906 F.3d 513
7th Cir.2018Background
- Exelon sold fossil-fuel plants in 1999, realized large gains, and sought to defer tax under 26 U.S.C. § 1031 by acquiring tax title to replacement coal plants via sale-and-leaseback transactions structured as headleases (longer than useful life) with concurrent triple-net subleases and fully funded unilateral purchase options held by tax-exempt original owners.
- Transactions (Spruce, Scherer, Wansley tested) involved Exelon prepaying headlease rent (using sale proceeds), paying accommodation fees to lessees, funding collateral accounts to secure sublease obligations and the repurchase options, and credit enhancements (AIG, Ambac) that insulated Exelon from loss.
- Under the subleases, sublessees retained legal title, uninterrupted possession, responsibility for all operating costs/risks, and had a fully funded option at lease-end to repurchase without paying out of pocket; Exelon’s remedies on default were contractually secured to recover its investment.
- Exelon claimed (1) §1031 like-kind exchange treatment to defer ~$1.23 billion in gain and (2) depreciation, interest, and transaction deductions for 2001; IRS disallowed benefits, asserting the deals were SILO-like sham transactions and assessed large deficiencies plus accuracy-related penalties under §6662.
- The Tax Court (after trial) applied substance-over-form, found Exelon lacked the benefits and burdens of ownership (transactions were economically loans/qualified shelters with circular money flows and tainted appraisals), rejected Deloitte’s valuations as influenced by counsel, and sustained deficiencies and penalties; the Seventh Circuit affirmed.
Issues
| Issue | Plaintiff's Argument | Defendant's Argument | Held |
|---|---|---|---|
| Whether Exelon acquired genuine ownership in replacement plants so as to qualify for §1031 like-kind exchange treatment | Exelon: transactions transferred tax ownership; Exelon bore ownership risk and could end up owner at lease-end | IRS: transactions were SILO variants that left risks/costs with tax-exempt lessees and effectively funded repurchase options, so no true transfer of ownership | Held: No §1031 exchange — Exelon did not bear benefits/burdens of ownership; transactions treated as loans/shelters |
| Proper legal standard to assess likelihood that lessees would exercise purchase options | Exelon: court should require that lessees be “economically compelled” or virtually certain to exercise option | IRS: standard is a reasonable likelihood/expectation that lessees would exercise option | Held: Adopted reasonable likelihood/reasonable expectation standard (rejected “economic compulsion” requirement) |
| Reliability/independence of Deloitte valuations supporting tax opinion (Winston communications) | Exelon: Deloitte appraisals were independent and support the claim that options were unlikely to be exercised | IRS: Winston tainted appraisals by prescribing required conclusions; Deloitte’s methods were flawed | Held: Court accepted government expert over Deloitte and found Deloitte’s work tainted by Winston’s specified conclusions; Deloitte rejected |
| Whether accuracy-related penalties under §6662 apply given reliance on professional advice | Exelon: reasonably relied in good faith on Winston (and other advisors) — reasonable cause to avoid penalties | IRS: Exelon was negligent; a sophisticated taxpayer knew or should have known opinions were flawed, so penalties apply | Held: Penalties upheld — Exelon lacked reasonable cause/good-faith reliance given the record (tainted appraisals, obvious inconsistencies) |
Key Cases Cited
- Wells Fargo & Co. v. United States, 641 F.3d 1319 (Fed. Cir.) (SILO precedent: benefits/burdens test for tax ownership)
- Frank Lyon Co. v. United States, 435 U.S. 561 (Supreme Court) (substance-over-form and objective economic realities govern tax characterization)
- BB&T Corp. v. United States, 523 F.3d 461 (4th Cir.) (tax planning lawful but courts disregard sham devices that subvert tax code)
- Consolidated Edison Co. of N.Y., Inc. v. United States, 703 F.3d 1367 (Fed. Cir.) (analysis of SILO-like transactions and end-of-lease option likelihood)
- Altria Group, Inc. v. United States, 658 F.3d 276 (2d Cir.) (use of likelihood standard over near-certain test)
- Coltec Indus., Inc. v. United States, 454 F.3d 1340 (Fed. Cir.) (anti-abuse doctrines prevent subversion of tax code)
- M&W Gear Co. v. Commissioner, 446 F.2d 841 (7th Cir.) (fact-specific inquiry into whether payments are installment/purchase vs. rent; no adoption of economic compulsion standard)