Court upholds Section 1031 tax ruling, affirming appraisals were unreliable

Exelon Corp. v. Commissioner, 906 F.3d 513 (Oct. 3, 2018)

In 2016, the U.S. Tax Court found for the Internal Revenue Service in a dispute over a series of exchanges that Exelon, the tax payer, designated as section 1031 transactions. The court found these were not like-kind exchanges as contemplated by tax law and disallowed the substantial deductions Exelon claimed. The court expressed dismay over the appraisals Exelon offered to support its claim, taking care to particularize how various actors manipulated the appraisals to achieve the desired outcome.

Recently, the 7th Circuit Court of Appeals upheld all of the Tax Court’s findings.

Exelon wanted to minimize tax liability related to the sale of two fossil power plants. On advice of its accounting firm, Exelon performed a number of so-called like-kind exchanges, leasing out-of-state power plants from tax-exempt parties for a period longer than each plant’s useful life and then subleasing each plant back to the original owner for a shorter sublease term. At the end of the subleases, the sub-lessees had the option to repurchase their plants. 

Exelon’s law firm worked very closely with an appraisal firm to come up with a valuation that showed exercising the purchase option was not “practically compelled.” This would allow Exelon to argue the transactions reflected a genuine investment, rather than a financial arrangement.

But the Tax Court found Exelon never obtained true ownership in the replacement plants. The appraisals, which were intended to show otherwise, were unreliable, the Tax Court found. The record showed they were not the work product of independent valuators but were, in part, written by Exelon’s law firm.

Exelon appealed the decision.

Read more about the 7th Circuit's analysis here.