Finally, guidance on like-kind exchanges; when do business swaps qualify for like-kind treatment? The Internal Revenue Service's new rules provide some answers.

In part one of this article (JofA, Oct. 90, pages 50-59), the Internal Revenue Service's new regulations on deferred like-kind exchanges were explored. Here, the other recently issued set of like-kind regulations--dealing primarily with multiple-as-set exchanges (business swaps)--are discussed.

Business swaps have become more popular in recent years. For example, a corporation may want to acquire a new business with the sale proceeds of an old business, without paying tax on the gain realized from the disposal of the old business. The usual like-kind exchange issues are made even more complex in business swaps, since many different types of property, such as real property, may be involved, as well as different combinations of tangible and intagible personal property.

In the past, many practitioners, relying on revenue ruling 85-135, concluded that an exchange of a business for a business could qualify in its entirety for nonrecognition treatment as long as the businesses themselves were of like kind. In the IRS ruling, an exchange of two television stations was held to qualify for nonrecognition treatment without a discussion on the similarity (or dissimilarity) of the underlying assets of each station. Consequently, many practitioners concluded it was unnecessary to examine the like-kind nature of the underlying assets in a business swap.

However, in revenue ruling 89-121, the IRS clarified its 1985 ruling by holding that the exchange of two like-kind businesses does not automatically qualify for like-kind treatment. Rather, an analysis of the underlying assets is require. Unclear, however, was how this analysis should be made. Should it be done on an asset-by-asset basis or on a class of assets basis (desks for desks, chairs for chairs?) Alternatively, should similar items be aggregated (office furniture for office furniture) or, even more broadly, should all tangible personal property be treated as like kind?

The new regulations answer these questions, first by providing rules for determining when a valid like-kind exchange of personal property has occured and then by applying these rules to multiasset exchanges.

Rules also are given to determine the amount of gain recognized, the basis of the various assets received and the treatment of liabilities transferred and assumed in the case of multiasset exchanges.

EFFECTIVE DATE

The new rules are proposed to be effective only for exchanges occurring after the date final regulations are issued. Accordingly, taxpayers are not required to follow the new rules at the present time.

DEPRECIABLE TANGIBLE

PERSONAL PROPERTY

Depreciable tangible personal property qualifies for nonrecognition treatment if it is exchanged for property that is either of a "like kind" or of a "like class." Properties are of a like kind based on all the facts and circumstances. Properties are of a like class if they are within either the same "general business asset class" or the same "product class" (see exhibit 1, page 80).

General business asset class property consists of certain specified generic classes of tangible personal property. The classes generally are divided into the broader classes of property, such as office furniture, fixtures and equipment. On the other hand, product class property (such as construction cranes and earth movers or food-packing equipment) is typically industry specific. As a general rule, it is less likely that two items of property will be within the same product class than they will be within the same general business asset class.

The like-class rules can be thought of as safe harbors. Although an exchange of properties still may qualify as like kind even though they are not of a like class, it is expected that the IRS will scrutinize such exchanges closely.

Finally, the like-class standard applies only to depreciable tangible personal property used by a taxpayer in his trade or business. It does not apply to property held by a taxpayer as an investment. No explanation is given by the IRS as to why they created this distinction.

OTHER PERSONAL PROPERTY

An exchange of intangible personal property, nondepreciable personal property or personal property held for investment can qualify for nonrecognition treatment only if the properties that are exchanged are of a like kind. According to the IRS, these types of property have not been divided into like classes because of their variety and the lack of a generally available classification system.

In general, like kind refers to the property's nature or character and not to its grade or quality. Whether intangible personal property is like kind to other intangible personal property generally depends not only on the type of right involved (a franchise right is not of like kind to a patent) but also on the type of underlying property to which the intangible relates (a copyright on a book is not of like kind to a copyright on a song; however, a copyright on a novel can be of like kind to a copyright on a non-fiction work).

Intangibles, such as goodwill or going-concern value, generally cannot qualify for nonrecognition treatment. In fact, exchanges of goodwill and going-concern value of dissimilar businesses (a restaurant and an auto dealer) can never be like kind, while exchanges involving similar businesses can qualify as like kind--but, according to the IRS, only in rare or unusual circumstances. As indicated by an example in the regulations that denies nonrecognition treatment of an exchange of goodwill between two very similar businesses, the IRS has adopted a hardline view that goodwill and going-concern value almost never will qualify for nonrecognition treatment--a position that already has drawn a great deal of criticism.

MULTIPLE-PROPERTY EXCHANGES

With respect to multiasset exchanges, the new rules provide a limited exception to the general rule that requires a property-by-property analysis. Rather, all properties transferred and received first must be combined into groups that are of like kind or like class (so-called exchange groups). If automobiles and computers are exchanged for other automobiles and computers, two exchange groups are created, one consisting of the automobiles transferred and received and the second consisting of the computers transferred and received.

Unlike the deferred like-kind exchange

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rules, the multiproperty rules do not contain any de minimis rules under which property incidental to a larger item of property would be treated as part of the larger property. As a result, an exchange involving two apartment buildings would be treated as a multiasset exchange if, in addition to the real property, personal property is transferred and received by the parties to the exchange.

Once the number of exchange groups is determined, Internal Revenue Code section 1031 rules are applied separately to each group to determine the amount of gain recognized and the basis of the property received. Under these rules, the taxpayer will be deemed to have made a taxable sale to the extent the aggregate fair market value (FMV) of the properties transferred in an exchange group is greater than the FMV of the properties received. When multiple properties are received in an exchange group, the basis of the entire group must be allocated to the properties within that group based on the relative FMV of the properties received (see exhibit 2, page 82).

TREATMENT OF LIABILITIES

In general, existing rules provide that liabilities assumed by the taxpayer may offset liabilities of which the taxpayer is relieved. If the taxpayer is relieved of more liabilities than he assumes, the excess is treated as boot received and is taxable to the extent of the gain realized in the transaction.

The new rules provide that liabilities incurred "in anticipation of" an exchange may not be offset by liabilities assumed by the taxpayer. In short, such liabilities are not considered part of the exchange and thus could result in gain recognition. Unfortunately, the regulations provide no further guidance with respect to this rule, which the IRS described as a clarification of existing law. Many practitioners have criticized this provision, requesting the IRS either delete it outright or provide a safe-harbor period (such as one year) after which borrowings will not be considered to have been made in anticipation of the exchange.

In the case of multiproperty exchanges, all liabilities with respect to which the taxpayer is relieved in the exchange are offset against all liabilities assumed by the taxpayer in the exchange, regardless of whether the liabilities are recourse or non-recourse and regardless of whether they are secured by or otherwise relate to specific property transferred or received as part of the exchange. If excess liabilities are assumed by the taxpayer in th exchange, the excess is allocated to all the properties received in each of the exchange groups, based on the relative FMV of the exchange groups.

The IRS stated that it adopted this approach over a specific identification approach because of its administrative simplicity. In fact, this rule may allow taxpayers to avoid the borrowing in anticipation of restriction, yet accomplish the same economic result through the transfer of other liabilities unrelated to the exchange (such as accounts payable and other notes payable.) However, the price for this simplicity may be that gain might now be recognized

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where it otherwise would not under existing law (see exhibit 3, page 84).

INTERESTS IN PARTNERSHIPS

The new rules make clear that exchanges of partnership interests after July 18, 1984, will not qualify under IRC section 1031, regardlesss of whether the interests exchanged are general or limited, or are interests in the same or different partnerships. Exchanges of partnership interests within the same partnership (that is, general to limited or vice versa), are not subject to this limitation. Rather, they are treated as a nontaxable distribution/recontribution under the general partnership taxation

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rules. This yields the same result as a non-taxable exchange.

Although the issue of whether a partnership interest can be exchanged for other property (land, for example) is not addressed, this transaction presumably would not qualify for like-kind treatment. Further, the IRS has asked for the comments of practitioners on the issue of whether an exchange of an interest in an organization that has elected out of the partnership rules can be eligible for nonrecognition treatment. The oil industry, in particular, commonly elects out of the partnership rules and is therefore concerned about the IRS's possible negative response. Thus, legislation already has been introduced to codify "prior legislative intent" that would allow entities electing out of the partnership rules not to be treated as partnerships for like-kind exchange purposes.

A STRAIGHTFORWARD APPROACH

In general, the new rules adopt a straightforward approach to addressing the major issues that rise in multiasset exchanges. These rules, as well as the deferred like-kind exchange rules, will allow for more certainty in properly structuring exchanges to help ensure like-kind nonrecognition treatment. Absent further legislative restrictions, the use of like-kind exchanges to defer income should continue to be a popular tax planning technique.

PHILIP J. WIESNER, CPA, JD, is a partner in the national tax practice of KPMG Peat Marwick, Washington, D.C. He is currently chairman of the American Institute of CPAs federal taxation division's partnership subcommittee and a member of the AICPA passive loss task force. DAVID G. MEULMESTER, CPA, is a senior manager in KPMG Peat Marwick's San Diego office. He is currently on a rotational assignment with the firm's national tax practice in Washington, D.C.