A New York utility, Niagara Mohawk, made payments of cash and stock in 1997 to owners of independent power plants that had long-term contracts to sell electricity to the utility to buy out the contracts. Electricity prices were lower in 1997 than when the utility signed the contracts. Niagara Mohawk wanted out of what, by then, had become bad deals.

The companies that received these buyout payments felt that their contracts were “involuntary converted.” That’s because Niagara Mohawk threatened at one point in the negotiations to seize their power plants by eminent domain if they failed to agree to a buyout of the contracts. The IRS agreed, and issued private rulings to that effect to many of the companies involved. This meant that they did not have to pay taxes immediately on the buyout payments provided the money was reinvested within two years in other property that is “similar or related in service or use to the property so converted.”

Some of the companies reinvested the money in new “greenfield” power plants that the companies had under development at the time. The IRS is now questioning on audit whether a power plant is “similar or related in service or use” to a contract to sell electricity.

The agency released in mid-April an internal memorandum written by an IRS associate chief counsel to the division that audits large and mid-sized businesses. The taxpayer whose case is addressed in the memo had his power contract bought out by a utility and, soon after, sold his power plant to a third party. He claimed that taxes could be deferred not only the buyout payment for the contract, but also the proceeds from sale of the power plant by using the amounts to acquire another power plant that was under construction at the time. The audit division asked the national office how much time it has to assess back taxes in the case. The memorandum is ILM 200315021.

In a related development, the IRS rejected a claim by another company on audit that insurance proceeds the company received to reimburse it for its environmental cleanup costs at contaminated sites were proceeds from an “involuntary conversion” of the contaminated sites. The IRS said the insurance policies were “commercial general liability” policies that protect the insured against liability to third parties. They were not received under property or casualty insurance that protects the insured from damage to his own property. The case is discussed in a “technical advice memorandum” that IRS released in late May. The number is TAM 200322017. A “technical advice memorandum” is a ruling by the IRS national office to settle a dispute between a taxpayer and an IRS agent stemming from an audit.