Compromised Section 1031 appraisal sinks Exelon tax strategy for fossil fuel power plant sale

Exelon Corp. v. Commissioner, 2016 U.S. Tax Ct. LEXIS 26 (Sept. 19, 2016)    
U.S. Tax Court Judge David Laro frequently has cautioned experts not to give in to hiring attorneys who want to shape the appraisal. Although federal and state discovery rules offer some protection for attorney-expert communication, there is a risk of exposure and with it a risk of damage to the expert’s work product and reputation. A recent Section 1031 case, which Judge Laro handled, illustrates what happens when the communication is discovered.
A Chicago-based company wanted to minimize the tax consequences of a $1.6 billion gain resulting from the sale of two fossil fuel power plants in 1999. The taxpayer decided to pursue a Section 1031 like-kind exchange. This provision of the Tax Code allows for the deferral of gain or loss where the relinquished 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.” 
In essence, the taxpayer used the untaxed proceeds from the sale to lease a number of like-kind replacement properties from third parties, in different states, for a term exceeding the respective replacement plant’s useful life and then subleased them to the plants’ original owners. At the end of the subleases, the sublessees had a cancellation/purchase option. 
A key legal question in terms of the success of the tax strategy was whether it was “reasonably likely” that the sublessees would cancel the subleases and buy back their properties. Appraisals for the replacement properties were critical to achieving the “right” answer. The Tax Court found the taxpayer’s legal advisor made sure the appraiser included a number of conclusions the lawyers provided “to be able to issue tax opinions at the ‘will’ and ’should’ level." A flagrant letter from the attorneys to the appraiser, which was revealed in discovery, was proof of the law firm’s interference “with the integrity and independence of the appraisal process,” the court said.
To read more about the court’s analysis and resolution of the case, click here.