TAX CASE

RC section 1031 permits the tax-free exchange of like-kind property. If the transferor receives “boot” (such as cash) in addition to the like-kind property, the boot is currently taxable. The application of these rules to the exchange of real property that was burdened by a supply contract was recently considered by the Tax Court.

On June 25, 1993, Peabody Natural Resources Co. transferred a gold mine in exchange for a coal mine. The coal mine was burdened by two contracts mandating that it supply a fixed minimum amount of coal. The contracts could be extended for five-year periods. Peabody reported the transaction as a tax-free exchange under section 1031. The IRS concluded that because the contracts were boot the exchange was taxable.

Result. For the taxpayer. The first question before the Tax Court was the nature of the supply contracts. After reviewing New Mexico law, the court concluded they were contracts for the sale of goods and an interest in real property.

Peabody argued that, since all real property is like-kind to all other real property, the transaction was tax-free. The court rejected this argument, noting that in prior cases the courts have held that real property, especially when leases or other contracts are involved, is not always like-kind to other real estate.

Since the exchanged properties were not automatically like-kind, the Tax Court had to reconcile two prior cases. One held that an overriding royalty interest was part of a like-kind exchange, the other that a carved-out oil payment was not part of a like-kind exchange. The court explained its rationale for the different outcomes as follows: In one case an overriding royalty would last until the mineral deposit was exhausted, while in the other situation a carved-out royalty ended after a stated time of production.

The explanation would seem to imply the Peabody supply contracts, which would terminate before the coal was exhausted, were not like-kind to other real property. However, the Tax Court determined the contracts were part of the bundle of rights the taxpayer received in exchange for the gold mine. As a consequence the contracts affected the grade or quality of the real property (rather than a difference in class). Based on this finding, the court ruled the exchange was tax-free under section 1031.

This decision appears to permit the tax-free exchange of real property burdened by supply contracts, as long as the contracts are considered real property interests under state law.

Peabody Natural Resources Co. v. Commissioner, 126 TC no. 14.

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

TAX CASE

o payments, either direct or indirect, to a subchapter S corporation always create an increase in the taxpayer’s basis? The Tax Court recently decided that they do not.

Sid and Al Ruckriegel were 50% shareholders in Sidal Inc., a subchapter S corporation, set up in Indiana. They were also 50% partners in Paulan Properties Partnership. Sidal incurred ordinary losses in 1999 and 2000. Between 1997 and 2000 Paulan transferred approximately $4 million directly and $2 million in bank loans indirectly to Sidal. The petitioners argued that Paulan was acting as their agent and that their basis in Sidal should be increased by $6 million. Because the petitioners were not the direct source of the funds, the IRS disagreed and assessed combined tax deficiencies of $220,000 and $250,000 for 1999 and 2000, respectively. The Ruckriegels petitioned the Tax Court.

Result. For the IRS as to the direct payments, for the Ruckriegels as to the indirect payments. The Ruckriegels argued that the payments were in substance back-to-back loans through them that had created a debtor-creditor relationship. They also claimed that, under Indiana law, intent governed whether a debtor-creditor relationship existed, and that board of directors’ minutes, promissory notes and accounting entries, along with the “incorporated checkbook” concept, as discussed in Yates and Culnen , provided evidence that this was their intent.

The Tax Court said the evidence had to show the Ruckriegels, not Paulan, made the loans to Sidal and that Sidal’s indebtedness was to them, not Paulan, regardless of the source of the funds. The court held that, for the direct payments, it did not. The promissory notes and board minutes were created three months to three years after the payments; the accounting treatment of the loan principal and interest was inconsistent; and the number of checks written by Paulan for the petitioners was simply too small to constitute an incorporated checkbook.

At the same time, the court found the evidence was sufficient for the Ruckriegels to claim they had made the indirect payments. In summary, the court stated that the petitioners had paid insufficient attention to the details that were needed to justify the tax treatment they were claiming.

Thus, the Ruckriegels were allowed to deduct a small portion of Sidal’s 1999 ordinary loss, but could not deduct any of the 2000 ordinary loss.

Ruckriegel v. Commissioner, TC Memo 2006-78.

Prepared by Michael H. Brown, CPA, PhD, assistant professor of accounting, Tabor School of Business, Millikin University, Decatur, Ill.

TAX CASE

arwood Irrigation Co., a Texas company, acquired very valuable water rights in 1900. Garwood had operated for a time as a C corporation, then elected S status before selling its rights in January 1999. The sale triggered recognition of a built-in gains tax, which the company reported and paid on its 1999 tax return. On audit, the IRS disagreed with the value assigned to the water rights on the date of the company’s conversion to S status and, therefore, the amount of built-in gains reported.

Garwood and the service litigated the issue of the value of the water rights and the resulting tax paid by the company, and the Tax Court determined that Garwood had overpaid its tax liability for that year by more than $10,000.

The IRS calculated interest on the refund at the federal short-term rate plus 0.5 percentage points (the rate prescribed for large corporate overpayments). Garwood argued that the appropriate rate was the short-term rate plus 3 percentage points, the rate prescribed for noncorporate taxpayers. The two sides returned to court to litigate the interest rate question.

Result. The conclusion was a draw—more or less. The court determined the appropriate rate was the federal short-term rate plus 2 percentage points, the rate prescribed for corporate taxpayers.

IRC section 6621 sets the rate of interest to be paid on overpayments of tax at the federal short-term rate plus 3 percentage points (+3 rate) for noncorporate taxpayers and plus 2 percentage points (+2 rate) for corporate taxpayers. Another provision limits the rate for a corporate overpayment that exceeds $10,000 to the federal short-term rate plus 0.5 percentage points (+0.5 rate). This would appear to have limited Garwood’s interest to the +0.5 rate, except that this part of the tax code contains a confusing cross-reference to section 6621(c)(3).

The section defines large corporate underpayments, with instructions to substitute “overpayment” for “underpayment.” It then specifies that an underpayment by a C corporation that exceeds $100,000 is a large corporate underpayment. It also defines taxable period for purposes of this large corporate underpayment. Garwood argued that the +0.5 rate did not apply to its overpayment because the cross-reference indicates that only C corporations are included in the definition of corporation for purposes of interest on overpayments.

The IRS argued that the cross-reference is intended to refer only to the definition of “taxable period” and that, since the large corporate underpayment had set up a different threshold ($100,000 vs. $10,000), it was not meant to be the same definition.

The court found some basis in a congressional committee report for concluding that the cross-reference refers to the large corporate underpayment definition. As Garwood was an S corporation, it was not subject to that definition, and the +0.5 rate did not apply. The court disappointed Garwood, however, by finding that the +3 noncorporate rate didn’t apply either.

The statute does not specifically exempt S corporations from the definition of a corporation for purposes of interest on the overpayment. In addition, Garwood operated as a C corporation for a time and the overpayment in question related to built-in gains tax that had resulted from its operation as such. The court concluded that the appropriate interest rate was +2.

Tax preparers need to keep in mind that, although an S corporation generally is taxed according to subchapter S of the Internal Revenue Code, it is taxed as a C corporation when an issue is not addressed in that subchapter. For interest on overpayments, S corporations are treated as corporations, but are not subject to the lower rate for large corporate overpayments.

Garwood Irrigation Company v. Commissioner, 126 TC no.12.

Prepared by Cheryl T. Metrejean, CPA, PhD, assistant professor of accounting, Georgia Southern University, School of Accountancy, Statesboro.