Employee home transactions by relocation companies: a critical analysis.

• Author: Roberts, David J.

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...