Internal Revenue Service (IRS)
General Counsel Memorandum (GCM)
Date Numbered: July 17, 1986
March 11, 1986
26 USC § 501 — Exemption From Tax on Corporations, Certain Trusts
26 USC § 1031 — Exchange of Property Held for Productive Use or Investment
Charles M. Morgan III
Associate Chief Counsel (Technical)
Attention: Director, Corporation Tax Division
This responds to your memorandum of October 18, 1985, requesting our advice on the following issue.
Whether the taxpayer, a ‘mutual ditch or irrigation company’ under IRC 501(c)(12)(A), may make a section 1031 tax-free exchange of land in return for stock in another such company.
Because IRC 1031 specifically excludes stock from nonrecognition treatment, and because we do not think the state law characterization of mutual ditch company stock overrides this exclusion, the exchange would not qualify for the nonrecognition treatment of section 1031.
Taxpayer is a ‘mutual ditch or irrigation company’ under section 501(c)(12)(A) of the Internal Revenue Code. It provides water to its member/shareholders, which include a * * * (* * *%) and farmer/rancher irrigators (* * *%). Taxpayer holds legal title to various parcels of land, water and water rights. Taxpayer proposes to convey a parcel of reservoir land (prime development land) valued at $ * * * to a developer, in exchange for $ * * * worth of stock in other ‘mutual ditch or irrigation companies’ and its own stock. Taxpayer presently owns stock in these companies and relies on their water to support some of its operations.
A. SECTION 1031 GENERALLY
IRC 1031 permits deferral of the recognition of gain realized in an exchange of property, and constitutes an exception to the general rule of IRC 1001(c) requiring recognition of gain upon the sale or exchange of property. Treas. Reg. 1.1002-1(b) provides that IRC 1031 must be construed strictly, and restricts nonrecognition under the section to exchanges that satisfy both the specific language and the underlying purpose of the section.
B. REQUIREMENTS FOR NONRECOGNITION UNDER SECTION 1031
Qualification for nonrecognition treatment under IRC 1031 requires an exchange of property held for productive use in a trade or business or for investment. The property transferred and the property received must be of ‘like kind’. Certain property, however, is specifically excluded from qualification for nonrecognition treatment. These requirements will be examined separately in connection with the taxpayer’s contentions.
1. ‘LIKE-KIND PROPERTY’ REQUIREMENT
Property received in an exchange must be of a ‘like kind’ to the property relinquished in the exchange. Treas. Reg. 1.1031(a)-l(b) provides:
As used in section 1031(a), the words ‘like kind’ have reference to the nature or character of the property and not to its grade or quality . One kind or class of property may not, under that section, be exchanged for property of a different kind or class. 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.
Clearly real property is a different kind or class of property from stock for federal tax purposes. It cannot be said that stock in a mutual ditch of irrigation company differs only in grade or quality from a parcel of land. Because the proposed transaction presumes the exchange of real property for stock, the exchange, on its face, appears not to fulfill the ‘like kind’ requirement.
a. STATE LAW
The taxpayer, however, asserts that under Colorado law, ownership of shares of stock in a mutual ditch company is merely incidental to the ownership of water rights and therefore the taxpayer is receiving real property interests in the form of water rights in exchange for a parcel of land, thus qualifying as a ‘like kind’ exchange.
The taxpayer cites Jacobucci v. District Court, 189 Colo. 380, 541 P.2d 667, 672 (1975) for the proposition that shares of stock in a mutual ditch corporation represent a ‘definite and specific water right, as well as a corresponding interest in the ditch, canal, reservoir, and other works by which the water right is utilized.’ The issue in Jacobucci was whether the individual shareholders of a mutual ditch company were indispensable parties in an action to condemn the shareholders’ decreed water rights. The court stated that mutual ditch companies in Colorado exist solely for the convenience of their shareholders and represent the consumers’ interest in the reservoir, canal, and water rights. Id. The court concluded that for STANDING PURPOSES (INDISPENSABLE PARTY ISSUE) because of the unique character of these corporations, a ‘different treatment which is not fully in accord with the principles applicable to corporations in general’ should be applied. Id.
The court in Jacobucci never suggested that the stock interest held by the shareholders was illusory. It merely stated that a shareholder in a mutual ditch corporation possessed one attribute of ownership representing a specific property interest in a water right, for indispensable party purposes. In fact, the court recognized that the rights of the shareholders were not identical to those of the corporation: ‘The relationship between the corporation and its shareholders arises out of contract, implied in a subscription for stock and construed by the provisions of a charter and articles of incorporation’. Id. at 671. Additionally, ‘the right of the corporation to hold title to the water rights and other property and to manage the affairs of the corporation, should be distinguished from the right of the shareholders to use the water on their lands.’ Id. at 674. The court was not indicating that the rights of shareholders in a mutual ditch company are synonymous with corporate ownership rights in property held for productive use or investment.
The taxpayer also cites Great Western Sugar Co. v. Jackson Lake Reservoir and Irrigation Co., ___ Colo. ___, 681 P.2d 484 (1984) for the proposition that ‘ownership of shares of stock in a mutual ditch corportion, unlike ownership of stock in other corporate entities, is merely incidental to the ownership of the water rights.’ Id. at 491. Similar to Jacobucci, the court in Great Western Sugar Co. was deciding a narrow state law issue. The issue related to implied restrictions on the use of storage water derived as a result of ownership of stock in a mutual ditch company. The court in Great Western Sugar Co., as in Jacobucci, acknowledged that ownership of stock is not tantamount to possessing water rights. The court stated that shareholders’ ownership rights are defined in part by the terms of the articles of incorporation, bylaws, corporate resolutions and terms of any applicable stock certificates. Id. at 490.
In Kendrick v. Twin Lakes Co., 58 Colo. 281, 144 P. 884 (1914) and Beaty v. Commissioners, 101 Colo. 346, 73 P.2d 982 (1937), the courts held that stock in mutual irrigation companies represented water rights which constituted part of the real estate and as such were taxable as part thereof. In Comstock v. Olney Springs Drainage Dist., 97 Colo. 416, 50 P.2d 531 (1935), the court similarly decided that because such stock represented the consumer’s interest in the reservoir, canal, and water rights, an assessment based on a statute which enabled assessment on ‘real property’ was proper.
The courts in the above cases, however, never intimated that mutual ditch company stock was sufficiently similar to real property so as to constitute ‘like kind’ property. The courts merely held that because this type of stock comprehended certain real property interests, it was subject to real property classification for specific local issues under certain circumstances. Because mutual ditch company stock encompasses other attributes, characteristics, and features, separate and distinct from those of real property, we believe that the exchange cannot satisfy the ‘like kind’ requirement.
Support for this position can be found in Denver Joint Stock Land Bank v. Markham, 106 Colo. 509, 107 P.2d 313, 315 (1940), where the Supreme Court of Colorado held that shares of stock in a mutual ditch company were not simply ‘muniments of title’ to water rights constituting real property. In Denver Joint Stock Land Bank, the issue was whether a deed that purported to transfer all ‘water rights’ did in fact transfer certain stock certificates in a mutual ditch company. The court distinguished Kendrick, Comstock and Beaty because of ‘the dissimilarity of the facts involved’, and held that because the shares of stock were not specifically mentioned in the deed, the shares were not transferred. Id. at 315-316.
Another related case is McComb v. Farmers Reservoir & Irrigation Co ., 167 F.2d 911 (10th Cir. 1948). In McComb, the issue was whether employees of an irrigation company were engaged in ‘agriculture’ within the exemption provisions of the Fair Labor Standards Act. If the employees were viewed as employees of the farmers, they would clearly fall within the exemption provisions. The court, citing Kendrick, Comstock and Beaty, stated that:
The defendant is a mutual irrigation company organized under the laws of Colorado, and it is the law of that state that IN RESPECT OF THE IMPOSITION OF SPECIAL ASSESSMENTS OR THE LEVYING OF AD VALOREM TAXES a corporation of that kind is to be treated as one organized for the convenience of its members in the distribution of water for use upon their land in proportion to their respective stock interests. . . . But local law, relating to the imposition of special assessments or the levying of ad valorem taxes is not the test for determining whether the employees of such a corporation are engaged in agriculture within the meaning of section 13(a)(b), supra.
The defendant is a corporate entity, separate and distinct from the farmers to whom it furnishes water for irrigation. Its employees are under its direction and control, and they are engaged in keeping its property in operating condition and in operating its irrigation system. They are not employed by the farmers and are not under their direction or control. . . . McComb at 915 (emphasis added).
Because of the corporate entity, employees were deemed to be engaged in activities ‘separate and distinct from the farming operations of the farmers ‘ and therefore ‘not engaged in agriculture’ within the meaning of the Act. McComb at 915.
In some instances, an examination of relevant state law is in order to determine whether certain rights are to be considered property rights of a ‘like kind’. See Commissioner v. Crichton, 122 F2d 181 (5th Cir. 1941), acq. 1952-1 CB 2, Rev. Rul. 55-749, 1955-2 CB 295, which was considered in ___, GCM 29118, A-615594 (Sept. 30, 1965). This, however, has only been applied to water, gas, oil and mineral rights. Because the characteristics of water, gas, oil and mineral rights are such that their property CLASSIFICATION is not readily apparent, state law has been considered in determining the nature of the legal interest possessed.
In GCM 29118 at 2, we concluded that ‘under the circumstances in the instant case water facilities in an irrigation district are considered to be a necessary adjunct to arid land in such district so as to constitute property of like kind within the meaning of the statute.’ This conclusion was based in part on a state statute which stated that both land and water rights were included within the definition of ‘real property’ or ‘real estate’ and that water rights were deemed appurtenant to and a part of the land irrigated thereby.
However, even assuming arguendo, that a state were to classify mutual ditch or irrigation stock as a real property interest, it would not necessarily follow that this classification would be accepted for federal tax purposes and the ‘like kind’ requirement. Because the classification of such stock is readily apparent for ‘like kind’ purposes, state law classifications are not determinative. Although a water right could possibly be classified as real property for ‘like kind’ purposes under Colorado law, we believe that this ‘classification’ cannot be extended to mutual ditch company stock.
In Rev. Rul. 55-749, 1955-2 CB 295, the Service stated that the fact that two varieties of property, namely water rights and a fee interest in land, may be legally classified as real property, does not of itself signify that the two are property of like nature or character within the meaning of section 1031(a) of the Code. Citing Fleming v. Commissioner, 24 T.C. 818 (1955), the Service concluded that ‘there must be considered not alone the nature and character of the physical properties but also the nature and character of the title conveyed or the rights of the parties therein’ and that ‘the properties exchanged must be of the same general character or of substantial equality’. Id. at 296.
We believe that in our situation as in McComb, the mutual ditch or irrigation company entity cannot be disregarded and that as in Denver Joint Stock Land Bank the mutual ditch company stock is not merely a ‘muniment of title’ to water rights. In other words, it is evident that the ownership of mutual ditch company stock comprehends significant rights, attributes and obligations which are distinct from those arising from the ownership of water rights. In the proposed transaction, therefore, stock, not water rights, would be exchanged for real property, thus resulting in an exchange that would not qualify as ‘like kind’.
b. NATURE AND CHARACTER
Exemption depends upon the receipt of ‘like kind’ property. The Tax Court, in Koch v. Commissioner, 71 TC 54, 63-65 (1978), acq. 1979- CB 1 has aptly stated that,
The basic reason for allowing nonrecognition of gain or loss on the exchange of like kind property is that the taxpayer’s economic situation after the exchange is fundamentally the same as it was before the transaction occurred. ‘(I)f the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit. H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 564. . . . The underlying assumption of section 1031(a) is that the new property is substantially a continuation of the old investment still unliquidated.’ Commissioner v. P.G. Lake, Inc., 356 U.S. 260, 268 (1958).
Thus, section 1031(a) requires a comparison of the exchanged properties to ascertain whether the nature and character of the transferred rights in and to the respective properties are substantially alike. In making this comparison, consideration must be given to the respective interests in the physical properties, the nature of the title conveyed, the rights of the parties, the duration of the interests, and any other factor bearing on the nature and character of the properties as distinguished from their grade or quality . . . . The comparison should be directed to ascertaining whether the taxpayer, in making the exchange, has used his property to acquire a new kind of asset or has merely exchanged it for an asset of like nature or character.
We believe that the stock received is not ‘substantially a continuation’ of the parcel of land relinquished, ‘still unliquidated.’ The taxpayer immediately achieves a considerable degree of liquidity as a result of the exchange. Additionally, ownership attributes of the stock will be governed by Bylaws, Articles of Incorporation, voting rights, and other restrictions incident to the stock received. Therefore, the reason for allowing nonrecognition under the provisions of section 1031(a) would not apply.
2. EXCLUDED PROPERTY
IRC 1031(a) specifically excludes certain categories of property from qualification for nonrecognition treatment. This is so regardless of the fact that the property exchanged would have been classified as ‘like-kind’, but for the express disqualification. IRC 1031(a)(2) specifically excludes stock or securities.
There apparently has been no controversy to date in determining when property constitutes ‘stock’ or when ‘stock’ might constitute real property for purposes of IRC 1031. There are neither regulations nor rulings on point. Nor is ‘stock’ defined in the Internal Revenue Code. We believe that the term ‘stock’ should be given its ordinary meaning, as evidence of the right of the holder or owner to share in the proceeds of a corporation’s property, in the form of transferable shares of a specified amount. As previously stated, the corporate entity, together with its attributes, cannot be disregarded. Therefore, the certificates to be received by the taxpayer would constitute ‘stock’ and, as such, would not qualify for non-recognition treatment.
b. UNDERLYING PURPOSE
The 1921 Revenue Act 202(c)(1) did not exclude from nonrecognition, exchanges of stocks, bonds, notes, securities, etc. However, the specific exclusions emphasized above were added to the predecessor of IRC 1031 by the Act of March 4, 1923, which amended the Revenue Act of 1921. Pub. L. No. 545, 67th Cong., 4th Sess 42 Stat. 1560 (1923). The origins and articulated history of section 1031 disclose a concern for the taxpayer who continues to have his money tied up in similar property, and the basic unfairness of imposing a tax when there is a continuation of an unliquidated and relatively liquid investment. See H . Rept. No. 704, 73rd Cong., 2nd Sess. (1934), 1939-1 (Part 2) C.B. 564 . However, to the extent that the original provisions of the 1921 Act would be used in connection with the reinvestment of funds so as to avoid tax, an amendment was deemed necessary. See G. Holmes, ‘Federal Taxes’, 1923 edition, at 528. It was felt that this abuse was present especially in the case of stocks and bonds. See S. Rept. No. 1113, 67th Cong., 4th Sess. (1923), 1939-1 (Part 2) C.B. 845-846 (adopting H. Rept . No. 1432, 67th Cong., 4th Sess.)
The taxpayer does not continue to have his money tied up in similar property. Nor can it be said that there is a continuation of an unliquidated and relatively illiquid investment. It is essential to recognize that unless an exchange falls clearly within the provisions of this nonrecognition section, the question of taxability should be determined by the general principles enumerated in IRC 1001(c). Because exceptions to the general rules regarding recognition of gains or losses must be strictly construed and because the transaction contemplates an exchange of stock for a parcel of land, the nonrecognition provisions of IRC 1031 would not apply.
James F. Malloy
Michael D. Finely
Assistant Chief, Branch No. 3