Employee home transactions by relocation companies: a critical analysis.

In a recent National Office Technical Advice Memorandum (TAM), [1](*) the Internal Revenue Service ruled that a taxpayer that contracted with relocation companies (relos) for the purchase and sale of homes owned by the taxpayer's employees will be treated as having purchased and sold the homes. It further held that the homes are capital assets to the taxpayer and that amounts paid by the taxpayer to the relos for such items as mortgage payments, broker's commissions, title examinations, and transfer taxes are nondeductible capital expenditures that must be added to the bases of the homes.

The TAM's conclusions could negatively affect many employers. For the most part, employers have probably been treating these outlays as deductible business expenses; the TAM would overturn this treatment, converting ordinary deductions into capital losses. Given the limited usefulness of capitla losses, particularly by corporations, this approach could make the relocation of employees a much more expensive proposition. [2] This article critically analyzes the TAM and discusses some of the issues that may arise as a result of the IRS's position.

THE TAM -- AN OVERVIEW

The taxpayer in Letter Ruling No. 9036003 was a corporation that does business in different locations in the United States. To facilitate the relocation of its employees, it entered into contracts with three relos for the purchase of designated employees' homes. A relo would offer to buy an employee's home at appraised value or, in certain cases, the relo would match a bona fide higher offer by a third party. If the relo's offer was accepted, the employee would execute a deed in blank and receive payment for his equity from the relo. The relo would then carry and maintain the home for sale to a third party. Title was usually not transferred until the relo sold the home to a third party.

Each contract provided that the taxpayer would reimburse the relo for its costs and, further, that the taxpayer would pay fees to the relo for services rendered. If the home was sold at a gain, the gain would reduce the amount that the taxpayer otherwise owed the relo. If the home was sold at a loss, the taxpayer was obligated to reimburse the relo for the loss. Under one of the three contracts, the taxpayer's loss was limited to the lesser of $5,000 or 5 percent of appraised value without the taxpayer's prior approval (but this approval was apparently routinely granted). Under each contract, the taxpayer agreed to indemnify and hold the relo harmless for all claims, liabilities, losses, damages, expenses, etc., caused by failure of an employee to fulfill any obligations under a contract of sale.

Each contract required the relo to maintain records and make them available to the taxpayer. The taxpayer had one full-time employee who managed the relocation program and worked directly with the relos. The taxpayer deducted all the amounts it paid to the relos as ordinary and necessary business expenses under section 162. Upon audit, the District Director treated the amounts as nondeductible capital expenditures, except for interest, real estate taxes, and certain fees unrelated to the sales of homes. Technical advice was sought from the IRS National Office.

In the TAM, the National Office reasoned that the homes, if purchased directly by the taxpayer, would have been capital assets. Applying a substance-over-form argument, it concluded that the taxpayer should be treated as if it had in fact purchased and sold the homes, with the relos acting as its agents. The National Office reasoned that if the taxpayer had purchased the homes on its own, the taxpayer would have paid the same costs and realized the same gain or loss that it did under the contracts. In either case, the IRS reasoned, the taxpayer would have the benefits and burdens of ownership, and the opportunity for gain and risk of loss on a sale to a third party.

CRITICAL ANALYSIS

These issues involving employee relocation costs are not new. They have apparently been raised many times by the IRS at the examination level. The IRS's treatment of the relo costs has not been entirely consistent. In fact, in Letter Ruling No. 8244032, [3] the IRS allowed an employer an ordinary deduction for payments made to a relo. The two relo compensation arrangements described there, however, differed from the arrangements described in the TAM, though one of them arguably had several similarities.

In the bona fide transaction at fair marke tvalue described in the TAM, the net result is likely to be a loss. Although there could be a gain on later sale if there were appreciation during the period the home was held by the relo, a loss is much ore likely because the home is purchased at fair market value and quickly resold at fair market value, with substantial transaction costs effectively resulting in the loss.

The IRS's scrutiny of this area could well have been triggered by its recognition that employees will almost certainly treat the entire amount received from the relo as proceeds of the home sale and will likely defer any gain under section 1034. [4] In the meantime, the employer will claim an ordinary deduction for its net outlay to the relo company. Thus, it could be argued that, at least in part, the employer is effectively bearing the employee's selling costs, and that the relo transaction is being used to alter the tax result.

Are the Homes Capital Assets?

A critical step in the IRS's reasoning in the TAM was its determination that, if the employer had purchased the employees' homes directly, the homes would have been capital assets in the hands of the employer.

The TAM cites Rev. Rul. 82-204, 1982-2 C.B. 192, which involved a manufacturing company that purchased the homes of relocating employees directly as part of an employee relocation program and subsequently resold the homes to the general public, either directly or through a real estate agent. The IRS ruled that the homes were capital assets in the employer's hands, reasoning that the two relevant exceptions in sections 1221(1) and (2) did not apply. [5] If further reasoned that the property was not "purchased and sold as an integral part of the taxpayer's business operations within the scope of the Corn Products doctrine." In the TAM, the IRS added that the Arkansas Best [6] decision further supports its position.

In Corn Products, [7] futures transactions that were engaged in as an integral part of the taxpaers business (to protect the taxpayer's manufacturing operations from a price increase and to assure an adequate supply of corn) were found not to be capital assets. It was not clear whether this was based on a narrow reading of the phrase "property held by the taxpayer" in section 1221 or a broad reading of the inventory exclusion in section 1221(1).

For more than 30 years, there was much debate over the holding of Corn Products. The case was frequently cited for the proposition that assets acquired and held for ordinary business purposes, rather than for investment purposes, should receive ordinary rather than capital asset treatment; that is to say, the case was said to create an exception for assets that are an integral part of the taxpayer's business. In Arkansas Best, the Supreme Court decided that "Corn Products is properly interpreted as standing for the narrow proposition that hedging transactions that are an integral part of a business' inventory purchase system fall within the inventory exclusion of section 1221." [8] Accordingly, the Court refused to apply Corn Products to allow a holding company ordinary loss treatment on the sale of certain bank stock, even though the stock had been purchased and held for the business purpose of protecting the taxpayer's reputation by fending off the bank's failure.

Prior to Arkansas Best, a taxpayer could argue that even the direct purchase and resale of employees' homes as part of a plan to relocate employees to meet the employer's business needs was an integral part of the employer's business and, further, that the Corn Products doctrine should be construed to characterize any loss on such transactions as an ordinary loss. Although the IRS did not subscribe to that view in Rev. Rul. 82-404, the issue could reasonably have been couched in terms of the breadth of the integral course of business exception, rather than the basic existence of such an exception. Given the holding in Arkansas Best, the business connection of the asset is not relevant to the initial determination whether an asset is a capital asset, but rather is relevant only in determining the applicability of certain of the statutory exceptions.

In Azar Nut Co., [9] a recent case that is cited in the TAM, the Tax Court applied this view in concluding that the taxpayer's business motives for a home purchase were not relevant. There, the taxpayer directly purchased the home of a terminated employee pursuant to an employment contract. The taxpayer had also contended that the home was real property used in the taxpayer's trade or business that should be excluded from capital asset treatment under section 1221(2). The court reasoned that, taxpayer's trade or business affairs, the home was not used in the trade or business. The taxpayer's subsequent loss on sale was held to be a capital loss.

After Arkansas Best, there is no exception from capital asset treatment merely because an asset is held as an integral part of the taxpayer's business. Business assets will be capital assets unless one of the five exceptions enumerated in section 1221 applies.

In the TAM, the IRS quickly determined that section 1221(1) does not apply to relo transactions. In cases involving a large volume of purchases and resales of employee homes, however, the homes might arguably fall under the exception in section 1221(1) for "property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business." The Supreme Court has held that, where property is held for more than one purpose, the word "primarily" in section 1221(1) means "of first importance" or "principally." [10] Consequently, since the homes -- if held by the employer -- appear to be held principally or of first importance for the purpose of accomplishing the relocation of the employees (rather than for sale to customers in the ordinary course of business), it is unlikely that the homes will be excluded from capital asset treatment under section 1221(1).

The Agency Issue

In the TAM, the National Office concluded that the relos should be treated as agents of the taxpayer and that, in substance, the taxpayer had purchased the homes. The linkage between the agency isue and the taxpayer-purchase issue, however, is not clear from the TAM. Although the IRS considered the agency issue and the substance issue together, an argument could be constructed that either one could be independently sufficient to support the IRS's position.

If the transaction meets all criteria necessary to justify disregarding its form, presumably the transaction should be taxed in accordance with its substance, without regard to whether an agency relationship is technically found to be present. On the other hand, if the relo is both in substance and in form the taxpayer's agent, the taxpayer should presumably be treated as the buyer and seller without further inquiry. Nevertheless, when viewed in tandem with the substance issue, the presence of an agency relationship (or even something close to it) strengthens the IRS's case.

In the TAM, the IRS argued that the application of the substance-over-form doctrine does not depend on a determination tha the relos are the taxpayer's agents under the standards set forth in National Carbide [11] and Bollinger. [12] It cited Derr v. Commissioner, [13] where the Tax Court held that one party was acting as ana gent or nominee in executing a real estate contract. In that pre-Bollinger case, a purchase and resale was found to be a sham and National Carbide was not mentioned. The TAM also cites Rev. Rul. 75-31, 1975-1 C.B. 10, where the IRS recognized an agency relationship (again pre-Bollinger) based not on National Carbide but on facts and circumstances.

The IRS's view that the agency question is not governed by National Carbide and Bollinger seems reasonable. National Carbide involved the question whether operating subsidiaries should be viewed as agents of the parent company so that the income distributed to the parent could be taxed to the parent and not to the subsidiaries. The Supreme Court found that the subsidiaries' relationships with the parent depended upon their ownership by the parent and were not true agency relationships. In Bollinger, a corporation (which was wholly owned by a partner in some partnerships) held title to apartment complexes in order to avoid restrictions imposed upon noncorporate borrowers under a state's usury laws. The partnerships were held to be the owners of the complexes since, in substance and in form, the corporation was an agent. The Supreme Court said:

It seems to us that the genuineness of the agency relationship is adequately assured, and tax-avoiding manipulation adequately avoided, when the fact that the corporation is acting as agent for its shareholders with respect to a particular asset is set forth in a written agreement at the time the asset is acquired, the corporation functions as agent and not principal with respect to the asset for all purposes, and the corporation is held out as the agent and not principal in all dealings with third parties relating to the asset. [14]

Importantly, in both National Carbide and Bollinger, the taxpayers - rather than the IRS - sought to have the agency relationship recognized for tax purposes. In addition, in both cases it was necessary to determine whether the relationship was really based on stock ownership rather than on agency. In such circumstances, the question of the genuineness of the agency relationship and the potential for manipulation of the tax consequences could reasonably warrant a different standard for recognition of the agency relationship than would be appropriate in the relo situation. National Carbide and Bollinger do not purport to describe the exclusive means by which an agency relationship will be recognized for tax purposes and it appears that, with other facts and circumstances, an agency relationship can exist without meeting those standards. For example, in Advance Homes, Inc., [15] the Tax Court considered whether a corporate taxpayer should be treated as an agent even though there was no written agency agreement. In agreeing with the taxpayer that an agency relationship did exist, the court reasoned that Bollinger merely enumerated the factors supporting the conclusion that an agency exists, not the requirements for agency status. The question, then, is what standard should be applied in determining whether an agency relationship exists in the relo situation? In form, the transaction was not cast in terms of an agency and, presumably, the taxpaher and the relos were not held out to third parties as principal and agent. The relos did engage in transactions at the behest of the taxpayer and did transfer the benefits and burdens of ownership and the potential for profit and risk of loss to the taxpayer through the compensation arrangement. The issue is whether there is something in these facts and circumstances that makes the relos the agents of the taxpayer for income tax purposes. If there is, the TAM does not clearly identify it. Arguably, the focus on facts and circumstances is just another way of saying "substance over form."

Substance Over Form

The form of a bona fide transaction should not be disregarded merely because the transaction could have been structured in a more tax-expensive way. As the Second Circuit has said: "[W]hen a taxpayer chooses to conduct his business in a certain form, 'the tax collector may not deprive him of the incidental tax benefits flowing therefrom unless it first be found to be but a fiction or a sham'" [16]

Because of the inherently factual nature of substance-over-form cases, [17] it is difficult to say what criteria will be used in analyzing the relo transaction, or what weight will be given to any particular aspect of the transaction. In order to provide a framework for applying substance-over-form principles in the relo context, the following discussion incorporates an example of how factors derived from a landmark case might be applied.

Frank Lyon Co. v. United States [18] involved a sale-leaseback transaction where a taxpayer sought to uphold the form of the transaction supporting the treatment of the taxpayer as the owner of the building. The Government argued that the transaction was a sham, averring that the taxpayer was not the owner and that the transaction was merely a financing arrangement. The Supreme Court said:

In short, we hold that where, as here, there is a genuine multiple-party transaction with economic substance which is compelled or encouraged by business or regulatory realities, is imbued with tax-independent considerations, and is not shaped solely by tax-avoidance features that have meaningless labels attached, the Government should honor the allocation of rights and duties effectuated by the parties. [19]

The Court emphasized that the transaction involved three parties and distinguished it from a situation involving only two parties. In the relo situation, there are multiple parties involved when the employee and the ultimate buyer are also considered, and arguably this should be viewed as a "genuine multiple-party transaction."

Before discussing how Frank Lyon might be applied in the relo setting, consideration should be given to why taxpayers would contract for the relo's services. Relos generally have real estate marketing and financing expertise, knowledge of the localized real estate market, physical locations near the property, and staff and systems in place for handling the purchase and sale in a businesslike manner. They may also have access to financing on favorable terms and are usually prepared to handle the maintenance of the empty house. They may also provide other services. It is not likely that a taxpayer who has a relatively small number of home transactions in any given locale could achieve the same economies of scale. Presumably, a relo would generally sell the home sooner and at a higher net return than the employer could if it chose to handle the sale directly using in-house staff; in other words, depending on the relo's compensation arrangement, there could be a real economic advantage to using a relo.

On the other hand, a survey reported in the Real Estate Review [20] found that "the median cost for a move through a relocation company in 1987-1988 was 20.6 percent of the transferred employee's salary . . . [whereas] [t[he cost to firms that used an in-house program was only 16.6 percent." If those amounts reflect all relevant costs and compare identical services and benefits, this might suggest that it is less cost effective to use a relo. [21] The Real Estate Review article also notes that the use of a relo can smooth the transition for the employee; the relo may also act as a buffer between management and the employee, shielding the company from employee dissatisfaction. (An unhappy employee may blame the relo instead of the employer.) The same article, however, suggests that tax savings are probably the most important reason for using a relo, and it is the tax savings motive that the IRS is likely to seize upon. [22]

In Newman v. Commissioner, [23] the Second Circuit recently considered the application of Frank Lyon to a taxpayer (a participant in a pooled investment plan) who claimed the investment tax credit on a truck used by a trucking company. The tax treatment turned on whether the taxpayer was the owner of the truck and the trucking company an independent contractor, as the form indicated, or whether the form should be disregarded and the transaction viewed as, in substance, a lease. In holding that the form of the transaction should be respected, the court described the factors from Frank Lyon, as follows:

The first factor inquires whether there is a legitimate non-tax business reason for the form; in other words, were the parties motivated at elast in part by reasons unrelated to taxes? . . .

. . .

The second . . . factor requires that the agreement have non-tax "economic substance." . . . We have construed this to require a "change in the economic interests of the relevant parties'. . . .

The remaining factors were not expressly stated as such in Frank Lyon, but were relied upon by the Court in reaching its decision. The Court found it relevant that the parties were independent of each other. . . .

The final . . . factor requires that the parties not disregard the form of the arrangement. . . . [24]

Consider how the Frank Lyon factors, as articulated by the Second Circuit in Newman, might be applied to relo transactions. First, is there a legitimate non-tax business reason for the form? [25] Presumably, the employer chose the relo arrangement for the skills, services, and other advantages that relos offer. Employers may also be able to identify other business reasons. The real issue may be whether there is any non-tax business reason for using a relo under an arrangement such as that described in the TAM, as contrasted with using a relo under an arrangement specifically providing for a principal-agent relationship. [26] Presumably, there would be no difference in the skills, services, and most other advantages. It is unclear whether the employer will be able to identify some other non-tax business reasons.

The second factor in Frank Lyon requires that the agreement have non-tax economic substance. The Second Circuit in Newman construed this to require a "change in the economic interests of the relevant parties" citing Rosenfeld v. Commissioner, [27] which involved a gift in trust and leaseback. There, the court considered whether the legal rights and beneficial interests of the relevant parties had changed. In the relo situation, the question becomes whether there is non-tax economic difference between a direct transaction not using a relo and a relo arrangement (with its all-important compensation terms). In other words, who had the benefits and burdens of ownership and the opportunity for profit and risk of loss on resale?

If the "change in the economic interests of the relevant parties" requires that the benefits and burdens of ownewrship and opportunity for profit and risk of loss be borne largely by the relo and not by the taxpayer, the relo arrangement described in the TAM would not meet this requirement. On the other hand, perhaps economic substance and the "change in the economic interests" should be construed more broadly to include situations where the economic result is favorably modified (e.g., where the form of the transaction results in cost savings). If the use of a relo is more cost effective than a direct transaction (taking into account all the services the relo provides and comparing all of the relevant costs), this economic advantage would arguably provide non-tax economic substance.

In the final analysis, the relevant question may be whether there is economic substance in the use of the relo under the arrangement described in the TAM, as compared with the use of a relo under an arrangement that specifically provides for a principal-agent relationship. In comparing these alternatives, there is probably little difference in who bears the benefits and burdens of ownership and the opportunity for profit and risk of loss. Also, there is not the same cost savings. It is unclear whether the employer will be able to identify other differences that arguably "change . . . the economic interests of the relevant parties."

An employer might arguably use a relo arrangement to favorably affect financial statement presentation (e.g., to avoid showing the homes and related liabilities), [28] to alter economic risk of liability to third parties (e.g., for tort or toxic waste liability, but consider the presence of insurance and the terms of the reimbursement arrangement), or to avoid being viewed as an owner for some other non-tax purpose. Such motivations may prove useful in applying the business purpose and economic substance tests. Thus, the issue might become whether the employer would otherwise have been viewed as the owner for a given non-tax purpose and whether the use of the relo arrangement changes this. The TAM stated that the employee generally executed a deed in blank and that title was usually not transferred until the relo sold the home to a third party. Non-tax principles may not correspond with the tax rules in determining if or when a sale occurs or who should be viewed as the buyer or seller.

According to Newman, the third Frank Lyon factor focuses on whether the parties were independent of one another. There is nothing suggesting that the relo transactions were anything other than arm's-length transactions. Unlike the situation in Newman, however, where there was tension between the tax positions of the two parties (there was only one investment tax credit to which either the taxpayer or the trucking company, but not both, would be entitled), the parties to relo transactions do not have conflicting tax interests that underscore their independence.

The last factor described by the Second Circuit requires that the parties not disregard the form of the arrangement. If one accepts the IRS's view that the form of the transaction is that the relos purchased the homes from the employees, it does not appear that the form was disregarded.

Consider another example of how Frank Lyon has been construed. In Rice's Toyota, [29] the IRS sought to treat a computer sale and leaseback arrangement as a sham. In upholding the IRS, the Fourth Circuit said:

The tax court read Frank Lyon . . . to mandate a two-pronged inquiry to determine whether a transaction is, for tax purposes, a sham. To treat a transaction as a sham, the court must find that the taxpayer was motivated by no business purposes other than obtaining tax benefits in entering the transaction, and that the transaction has no economic substance because no reasonable possibility of a profit exists. . . . We agree that such a test properly gives effect to the mandate of the Court in Frank Lyon that a transaction cannot be treated as a sham unless the transaction is shaped solely by tax avoidance considerations. . . . [30]

The court construed the business purpose inquiry to focus on the motives of the taxpayer, and the economic substance inquiry to require "an objective determination of whether a reasonable possibility of profit from the transaction existed apart from the tax benefits." [31]

It is uncertain how a relo transaction would fare under this two-step approach. Although relo transactions are arguably not "shaped solely by tax avoidance considerations," a court employing the Rice's toyota analysis might find them lacking both business purpose and economic substance. More fundamentally, Frank Lyon has been construed in a number of cases not to require this rigid two-step sham analysis. [32] Of course, in the TAM the IRS did not specifically characterize the relo transactions to be "shams." Rather, the IRS focused on the taxpayer's economic position, the benefits and burdens of ownership, and the potential for profit and risk of loss on resale. The IRS reasoned simply that the taxpayer purchased and sold the homes and that the relos were its agents.

The question remains, at what point do these economic similarities to a purchase and resale through an agent warrant ignoring the form? In Azar Nut Co. (which is cited with favor in the TAM, but not for this point), the Tax Court was unwilling to ignore the form of the transaction. The taxpayer argued that, instead of buying the home of a terminated employee pursuant to the employment contract, it could have either reimbursed the employee for any loss on the sale of the house or engaged a third party to purchase the house and reimbursed the third party for any difference in amount realized on a subsequent sale. The taxpayer contended that such a reimbursement would have been fully deductible. The Tax Court dismissed the argument as moot:

Without deciding the merits of these contentions, we find them to be of no assistance to petitioners because the hypothetical scenarios do not comport with the reality of the matter before us. The actual property transaction may not be disregarded simply because it could have been structured in a different way and may have resulted in a different tax consequence. . . . [33]

Ironically, about six months after the Tax Court's decision in Azar Nut, the IRS issued the TAM seeking to disregard the actual transaction when structured using a relo.

An employer might argue that, if the form of the relo transaction is to be disregarded, the substance is that the employer incurred a cost to have the relocating employee's home sold to the ultimate purchaser in order to facilitate the move of the employee. The employee receives cash payment for his equity and is relieved of the benefits and burdens of ownership, making the employee more able to qualify for the purchase of a home in the new location. To effect this result, the employer has two choices: either to bear the benefits and burdens of ownership and take over the opportunity for profit and risk of loss for itself, or to arrange for someone else to do so. Of course, under either approach, the employer bears the cost; under either aproach, the purchase and resale can be viewed as transitory steps in a larger transaction. [34]

The role of the Compensation Arrangement

The TAM emphasizes the nature of the compensation arrangement with the relo in the substance-over-form analysis. Since the taxpayer reimbursed the relos for their costs, received credit for homes sold at a gain, and reimbursed the relos for homes sold at a loss, the IRS reasoned that the taxpayer was in essentially the same economic position as it would have been in if it had undertaken the same activities on its own. This was the case even under those contracts that limited the risk of loss on sale to the lesser of $5,000 or 5 percent of appraised value without taxpayer's prior approval. The IRS noted that approval was routinely granted and analogized the loss limitation provision to insurance for which the taxpayer probably paid consideration.

This taxpayer's compensation arrangement with the relos resembles a cost-plus contract, which is frequently used in manufacturing or construction. Unfortunately, the reported cases and rulings in the cost-plus are generally focus on the taxpayer who is being compensated under such an arrangement, rather than on the party paying the compensation. In addition, cost-plus arrangements usually involve property to be manufactured or constructed for business use or for resale to customers in the ordinary course of business, rather than the purchase and resale of what might be a capital asset. [35]

Under the relo compensation arrangement, the relationship of the taxpayer's payment to the benefits and burdens of ownership and the ultimate profit or loss is apparent. It is difficult to construct any other arrangement for compensating the relo, however, that would not reflect these same factors. For example, the relo could charge a flat fee based on its market analysis of a particular property; in computing the fee, the relo would take into account the same costs, the same potential for subsequent gain or loss, and the same amount of profit for itself. It would also add a charge intended to insulate it, on average, from losses attributable to errors in computing these other amounts. This additional component of the flat fee could be viewed as the economic equivalent of insurance. Thus, one could argue that the flat fee is, in substance, not materially different from the fee arrangement described in the TAM, with insurance to eliminate the risk. The TAM, however, does not address the flat fee arrangement.

Which Amounts Must Be Capitalized?

The TAM provides that amounts paid to the relos "for such items as mortgage payments, brokers' commissions, title exsaminations, transfer taxes, etc., are nondeductible capital expenditures that must be added to the bases of the homes." In a direct capital asset purchase and subsequent sale, selling costs are usually treated as a reduction of the sale proceeds rather than being added to basis. Of course, whether they are added to basis as required under the TAM, or subtracted from proceeds, these amounts will not be currently deductible.

The TAM does not specifically say how the fee paid to the relo for its services (i.e., 2.5 percent to 3.25 percent of appraised value) should be treated. Presumably, the fee is to be capitalized. Unlike the other transaction costs, however, the fee is specifically attributable to the use of the relo and would not have been paid if the taxpayer had engaged in the transaction directly. On the other hand, the employer would have incurred additional in-house costs (e.g., salary) had the relo not been used, and arguably these costs should be capitalized. In practice, however, such costs are probably often deducted. Interestingly, although the TAM mentions that the taxpayer had one full-time employee who managed the relocation program and worked directly with the relos, it does not address whether any of those in-house employee costs should be capitalized. [36]

Treatment by the Employee

From the employee's standpoint, the cost of moving is a personal expense, even though motivated or required by business reasons. Under section 82, the employee must include in gross income amounts received, directly or indirectly, as payment for or reimbursement of moving expenses. The employee may then be allowed a limited itemized deduction under section 217. [37] If the employee's income inclusion uneer section 82 exceeds the allowable deduction, many employers will reimburse the employee for the tax on the excess under a "gross-up" arrangement.

The IRS's scrutiny of relo transactions was prompted, at least in part, by the lack of symmetry between the employer's and employee's tax treatment. The employer claims an ordinary business expense deduction under section 162 while the employee typically pays no tax, because the entire amount is treated as proceeds of the sale (with no part included in income under section 82) and because section 1034 will typically operate to defer gain on the sale of the employee's residence.

When the employer buys the employee's home, or arranges for a relo transaction, the employee is usually better off than he wold have been if he had sold the house to a third party on his own. He avoids paying a real estate sales commission and may sometimes avoid other transaction costs as well. Although the IRS could conceivably seek to treat this benefit to the employee as a separate item of gross income (rather than as part of the sale proceeds), at least as to the commission, it has apparently not done so.

In Rev. Rul. 72-339, 1972-2 C.B. 31, an employer purchased a transferred employee's home at average appraised value, resulting in a gain to the employee. No sales commissions were paid, nor did the employer incur any of the closing costs that under local law and custom are treated as imposed on the seller. The ruling concludes:

[T]he employee must account for the gain he realized on the sale of the residence, but no part of the transaction will give rise to income as compensation for the amount of a real estate commission that was neither paid nor incurred.

In Letter Ruling No. 8244032, the IRS reasoned that the principles of Rev. Rul. 72-339 apply under section 82 where the employer buys and sells the homes of relocating employees through a relo company. Thus, it determined that the selling employee did not have income under section 82 as compensation for a commission that was neither paid nor incurred. The private ruling also concludes that if the employer "pays any of the 'direct home selling costs' treated under local law and custom as imposed on the selling employee, the selling employee is to that extent in receipt of gross income under section 82. . . ." In the ruling, selling expenses and commissions were incurred when the relo later resold the house, but none was imputed to the employee. This same ruling, as mentioned earlier, allowed the employer an ordinary deduction for the relo costs. Of course, private letter rulings cannot be relied upon as precedent and the IRS is not bound by this view of the employee's treatment. The persuasive value of the ruling, moreover, is mitigated by the TAM.

A Dual Transaction -- Would Allocation be Appropriate?

Relief might still be provided even if the homes are viewed as capital assets in the employer's hands. For example, recognizing that the transaction represents, at least in part, an expense of moving the employee, the transaction could be bifurcated, with part of it viewed as capital and the remainder treated as ordinary in nature. Such an allocation procedure could be established by the IRS, the courts, or Congress.

There is much to be said for the allocation approach. If the employer purchased an employee's residence, there would be twolikely reasons a loss might be sustained (disregarding the effect of transaction costs). First, the value of the residence might decline while the employer held it, which should conceptually give rise to a capital loss if the residence is a capital asset. Second, the employer might have paid the employee more than a fair market value purchase price; the excess in such a situation could be characterized not as part of the purchase price of the asset but rather as compensation to the employee or another ordinary and necessary payment to encourage and facilitate the relocation. The regulations under section 82 give limited recognition to this point from the employee's perspective by providing that certain amounts related to a home sale must be included in the employee's gross income (e.g., payment in excess of fair market value, paid to prevent the employee from sustaining a loss, is includible). [38]

Where the employer purchases the employee's home at an amount equal to fair market value as determined by one or more reliable appraisals, or arranges for a relo to do so, the dual nature of the transaction may not be apparent. When transaction costs are considered, however, the situation becomes clearer. Stated candidly, absent some other motive, a prudent business person will not purchase an asset with the intent of immediately reselling it at that same price where that purchase and resale will yield a net loss. Such a motive is present here: the employer is willing to pay an amount greater than it can expect to net on an immediate resale of the home because the transaction, while involving a capital asset, also involves an ordinary and necessary expense of moving the employee.

The dual nature of the transaction could be recognized in assigning the cost to the capital asset. The residence could be assigned a cost equal to estimated net realizable value, i.e., the amount paid (fair market value) less expected selling expenses. The excess (an amount equal to the expected selling expenses) could be viewed as an expense of relocating the employee rather than as a cost of the house. (39)

For example, if the employer pays fair market value of $100,000 and estimates that in order to resell it will incur selling costs of $8,000, the cost of the residence could be viewed as $92,000, with the remainder treated as a business expense that the employer is willing to pay only because the relocation of an employee is involved. To assign the $8,000 excess to the basis of the capital asset arguably ignores the substance of the transaction. In addition, if the employer's basis is fixed at the property's estimated net realizable value, a subsequent sale at a lesser amount will reflect a loss attributable to a decline in the value of the asset while holding it, rather than reflecting a cost of moving the employee.

Of course, anytime a taxpayer purchases an asset at fair market value, an immedaite subsequent sale at that same value would produce a loss equal to the transaction costs. In the usual transaction, however, the buyer plans to hold the asset until the price rises sufficiently to recoup the transaction costs and yield a profit or until the asset can provide some other economic value. In the employee relocation situation, there is no expected price rise or other economic value from the holding of the residence. Rather, from the employer's perspective, the acquisition involves an overpayment that is more akin to a business expense than a capital asset purchase. The bifurcated approach would give effect to this economic reality.

On the other hand, the taxpayer's business motives may not be relevant in light of Arkansas Best. Of course, Congress, the courts, or the IRS could decide that the taxpayer's business motives are relevant for purposes of determining the proper allocation to the capital asset transaction without changing the definition of a capital asset. In addition, the bifurcated approach could be criticized as depending on estimates of the employer's expected transaction costs. These amounts, however, are relatively predictable. (40) Moreover, since the sale will likely take place within a short time, any errors in the estimate could be corrected without statute of limitations problems or other serious administrative difficulties.

The bifurcated approach raises the specter of the non-parallel treatment by the employer and employee. Ordinarily, the seller's selling price corresponds with the buyer's purchase price; in the above example, however, the employee's selling price is $8,000 more than the employer's purchase price (since that excess is treated as a business expense). The lack of parallel treatment should not be fatal, since there are many places in the tax law where the treatment by the payor does not correspond exactly with the treatment by the recipient. For example, a payor who pays for labor to construct a capital asset counts the payment as part of the basis of the capital asset, yet the contractor who receives the payment is required to include it as ordinary compensation income.

Nevertheless, the IRS would likely contend that the employee should also be required to bifurcate the selling price. In the above example, an employee who sold the home directly (bearing all transaction costs) would have netted only about $92,000; (41) the excess proceeds are attributable to the employer-employee relationship. Thus, the employee would have income under section 82 for the amount of the $8,000 transaction costs, followed by a limited moving expense deduction under section 217. The employee would then either bear the additional tax burden or have it absorbed by the employer under a gross-up arrangement. If the employee is required to bifurcate the selling price, the combined tax burden would likely increase as compared with the situation where the employee does not bifurcate and the employer has a capital loss.

Another approach would be to allow the employer to treat the transaction costs as a deductible business expense. These costs consists primarily of the service fee paid to the relo and the other selling costs, which would normally be taken into account in computing gain or loss on the subsequent sale. In the traditional capital asset sale, selling costs relate only to the sale of the asset; here, however, they could reasonably by viewed as expenses of relocating the employee. If they were treated separately as business expenses, the loss or gain on the capital asset transaction would be more reflective of the decline or growth in the value of the house during the time the taxpayer is treated as holding it. This would be a reasonable and simple way of recognizing the dual nature of these transactions. The IRS would likely reason, however, that the employee should be required to treat as income under section 82 the amount that the employer is deducting for transaction costs. The employee would then be entitled to a limited deduction under section 217. If this were required, it is likely that the combined tax burden would increase.

CONCLUSION

Where the employer bears the actual cost of moving an employee for the employer's business purposes and the employee is no better off as a result of the arrangement than he or she would have been if no move had been required, the employer's cost is arguably an ordinary and necessary business expense deduction that should not trigger a corresponding income inclusion for the employee. Unfortunately, this view has not been accepted by the IRS, which is apparently troubled by the relo transaction because the employer is seeking to deduct the net cost as an ordinary deduction while the employee will probably defer any gain from the transaction.

Given the case law, the homes would likely be found to be capital assets if purchased directly by the taxpayer. The more difficult question is whether the courts will either ignore the form of the relo transaction or apply the IRS's agency view. Whether the residence is pruchased directly by the employer or a relo arrangement is used, economically the transaction also involves a cost of moving the employee. It remains to be seen whether the IRS, the courts, or Congress will be willing to give some recognition to the dual nature of this transaction by allowing for ordinary deduction treatment for all or part of the transaction, and whether they will do so without requiring a corresponding amount of ordinary income recognition by the employee.

DAVID J. ROBERTS is an Associate Professor in DePaul University's School of Accoutancy, where he teaches primarily in the tax area. He received his B.S. degree (summa cum laude) from Northern Illinois University, his M.S.T. and M.B.A. degrees from DePaul University (both with distinction), and his J.D. degree (with honor) from the DePaul University College of Law. He also holds a CPA certificate. Mr. Roberts has published articles in several journals, including The Tax Executive.

(*1) Numbered notes are printed on page 266.

Notes

[1] Letter Ruling No. 9036003 (date not given).

[2] See I.R.C. [subsection] 1211, 1212, and 165(f). Although the employer in the TAM was a corporation, this approach could also affect individual taxpayers (e.g., relocation costs that flowed through to individual partners in a large professional partnership). The approach espoused in the TAM will often result in a greater tax cost, but in other cases it may make no difference and in still others could conceivably be taxpayer-favorable. The interplay with other items on the tax return will have to be considered. For example, if a corporation has enough current-year capital gains to absorb any resulting capital loss, then capital loss treatment may make little difference. On the other hand, should a favorable corporate capital gain rate become available, capital loss treatment would tend to become more unfavorable because such loss might absorb otherwise favorably taxed capital gain from other sources. In the rare case where relo transactions result in a net gain, capital gain could be beneficial. This is true even for a corporate taxpayer today, where capital loss from other sources might then become usable. In addition, capitalization of the amounts may change the year in which they are ultimately taken into account.

A further example of the interplay of this issue with other items involves the taxpayer's ability to use foreign tax credits. The differences in the sourcing of a capital loss from a real estate sale, as compared with an ordinary business expense deduction, could affect the computation of the foreign tax credit limitation. In some cases, the taxpayer might actually benefit from this.

[3] Letter Ruling No. 8244032 (date not given).

[4] A matter that the IRS should address is the treatment of mortgage interest by the selling employee. The mortgage is usually not paid off until the relo sells the property to the third party; the relo generally makes the mortgage payments in the interim. Since the mortgagee is usually not aware of this, the Form 1098 that is issued to the employee generally reflects the additional interest paid by the relo. There are likely many taxpayers who, in reliance on the Form 1098, deduct interest expense that they never paid.

[5] The IRS ruled that the homes were not "(1) stock in trade of the taxpayer or other property of a kind that would properly be included in inventory if on hand at the close of the tax year, or property held by the taxpayer primarily for sale to customers in the ordinary course of a trade or business; or (2) property, used in a trade or business, of a character that is subject to the allowance for depreciation provided in section 167, or real property used in a trade or business."

[6] Arkansas Best Corp. v. Commissioner, 485 U.S. 212 (1988).

[7] Corn Products Refining Co. v. Commissioner, 350 U.S. 46 (1955).

[8] 485 U.S. at 222.

[9] Azar Nut Co. v. Commissioner, 94 T.C. 455 (1990), aff'd, No. 90-4462 (5th Cir. May 15, 1991).

[10] Malai v. Riddell, 383 U.S. 569, 572 (1969).

[11] National Carbide Corp v. Commissioner, 336 U.S. 422 (1949).

[12] Commissioner v. Bollinger, 485 U.S. 340 (1988).

[13] 77 T.C. 708 (1981).

[14] 485 U.S. at 349.

[15] T.C.M. 1990-302.

[16] Newman v. Commissioner, 894 F.2d 560, 562 (2d Cir. 1990), citing W. Braun Co. v. Commissioner, 396 F.2d 264, 267 (2d Cir. 1968).

[17] For further discussion of this point, see B. Bittker, Federal Taxation of Income, Estates and Gifts [paragraph] 4.3.3 (1981) and [paragraph] 4.3.3. (1990 Cumulative Supplement No. 3).

[18] 435 U.S. 561 (1978).

[19] Id. at 583.

[20] Baen & Sicking, The Advantages of Corporate Relocation Companies, 19 Real Estate Review 92, 93 (Spring 1989). The survey referred to was Runzheimer International, Survey & Analysis of Employee Relocation Policies & Costs 1987-88 (1988).

[21] For a particular taxpayer, however, the use of a relo may prove more cost effective than an in-house program, given the particular employee relocation needs and potential in-house costs.

[22] The Real Estate Review article, however, compared the use of a relo with employer reimbursement of employee's selling costs. It is probably equally true, however, that tax savings have been an important consideration in an employer's choosing the relo arrangement over engaging in the transaction without a relo.

[23] Newman v. Commissioner, 894 F.2d 560 (2d Cir. 1990).

[24] Id. at 563.

[25] According to the Second Circuit, the Supreme Court in Frank Lyon, "held that, as long as one party is motivated by non-tax considerations, even if it is not the taxpayer, the form of the agreement will satisfy this factor." Id., citing 435 U.S. at 576. It appears that the focus is on the motivation of the party for engaging in the transaction under that particular form. If it can can be shown, for example, that the relo itself had a non-tax business purpose, not just for engaging in the transaction, but for using the form of the arrangement described in the TAM, that would seem to be sufficient under this approach.

[26] The TAM does not state whether the relos would have made their services available under an arrangement providing for an express principal-agent relationship. Presumably, even if such an arrangement were not offered, the IRS could argue that the relo transactions should be viewed this way.

[27] 706 F.2d 1277 (2d Cir. 1983).

[28] In Newman, the Second Circuit recognized that the trucking company's business purpose was to keep the transaction off its balance sheet for financial reasons. 894 F.2d at 560, 563. In Frank Lyon, the Supreme Court gave some consideration to financial accounting presentation in examining the transaction's substance. 435 U.S. at 577.

[29] Rice's Toyota World, Inc. v. Commissioner, 752 F.2d 89 (4th Cir. 1985).

[30] Id. at 91 and 92 (emphasis added).

[31] 752 F.2d at 94.

[32] For example, a recent Nith Circuit opinion points out that "[s]everal courts, including this circuit, have found that the Court's holding in Frank lyon was not intended to outline a rigid two-step analysis." Casebeer v. Commissioner, 909 F.2d 1360, 1363, (9th Cir. 1990), and cases on this point cited there.

[33] 94 T.C. at 460.

[34] Furthermore, the employer could argue that, even in form, the transaction is akin to a sale from the employee to the ultimate purchaser. Thus, although disparate state laws might affect the strength of this argument, the employer can note that the employee executed a deed in blank and that title was usually not transferred until the home sold to a third party. Hence, the employer could contend that the net cost of the relo transaction should be treated as a business expense, arguing that the from itself warrants this or, alternatively, invoking a substance-over-form or step-transaction argument. In such a case, however, the IRS would probably impute the same amount of ordinary income tot he employee. The employee would then be eligible for only a limited deduction under section 217. As a result, the combined employer-employee tax burden would likely increase.

[35] Consider a cost-plus manufacturing contract where the manufacturer deducts otherwise deductible period costs when incurred. The deduction apparently does not flow through to the purchasing taxpayer, even though it is this party who ultimately bears the economic burden. Consider further the situation where the manufacturer sustains a section 1231 gain or loss on the sale of equipment used in fulfilling the contract, and the cost-plus contract provides that such gain or loss is to be taken into account in determining the net amount due. Under traditional tax principles, section 1231 apparently applies to the manufacturer and not to the purchasing taxpayer, even though again it is the purchasing taxpayer who ultimately bears the benefit or burden of the section 1231 transaction.

Arguably, the typical cost-plus contract shifts the benefits and burdens of ownership to the purchasing taxpayer who has the opportunity for gain and the risk of loss. Nevertheless, the dearth of reported cases suggests that the IRS has not disturbed the form of such contracts or characterized the manufacturer as merely the purchaser's agent. If the nature of the traditional cost-plus contract does not require disregard of the form or a finding of an agency relationship, the cost-plus nature of the relo contract should not do so.

[36] The TAM concludes that mortgage payments must be capitalized by the employer, and does not distinguish between principal and interest payments. In addition, there is no discussion of the proper treatment of payments to a relo to cover interest on any funds borrowed by the relo and used to pay for employees' equity. Finally, the TAM does not clearly address the treatment of real estate taxes.

[37] This deduction for expenses related to selling the residence, together with certain other indirect moving expenses, will usually be limited to $3,000. See I.R.C. [subsection] 217(b)(2) and (3).

[38] See Treas. Reg. [section] 1.82-1(a)(5).

[39] There are numerous situations in other areas of the tax law where payments are bifurcated. For example, the Code separates real estate taxes for the year of sale from the consideration paid for the property itself, even if the parties do not agree to prorate the taxes. I.R.C. [subsection] 164(d), 1001(b), and 1012. As examples of situations where bifurcation is provided for in the regulations, even though not mentioned in the Code, see Treas. Reg. [section] 1.1015-4, which bifurcates a part sale-part gift into its two components, and Treas. Reg. [section] 1.100-2, which segregates any discharge of indebtedness element from the amount realized on a disposition of property that secures a recourse liability.

[40] For example, standard brokers commissions, the relo fee, closing costs, and transfer taxes can all be estimated based upon the appraised value that the employer paid the employee.

[41] Actually, the employee might net a somewhat higher amount, for while the employee might incur most of the same transaction costs (e.g., broker commission, transfer taxes), the employee would not incur an added fee for the services of a relo company. Perhaps the fact that the relo fee (or equivalent in-house cost borne by an employer) would not apply if the employee sold the house on his own should justify some difference in the treatment of these amounts.