoline storage tanks. Prior to the purchase, these tanks had leaked and contaminated the soil. United had to capitalize the cost of cleaning the soil since the problem existed at the date of its purchase. In contrast, Cinergy did not have an asbestos problem when it completed the building construction. Instead the company constructed property with the potential to require future remediation as opposed to having constructed property containing a defect. The court further said Cinergy could not have anticipated the asbestos problem when it built the building; therefore it could deduct the costs currently.

The Court of Claims drew an analogy between this case and Chicago, Burlington, & Quincy Railroad v . United States, 7401 USTC 9253, to support its conclusion. In Chicago , the court held the costs of water diversion projects to stop the erosion of rail embankments were deductible expenses since the owner had incurred them to stop a problem which, if allowed to continue, would have shortened the property’s useful life. The deduction was allowed even though the erosion abatement work was relatively permanent, had a life of more than a year, had restored the rail embankments to their original condition and had added value. Likewise, in this case, the court held that Cinergy could deduct its costs since the asbestos removal and encapsulation fixed a problem that could have shortened the building’s useful life. Further, the Court of Claims cited a list of courts that allowed current deductions for fixing an unforeseeable problem assuming that work did not increase the value or useful life of the property compared to what it was before the problem existed.

Note: It is important for CPAs to understand how the court determined whether the useful life or value had increased. It compared the value and useful life of the property before the deterioration and after the remediation as opposed to comparing the property’s value and useful life after the deterioration and remediation.

Cinergy Corp. v. United States, 2003-1 USTC 50,602.

Prepared by Charles J. Reichert, CPA, CIA, professor of accounting at the University of Wisconsin, Superior.