When Is a Loan a Sale?

Sometimes I am amazed at the lengths to which some people will go to not pay taxes.

I was reading Sollberger v Commissioner, recently decided by the Court of Appeals for the Ninth Circuit.

Before getting into Sollberger, let’s talk about Derivium Capital.  Derivium was based in Charleston, South Carolina, and was headed by Charles D. Cathcart, an economist whose resume included a University of Virginia Ph.D., a stint at the CIA and a term at Citicorp working with derivatives.  Derivium presented a way for taxpayers to dispose of significant stock positions without triggering immediate tax. At least that was their pitch. They would lend up to 90% of a stock position on a nonrecourse basis. Nonrecourse means that the borrower could walk away from the debt. If memory serves, their deals generally ran approximately three years, and their loans did not require interest payments. Rather the interest was added to the loan. At the end of the term, the borrower could repay the loan, plus interest, and get the stock back. It goes without saying that one would do this only if the stock had appreciated. Otherwise the borrower would simply walk away from the loan.

Derivium would immediately sell the stock, providing money for the loan back to the borrower. In addition, they wrapped the loans using offshore lenders, first using a company in Ireland and then another company in the Isle of Man. This was apparently a good deal for Derivium, as it received approximately $1 billion in stock, originated $900 million in loans, kept $20 million and sent the rest to the offshore lenders.

Nice payday, when you can get it.

You can guess how this tuned out. Derivium was investigated by the IRS and the state of California and then filed for bankruptcy. Once the IRS stepped-in, they began looking at the other side of the transaction, which meant looking at the individual returns of the people who had transacted with Derivium.

Enter Kurt Sollberger. He transacted with a company called Optech, not Derivium, but it was a Derivium-inspired deal. Sollberger was president of Swiss Micron, which adopted an Employee Stock Ownership Plan (ESOP). In 2000 he sold his shares to the ESOP for a little more than $1 million. With the money he bought floating rate notes (which is pretty esoteric by itself). In 2004 he entered into the loan deal with Optech. That deal was pretty sweet. Optech loaned him 90% on a seven year nonrecourse debt, with the option of adding interest into the loan. Optech would collect interest from the notes (at least, until Optech sold them) and in turn charge Sollberger interest. If there was net interest due, Sollberger could pay the interest or add it into the note. He could not prepay the loan for seven years, however, at which time he could get retrieve the notes by repaying the loan with accrued interest.  That would be awkward for Optech, seeing how it had SOLD the notes.

Then it gets weird.

Sollberger received quarterly statements from Optech for less than one year. He diligently paid the net interest due. Then Optech quite sending statements and he quit paying interest.

Sure, happens all the time. When was the last time Fifth Third forgot to bill the interest on your loan?

The IRS audited Sollberger, said he sold the notes in 2004 and sent him a bill for $128,979, plus interest and penalties.

Sollberger went to Tax Court, which recognized the Derivium-inspired deals. It did not go well. After losing there, Sollberger petitioned the Ninth Court of Appeals. The Court had some trenchant observations:

If the FRN’s lost value after Sollberger transferred them to Optech, he would have been foolish to repay the nonrecourse loan at the end of the loan term, as he had no personal liability for the principal or interest allegedly due.”

Sollberger’s and Optech’s conduct also confirms our conclusion that the transaction was, in substance, a sale. Although interest accrued on the loan, Sollberger stopped receiving account statements and making interest payments after the first quarter of 2005, less than one year into the seven-year term. Thus, neither Sollberger nor Optech maintained the appearance that a genuine debt existed for long.”

Although the transaction is byzantine, the tax concept involved is simple: how far can someone push the limits of a “loan” before a reasonable person simply concludes that there was a sale. A seven-year nonrecourse loan looks very aggressive, and stopping interest payments less than a year into the loan sounds like tax suicide. The Ninth Circuit decided against Sollberger and told him to pay the taxes.

My Take: Let me see. Sollberger received a little over $1 million and the IRS wanted approximately $129,000. This leaves him approximately $871,000, although there is still state tax. For this he enters into a complicated scheme involving folded interest, a “put” seven years out and bankers from Ireland and the Isle of Man?

A word of advice from a tax pro: one does not tax shelter at a 15% tax rate. The government could virtually eradicate tax shelters (and many tax advisors) by lowering the tax rate to a flat 15% and requiring everyone to pay-in their fair share.

Good grief, man. Just pay the tax.