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Like-Kind Exchanges In The Energy Industry

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1 Like-Kind Exchanges In The Energy Industry
Parker C. Fielder Conference November 21-22, 2013 K. Peter Baumgarten Internal Revenue Service Washington, DC Todd D. Keator Thompson & Knight LLP Dallas, Texas Lou Weller Bryan Cave LLP San Francisco, California

2 Background General Rule – Gain or loss recognized upon a sale or exchange of property. § 1001. Current LTCG tax rate either 20.0% or 23.8%. Exception – Since 1924, no gain or loss recognized if disposition structured as a “1031 exchange” for “like kind” property. Purpose – Congress did not want to impose a tax on theoretical gain where taxpayer continued his investment in like kind property.

3 Exceptions Key exclusions: no stock, partnership interests, certificates of trust, or “dealer” property. Oil and gas tax partnerships must elect out of subchapter K prior to a 1031 exchange. No buying and “flipping” inventory. Special rules for related parties (1031(f)).

4 “Boot” Boot: taxpayer allowed to receive cash “boot” in the exchange, but boot is taxable to the extent of gain realized. Liability relief also considered boot, but may be offset by liabilities assumed in the exchange or cash paid in the exchange. Boot always recognized first without any basis offset.

5 Basis Basis: generally, basis in relinquished property rolls over into replacement property, with certain adjustments. MACRS – the default MACRS Treatment for replacement property is to “step into the shoes” of the relinquished property. Treas. Reg (i)-6.

6 Key Elements of § 1031 § 1031(a) provides: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such 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.” 3 prongs of the general rule: There must be an “exchange.” The exchanged properties must be “held for” productive use in trade or business or investment (“held for” test). The exchanged properties must be of “like kind.”

7 Meaning of “Exchange” Reciprocal transfer of property.
Sale and immediate reinvestment of cash does not qualify – can’t touch the cash. No requirement that exchange be simultaneous; forward and reverse exchanges are allowed (and normal). Special rules govern “exchanges of multiple properties.” Treas. Reg (j)-1. Cannot start a 1031 exchange with a lease (but oil & gas leases are different). Pembroke v. Helvering, 23 B.T.A (1931) (99-year lease).

8 The “Held For” Requirement
Both “relinquished property” and “replacement property” must be held for productive use in a trade or business or for investment. Intent determined at time of the exchange. Oil and gas properties generally qualify, unless held as dealer property. See, e.g., H.E. Gerke v. Comm’r, TC Memo ; FSA

9 Satisfying the “Held For” Requirement
Test is intent at the time of the exchange; prior bad intent may be converted to good. No bright line tests for holding period of relinquished or replacement property. Same taxpayer must start and complete the 1031 exchange; disregarded entities are disregarded. Ex.) TP owns royalties and exchanges them for working interests. For liability reasons, TP causes a new, 100%-owned LLC to take title to the working interests exchange still valid because the LLC is a DRE.

10 Meaning of “Like Kind” Broadly defined:
“The words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality The fact that any real estate involved is improved or unimproved is not material, for that fact relates only to the grade or quality of the property and not to its kind or class.” Any real property usually qualifies. By statute, foreign and domestic properties are never of “like kind.”

11 Oil & Gas Interests = Real Property Examples of “Like Kind”
Mineral properties for undivided interest in hotel (Comm’r v. Crichton, 122 F.2d 181 (5th Cir. 1941)); Undivided interest in unimproved real estate for interest in overriding oil and gas royalties (General Counsel Memorandum 34651); Working interests in two leases (Revenue Ruling );

12 Examples, cont’d Interest in a producing lease of an oil deposit in place for a fee interest in an improved ranch (Revenue Ruling ); Overriding oil and gas royalties for unimproved real estate (Revenue Ruling ). Note that the above examples are unlimited “economic interests” in oil and gas in place. See Palmer v. Bender, 287 U.S. 551 (1933); Rev. Rul

13 Potential Exceptions Production payments are treated as loans and are not “like kind” to other real property. Recapture items may not be deferred (e.g., depletion recapture cannot roll over into a fee interest in real property).

14 Potential Exceptions, cont’d
Personal property and equipment not like kind to real property, but might be like kind to other personal property and equipment acquired in the exchange. Personal property generally must be within same 6-digit NAICS code to qualify. Examples: (derricks, drilling equipment, drilling rigs); (oil-field pumps); (floating oil and gas drilling platforms); Pipelines not listed in any of these categories.

15 Pipelines and Distribution Systems
State law determines whether property is real or personal. Fixtures generally regarded as real property under most state law. Installed pipeline generally (but not always a fixture).

16 Pipelines, cont’d TX v. OK-
In Texas, pipelines are real property if they are buried. In Oklahoma, pipelines are personal property. Can a pipeline in TX be “like kind” to a pipeline in OK? IRS has tried to alleviate some of the tension for 1031 exchanges in ILM

17 Typical Exchange Structures
“Forward” Exchanges are products of IRC 1031(a)(3) and generally use a “Qualified Intermediary” (and sometimes a “qualified trust” or “qualified escrow”). “Reverse” Exchanges have no Code authority and rely on safe harbor Rev Proc , generally using an “Exchange Accommodation Titleholder.” 45-day “identification” and 180-day closing required.

18 Forward Exchange Taxpayer owns Barnett (“B”) Leases and desires to acquire Haynesville (“H”) Leases from Seller. However, Seller wants to sell H Leases for cash. A different Buyer, however, desires to purchase B Leases for cash. Taxpayer engages QI to facilitate the transaction. At closing, Taxpayer “transfers” B Leases to QI, and QI sells B Leases to Buyer for cash. Next, QI uses the cash to purchase H Leases from Seller, and then QI “transfers” the H Leases to taxpayer to complete taxpayer’s 1031 exchange. QI normally doesn’t take title to anything. Transfers typically occur via “direct deeding” per Reg authority. QI respected as the “exchange” counterparty (not agent).

19 Typical Forward Exchange
Direct Deed Seller - H (5) H (1) B (4) Cash Qualified Intermediary (QI) Taxpayer (6) H (3) Cash (2) B B Leases Buyer - B Direct Deed

20 “Identification” of Replacement Property
Identification for each “single exchange” is limited to 3 properties (without regard to the FMV) OR Any number of properties so long as aggregate FMV does not exceed 200% of FMV of the relinquished property. There is also safety valve 95% rule

21 Identification of Oil & Gas
Identification of Oil and Gas properties in 1031 exchanges raises several questions: Do non-contiguous properties under a single lease represent multiple properties for 3 prop/200% Rule? How specific do you need to be in identifying oil and gas properties? For oil & gas, each individual lease or royalty must be identified; thus, 200% rule usually applies.

22 Reverse Exchange Safe Harbor
The IRS issued a safe harbor Rev Proc pursuant to which taxpayers may safely engage in reverse 1031 exchanges. To summarize, the taxpayer engages an “Exchange Accommodation Titleholder” (EAT, similar to a QI) to “park” either the replacement property or the relinquished property in a “Qualified Exchange Accommodation Arrangement” (“QEAA”). Basic requirements: taxpayer and the EAT must enter into a written QEAA Agreement; if the replacement property is parked, taxpayer must properly identify the relinquished property in the same manner as described for forward exchanges; taxpayer must complete the entire transaction within 180 days; EAT must report itself as tax owner of the property it holds during the QEAA period.

23 Reverse Exchange Safe Harbor
Where EAT parks replacement property, known as Exchange Last QEAA, since exchange occurs at end when relinquished property is sold. This is most common structure. Where EAT parks relinquished property, known as Exchange First QEAA, since exchange occurs at beginning when replacement property acquired, EAT acquires and immediately trades for taxpayer relinquished property, holding it until sale. Benefits: taxpayer can safely loan money to the EAT to acquire the replacement property (whether or not it is to be parked), or taxpayer can guaranty loans to the EAT for such purpose. Taxpayer can lease the parked property from the EAT pending completion of the exchange for no rent. Taxpayer can also manage the parked property during such period.

24 Typical Exchange Last Reverse Exchange
Direct Deed Seller - H (3) H (1) Loan Cash (2) Cash (4) B Exchange Accommodation Titleholder (EAT) Taxpayer (7) H (8) Repay Loan (5) Cash (6) B B Leases Buyer - B Direct Deed

25 Key Issues in Oil & Gas Exchanges
Sale vs. Lease Recapture Tax Partnerships Royalty Trusts Unitizations and 1031(f) Exchange Bifurcation

26 Sale vs. Lease

27 1a. “DrillCo” owns a 75% working interest in approximately 10,000 acres (comprised of hundreds of individual leases). DrillCo has negotiated to sell the entire working interest to a purchaser (“Buyer”) for $100,000,000. Can Section 1031 apply to DrillCo’s transaction? 75% Working Interest Buyer DrillCo. $100,000,000 75% Working Interest 10,000 Acres

28 Example 1a – Authorities
The answer is yes. See GCM 39572; Rev. Rul ; GCM 34033; Rev. Rul ; Comm’r v. Crichton, 122 F.2d 181 (5th Cir. 1941); GCM 34651; Rev. Rul ; Rev. Rul ; Rev. Rul The answer would be the same upon an exchange of a lesser fraction of the working interest (e.g., 65% of the 75%). See Berry Oil Co. v. U.S., 25 F. Supp. 96 (Ct. Cl. 1938); Ratliff v. Comm’r, 36 B.T.A. 762 (1937).

29 1b. Continue assuming that DrillCo owns the 75% working interest, but now DrillCo instead agrees to sell only a 25% overriding royalty in the leases to the Buyer for $25,000,000. Can Section 1031 apply? 25% Overriding Royalty Buyer DrillCo. $25,000,000 75% Working Interest 10,000 Acres

30 Example 1b – Authorities
Probably so. See PLR (exchange of working interests for overriding royalty interests in the same properties qualified as a Section 1031 exchange); G.C.M (carved out net profits interest is not an assignment of income); G.C.M (sale of carved out royalties). Any issue with the “held for” test? Probably not. See Fleming v. Comm’r, 241 F.2d 78 (5th Cir. 1957), rev’d sub nom. Comm’r v. P.G. Lake, 356 U.S. 260 (1958).

31 1c. Assume DrillCo negotiates a better deal to sell the 75% working interest to Buyer for (A) $100,000,000 and (B) retention of an overriding royalty (an “ORRI”) equal to 25% less all landowner royalties on the leases. Thus, on leases burdened by a 20% landowner royalty, the ORRI will be 5%, but on leases burdened by a 25% landowner royalty, there will be no ORRI. Is the transaction eligible for a 1031 exchange? 75% Working Interest Buyer DrillCo. $100,000,000 75% Working Interest Retained ORRI 10,000 Acres

32 Example 1c – Authorities
The answer is determined on a lease-by-lease basis. See Cullen v. Comm’r, 118 F.2d 651 (5th Cir. 1941) (whether a sale or lease occurs must be determined on a property-by-property basis). The answer is no for any leases upon which DrillCo retains an ORRI. See Crooks v. Comm’r, 92 T.C. 816 (1989) (retention of a royalty in the “sale” of mineral interests converts the transaction into a lease for federal income tax purposes; Section 1031 is not available); Rev. Rul The answer is yes for leases upon which DrillCo does not retain an ORRI.

33 Example 1c, Continued Can DrillCo change the business deal and fix the problem? Probably so. Some possibilities are: Don’t retain an ORRI and instead ask for more cash or other consideration. Sell a smaller working interest for the same cash payment. Re-define the retained “ORRI” so that it is not a “royalty” for federal income tax purposes (e.g., use a term shorter than the expected life of the burdened properties). What impact does this have on the Buyer? See Cullen and PLR (re. retained production payments). Beware retained production payment on “wildcat” acreage! See Watnick v. Comm’r, 90 T.C. 326 (1988).

34 1d. Now assume instead that Drillco sells the 75% working interest to Buyer for $75,000,000 plus reservation of the ORRI, and at closing, Drillco also sells the ORRI to a third party for $25,000,000 as part of an integrated plan. Can Drillco use the $100,000,000 total consideration in a Section 1031 exchange? ORRI ORRI Buyer 75% Working Interest Buyer $25,000,000 DrillCo. $75,000,000 75% Working Interest Retained ORRI 10,000 Acres

35 Example 1d – Authority Because DrillCo has disposed of its entire interest in the leases in one transaction, the answer should be yes, but is not clear. See FSA (sales of working interests to third parties, coupled with reservation of ORRIs and contemporaneous conveyance of ORRIs to trust for benefit of seller’s children, respected as sales of the working interests for federal income tax purposes).

36 1e. Assume that DrillCo wants to preserve the ORRI as part of the deal with a potential buyer. Thus, prior to entering into discussions with Buyer, DrillCo carves off the ORRI and assigns it to a separate, related entity (“Related Party”) for a business reason. Later, DrillCo negotiates the same deal with Buyer, except that DrillCo’s sale to Buyer now is “subject to” the pre-existing ORRI held by Related Party (instead of DrillCo reserving the ORRI at closing). Can DrillCo use a Section 1031 exchange? Later, convey % Working Interest First, assign ORRI Related Party Buyer DrillCo. $100,000,000 75% Working Interest 10,000 Acres

37 Example 1e – Authorities
The answer clearly is yes under the form of the transaction because DrillCo has sold a working interest and has not “retained” an ORRI as part of the transaction with Buyer. Instead, the ORRI is a pre-existing interest owned by a separate taxpayer (Related Party). Cf. Badger Oil Co. v. Comm’r, 118 F.2d 791 (5th Cir. 1941). Can IRS attack the transaction on substance over form or step transaction grounds. Provided DrillCo has a bona fide business purpose and the assignment has economic substance, DrillCo’s Section 1031 exchange should be valid. See FSA What business purposes might suffice?

38 Example 1e - Continued What if Drillco is a partnership, and Drillco carves off and distributes the ORRI to its partners the day before closing, to be held by the partners in proportion to their % interests? In form, the answer looks the same at 1(d). In substance, this transaction seems more vulnerable on economic substance or step transaction grounds.

39 Recapture

40 2a. Assume DrillCo owns a working interest upon which DrillCo has 3 operating wells. Drillco previously has taken IDC deductions of $500 and depletion deductions of $600. At a time when Drillco’s adjusted basis in the working interest is $0, Drillco sells the working interest to Buyer for $2,000. What result? 75% Working Interest Buyer DrillCo. $2,000 75% Working Interest Prior IDC = $500 Prior Depletion = $600 3 Operating Wells

41 Example 2a – Authorities
Drillco recognizes gain of $2,000. IRC § $1,100 of such gain is recaptured as ordinary income. IRC § 1254. i.e., must recognize recapture in an amount equal to the lesser of prior deductions ($1100) or gain from the sale ($2000).

42 Other producing working interests?
2b. Recall that DrillCo contemplates selling working interests subject to $500 of IDC recapture and $600 of depletion recapture. Now assume that Drillco is investigating a possible Section 1031 exchange of the working interest for the following property interests (each valued at $2,000) and asks you what recapture it might face in the exchange: Other producing working interests? Drillco recognizes no gain pursuant to the Section 1031 exchange and is not required to recognize any recapture. Treas. Reg. § (d). Instead, the recapture of $1,100 rolls over and remains preserved in the replacement properties. Treas. Reg. § (d). Reason: No recapture required if “Sec property” is exchanged solely for other “Sec property.” Exception: Must still recapture to the extent of boot and like kind property that is not Sec property received in the exchange.

43 Example 2b, Continued Royalties worth $1,800 and $200 cash boot?
Drillco must recapture $200, to the extent of the cash boot. A ranch in Montana? Because the ranch is “like kind,” Drillco recognizes no gain from the exchange but must recapture all $1,100 of prior deductions because the ranch is not “section 1254 property.” Treas. Reg. §§ (d), (b)(2). Other working interests with producing wells ($1,500) and a ranch in Montana ($500)? Again, Drillco recognizes no gain pursuant to the Section 1031 exchange but must recapture $500 of prior deductions because the ranch is not “section 1254 property.” Treas. Reg. §§ (d), (b)(2).

44 Example 2b, Continued Undeveloped leases in a recently-discovered shale play? The answer depends on whether undeveloped leases constitute “section 1254 property.” See Treas. Reg. § (b)(2)(iv)(A) (defining property as Sec property in part if the property “is an operating mineral interest with respect to which the expenditure [IDC] has been deducted.” Note the past-tense language – may mean recapture is required on exchange of producing for nonproducing. Contrast § 1245 and § 1250 recapture which define “section 1245 property” and “section 1250 property” as property “which is or has been property of a character subject to the allowance for depreciation.”

45 Tax Partnerships

46 3a. DrillCo owns a 75% working interest in Texas leases
3a. DrillCo owns a 75% working interest in Texas leases. DrillCo sells half of the leases to Buyer for $1,000,000. DrillCo and Buyer execute a joint operating agreement appointing DrillCo operator. The first well is a gusher. Investor then seeks to purchase DrillCo’s 37.5% working interest for $10,000,000. Can DrillCo structure the deal as a 1031 exchange? 37.5% Working Interest Buyer DrillCo. $1,000,000 75% Working Interest After the sale, the parties own the Texas Leases 50/50. They execute a JOA. Texas Leases

47 Example 3a – Authorities
Yes, unless the WI is subject to a tax partnership. By default, the working interest jointly owned and operated by Drillco and Buyer creates a tax partnership. See Bentex Oil Corp. v. Comm’r, 20 T.C. 565 (1953); I.T. 2749, XIII-1 C.B. 99 (1934). Notwithstanding the tax partnership, Drillco and Buyer may jointly elect out of subch. K, and then Drillco may proceed with a 1031 exchange. §761(a). Election out effective as of first day of taxable year for which the election is filed.

48 3b. Now assume that the consideration paid by Buyer for half of Drillco’s working interest is (A) $1,000,000 plus (B) Buyer’s obligation to pay 100% of the cost of the first 3 wells to be drilled on the property. Buyer and Drillco will divide all revenues 50/50. As a practical matter, will Buyer consent to Drillco’s request to elect out of Subchapter K? 37.5% Working Interest Buyer DrillCo. $1,000, well carry obligation 75% Working Interest After the sale, the parties own the Texas Leases 50/50. They execute a JOA. Texas Leases

49 Example 3b – Authorities
Not likely. The arrangement does not satisfy the “complete payout” rule. See Rev. Rul ; Rev. Rul Thus, Buyer needs the tax partnership in place in order to deduct 100% of the IDCs funded by Buyer on the first 3 wells. As a practical matter, Drillco probably cannot obtain Buyer’s consent to elect out, meaning Drillco cannot dispose of the 37.5% working interest in a Section 1031 exchange.

50 3c. Now assume that DrillCo contributes appreciated leases to a tax partnership and Buyer contributes cash to develop the properties. Later, the tax partnership acquires additional leases within an AMI. Three years later, after Buyer has deducted all of its IDCs, DrillCo locates a purchaser for its share of the leases and requests and election out of subchapter K. Issues? Buyer DrillCo. Cash Appreciated Leases Tax Partnership

51 Example 3c – Authorities
DrillCo may recognize gain due to the distribution of the AMI properties. See IRC Sec. 737. See also IRC Sec. 704(c)(1)(B).

52 Royalty Trusts

53 Exchange Counterparty
4. DrillCo desires to exchange a 75% working interest (valued at $5,000,000) for 100,000 units in the W&K Royalty Trust (valued at $5,000,000). The W&K Royalty Trust (a) is publicly traded on the NYSE, (b) is a “grantor trust” for federal tax purposes, and (c) owns thousands of interests classified as oil and gas royalties for federal tax purposes. Are the properties “like kind”? 75% Working Interest Exchange Counterparty DrillCo. 100,000 units in W&K Royalty Trust

54 Example 4 – Authorities Prohibited trust interest?
See Rev. Rul addressing a non-public Delaware Statutory Trust. See also CCA (grantor trusts are “DREs”). Prohibited security? See G.C.M (whisky warehouse receipts were not “securities” for purposes of Section 1031); Plow Realty Co. of Texas v. Comm’r, 4 T.C. 600 (1945) (mineral deeds were not securities under [former] Section 543 even though they were securities under the securities laws). Eligible real property? Identification? IRS opinion?

55 Unitizations and Related Parties

56 5a. A and B each own 80 acres of contiguous mineral property, each with a FMV of $100 and basis of $0. State implements a unitization program and forces A and B to combine their 80 acre tracts into one 160-acre unit. A and B each receive a 50% interest in the 160-acre unit. Is this a 1031 exchange? Before Unitization After Unitization A – 50% B – 50% A – 80 acres B – 80 acres

57 Example 5a – Authorities
Unitization qualifies as a 1031 exchange. See Rev. Rul (unitization of oil and gas interests was a 1031 exchange); GCM (same).

58 5b. Same question as 5a, but now assume that A and B are father and son, and that one year later A sells his 50% interest in the unit for $200. Before Unitization After Unitization A – 50% B – 50% A – 80 acres B – 80 acres

59 Example 5b – Authorities
The original 1031 exchange may no longer be valid. See IRC 1031(f)(1). Does the “no tax avoidance purpose” exception apply? See IRC 1031(f)(2)(C).

60 Exchange Bifurcation

61 6. DrillCo owns 50,000 acres in the H Shale
6. DrillCo owns 50,000 acres in the H Shale. Half of the acreage is located in De Soto Parish, and the other half in Red River Parish. DrillCo accepts an offer to sell everything to Buyer for $500 million. DrillCo desires to acquire new leases in the Eagle Ford Shale for at least $250 million, and possibly up to $500 million. Therefore, DrillCo structures the sale of the H acreage as a 1031 exchange. DrillCo asks if it can split the transaction into 2 separate exchanges ($250M each). Why? Is this possible? DrillCo’s H Acreage De Soto FMV $250 Million Basis $20 Million BIG $230 Million Red River FMV $250 Million Basis $200 Million BIG $50 Million Buyer 50,000 Acres $500 Million QI *Total BIG = $280 Million

62 Example 6 – Authorities Can the transaction be bifurcated into two exchanges? Maybe. See Sayre v. U.S., 163 F. Supp. 495 (D. W.Va. 1958); Serdar v. U.S., TC Memo Factors: Separate PSAs? Separate negotiation? PSAs cross-conditioned? Division of assets along natural lines? Different closing dates? Different buyers? Do separate QIs solve the problem? Is a business purpose required?


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