So what do you do when you own a fortune in stock but do not want to pay the tax man?
Let’s look at Philip and Nancy Anschutz and The Anschutz Company (TAC). Philip Anschutz (PA) began acquiring oil and mineral companies during the 1960s. He expanded his activities to include railroad, real estate and entertainment companies. This meant he owned large blocks of various companies’ stock, and he housed them in TAC. TAC was an S corporation, a fact which is important and to which we will return later.
Well, if you keep buying companies, eventually you wind up having a lot of money invested in those companies. In the late 1990s and early 2000s, PA and TAC began looking for ways to free up some of that invested cash.
In 2000 and 2001 TAC received approximately $375 million from a series of variable prepaid forward contracts with Donaldson, Lufkin & Jenrette (DLJ). The contracts involved shares of Union Pacific and Andarko Petroleum. DLJ later became part of Credit Suisse.
Let’s get into eye-rolling territory and talk about a “forward contract.” Here is an example:
You want to unload $250 million worth of AJ stock but delay any tax consequence. Tony Soprano (TS) wants to help you. You hire a firm (BADA BING) who proposes a business deal involving TS. You loan the stock to TS. No, instead you loan the stock to BADA BING and you grant TS a security interest in the shares. TS then sells the stock. TS sells short, though.
QUESTION: By selling short, TS is saying that he does not own the stock. This is consistent with the story so far, as you lent the stock to TS. TS has a security interest in the stock, but that interest is not the same as owning the stock. Therefore TS has to sell short. He is protected however because – if ever called upon – he can deliver your shares to close-out the trade. Remember, your shares are in his possession.
What do you get out of this? Nothing so far.
But let’s say that TS gives you 75% the money from the short sale. Ah, now you have something – you have cash in your pocket. The transaction as described is now a “prepaid” forward contract. The “prepaid” means that you got money.
There is more. You get a 5% prepaid lending fee because, by golly, you are lending the use of your shares to TS.
Somewhere down the line this story has to end, however. Say that 8 or 10 years down the road you are obligated to deliver to TS either:
· a (variable) number of AJ shares, or
· cash, or
· equivalent but not identical stock
The variable number of shares permitted to settle the contract makes this a variable prepaid forward contract.
There is also a way to do this with puts and calls and is referred to as a collar. It is interesting in a train-wreck sort of way, but let’s spare ourselves that discussion.
Let’s give TS some incentive to do the deal. We can add the following:
· If the stock appreciates over the term of the deal, you get the first 50% in appreciation but TS gets ALL the appreciation after that.
· TS kept 25% of the cash. He could invest it over the term of the deal and keep the earnings.
· TS did sell the stock short, so if the stock goes down, the short sale would earn TS additional profit.
· Upon the occurrence of certain events (bankruptcy, material change in economic position), TS could accelerate the settlement date of the deal.
How could TS lose money? TS already sold all the stock and paid you 75% of the proceeds. TS kept the remaining 25% for a period of time. Granted, TS did sell the shares short, so TS would have the risk of the stock going up in price over the term of the deal. This is how one loses money on a short sale, as it would make it more expensive for TS to close out his short position. But wait, TS has physical possession of your stock. If you do not make TS whole, he will simply take your stock to cover the short sale. What if the stock goes down? Then TS has a profit on the short sale. TS dealt a pretty good hand for himself.
How could you lose money? You really can’t. If the stock goes down, you buy it at the lower price and deliver it to TS. If the stock goes up you participate in the gain. Not all the gain, but still a gain. You lose by not making as much money as you could have by holding on to the stock. I can live with that kind of loss.
What was the underlying tax law that drove this transaction? Under long-standing tax law, a taxpayer did not have a sale - for tax purposes – of securities until the taxpayer delivered shares from his/her long position. In a forward contract, the delivery is delayed for years, possibly many years. So a forward contract, even a prepaid forward contract, of securities was not considered a "sale.” The IRS changed this in 1997 with Section 1259, which provided tax rules for constructive sales of financial positions. You may remember that you used to be able to protect an appreciated stock position at year-end by something called a “short sale against the box.” Then one day your accountant told you that you could not do that anymore because the law had changed. Tax law now requires you to have some level of risk in the position. The question is: how much risk?
Since TAC entered into these transactions in 2000 and 2001, it at least had the warning of Section 1259. TAC did not however have clarification of how far it could push the “link” between a variable contract and a stock loan. Tax law takes time to evolve. This is an innovative tax area involving financial instruments and derivatives, and tax clarification takes time. In 2006 the IRS finally gave warning that it did not like this structure. Too late for TAC to close the barn door, of course.
The IRS went after TAC.
What was the IRS position? We can hear the IRS saying:
“TAC did not keep enough risk to avoid a constructive sale of the Union Pacific and Andarko stock.”
What was TAC’s position? We can almost hear them saying:
“What are you talking about? We entered into two transactions - a prepaid variable and a stock loan, not one. The prepaid variable did not rise to the level of a constructive sale. The loan was to Wilmington Trust Company as collateral agent and trustee. Last time we checked, Donaldson, Lufkin & Jenrette was not Wilmington Trust Co.
In addition, is it fair to make tax law retroactive?”
In 2010 the Tax Court agreed with the IRS. TAC immediately appealed. The Appeals Court handed down its decision on Tuesday, December 27, 2011.
The 10th Circuit Appeals Court noted that TAC effectively exchanged its shares for …
(1) Upfront monies of 75% and 5%
(2) the potential to benefit to a limited degree if the pledged stock increased in value, and
(3) the elimination of any risk of loss of value in the pledged stock
NOTE: Think about this for a moment. TAC transferred its shares to DLJ and DLJ relieved TAC of any risk of loss. What does this sound like?
The 10th Circuit Appeals Court further reasoned that DLJ…
(1) obtained all incidents of ownership in the shares, including the right to transfer them
(2) acquired an interest in the property that it could not prudently abandon
(3) had a present obligation to pay monies to TAC
(4) had the right to sell or rehypothecate the shares
NOTE: DLJ had an immediate obligation to pay TAC and also had the right to sell the shares. What does that sound like?
Welcome to the new tax shelters. There was a time that shelters involved real estate or oil and gas and relied on nonrecourse loans or accelerated depreciation. Contemporary shelters use financial derivatives.
At the heart of this case is a metaphysical tax question: when is a sale a sale? The IRS did not challenge the substance of the deal. What it did challenge was this important detail: TAC lent its shares to DLJ to make the deal work. TAC argued that the stock loan and variable forwards were separate deals and that the stock was loaned to Wilmington Trust, not DLJ. The Tax Court in 2010 could not overcome the fact that, when TAC lent its shares, the shares were effectively gone and could not be recovered. A common factor of a sale is that the seller no longer has possession of the property sold.
Why did TAC do this? TAC is an S corporation. S corporations can pay tax if they have a unique fact pattern called “built-in gains.” Sure enough, TAC had built-in gains in the Union Pacific and Andarko stock. The built-in gain had a clawback period of ten years. Sale of property with built-in gains within this period triggers the built-in gains tax. TAC was trying to avoid the double-taxation of built-in gains and then capital gains.
TAC lost big. The taxes were about $110 million. Oh, add on about another $30 million for penalties and taxes. Since TAC was an S corporation, all its income, deductions and credits flowed-through to PA and were reported on his individual income tax return. This means that PA lost big too.
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