Contract buyout payment recipients got good news.

The Internal Revenue Service ruled privately that the owner of a power plant who agreed to cancel a long-term contract to supply electricity to the local utility for a lump-sum buyout payment not only did not have to pay taxes immediately on the buyout payment, but also could use the payment to pay down debt on another power plant that an affiliated company had under construction at the time.

When utilities signed contracts years ago to buy electricity from independent power producers, electricity prices were much higher than they are today.  Utilities chafe at the high prices in such contracts.  The power plant owner in this case eventually agreed to let the utility buy out its contract for a combination of cash and common stock in the utility.  During negotiations, the utility proposed to its state regulators that it be allowed to take over power plants by eminent domain from any generators who refuse to restructure their contracts.  The threats by the utility led the IRS to rule privately in December 1999 that the contract was “involuntarily converted” into cash.  A taxpayer who is effectively forced under threat of condemnation to take cash for his property does not have to pay taxes immediately on the buyout payment as long as the money is reinvested within two years in other property that is “similar or related in service or use.”

The IRS issued a series of rulings in the late 1990’s confirming that a number of power contracts with utilities were involuntarily converted.

However, the agency declined at the time to address what the money could be reinvested in.  Each of the bought-out contracts was tied to a particular power plant.

Some independent power companies used the money to pay down debt on other power projects and have been challenged by IRS agents on audit.  One such case went to the IRS national office for resolution.  The national office said in a private ruling — called a “technical advice memorandum”— that the buyout payment could be used to pay down debt in another power project that was under construction when the buyout payment was received.

The case involved in the audit raised two issues.  One is whether a power plant is “similar or related in service or use” to a power contract.  The IRS national office said yes.  It views a power plant and contracts tied to it as a single economic unit.  Compensation for any part of the economic unit can be reinvested in property that is similar to another part of the unit.  Therefore, a buyout payment for a power contract can be reinvested in a power plant.

The other issue was whether the independent power producer “purchased” replacement property with the buyout payment.  The tax laws bar reinvestment in property acquired from an affiliate of the taxpayer, unless the affiliate acquired the property from a third party during the two-year period for reinvesting the buyout payment.  The taxpayer acquired the affiliate’s power plant by merger before the debt was paid down.  The debt the buyout payment was used to repay was owed to the parent company of the taxpayer.  Nevertheless, the IRS said the transaction qualified because — before the merger — the affiliate had paid a unrelated construction contactor to build the power plant.  Thus, the power plant was purchased from a third party.

The ruling is TAM 200411001.  The IRS made it public at the end of March.

Keith Martin