Use Certified Mail With The IRS

I am looking at Baldwin v U.S., at least as much as I can between the September and October 15^th due dates.

In the blog equivalence of cinematic foreboding, the case comes out of the Ninth Circuit.

The Baldwins filed a 2007 joint tax return showing an approximate $2.5 million loss from a movie production business.

They filed to carry the loss back to 2005 for a refund.

They had three years to file the refund claim. The three years started with the filing of their 2007 return – that is, the year that showed the loss. They filed their 2007 return on extension, so three years later would be October 15, 2011.

They filed the refund claim on June 21, 2011.

Seems plenty of time.

They filed using regular mail.

The IRS said they never received the refund claim.

Problem.

The three years expired. Sorry about your luck, Baldwins, purred the IRS.

You know this went to court.

It went to a California district court.

And we get to talk about the mailbox rule.

There is a provision in the tax Code that timely-mailing-equals-timely filing with the IRS. That is the reason you hear (not as much now in the era of electronic filing) of people heading to the post office on April 15^th. Folks want to get that “April 15” stamped on the envelope, as that stamp means the return is considered timely filed with the IRS.

By the way, that provision did not enter the Code until 1954.

What did folks do before 1954?

They relied on common law.

Common law allows one to presume that a properly-mailed envelope will arrive in the ordinary time required to get from here to there. One would have to prove that one mailed the envelope, of course, but once that was done the presumption that the mail arrived in normal time would kick-in.

In 1954 Congress added the following:

§ 7502 Timely mailing treated as timely filing and paying.

(a)  General rule.

(1)  Date of delivery.

If any return, claim, statement, or other document required to be filed, or any payment required to be made, within a prescribed period or on or before a prescribed date under authority of any provision of the internal revenue laws is, after such period or such date, delivered by United States mail to the agency, officer, or office with which such return, claim, statement, or other document is required to be filed, or to which such payment is required to be made, the date of the United States postmark stamped on the cover in which such return, claim, statement, or other document, or payment, is mailed shall be deemed to be the date of delivery or the date of payment, as the case may be.

Section (c) is important here:

(c)  Registered and certified mailing; electronic filing.

(1)  Registered mail.

For purposes of this section , if any return, claim, statement, or other document, or payment, is sent by United States registered mail-

(A)  such registration shall be prima facie evidence that the return, claim, statement, or other document was delivered to the agency, officer, or office to which addressed; and

(B)  the date of registration shall be deemed the postmark date.

Section (c) is why accountants encourage the use of certified mail with tax returns.

But the Baldwins did not certify their mailing.

They instead argued that they met the common-law standard for timely filing.

Seems a solid argument.

The IRS went low.

There are Court cases out there (Anderson, for example) that decided that the common law standard continued to exist even after the codification of Section 7502. It makes sense – at least to me - as that is what common law means.

The IRS argued that Section 7502 did away with the common-law standard, and the cases deciding otherwise were decided erroneously.

Sounds like a truckload of fine-cut bull manure to me.

Let’s load the truck.

There was a case in 1984 called Chevron. From it came the Chevron doctrine, an administrative law principle that a government agency’s interpretation of an ambiguous or unclear statute should be respected by a court.

I get the concept.

The first thing the agency has to do is show that the statute is ambiguous or unclear.

Does Section 7502 appear ambiguous or unclear to you?

We are going to need a jump to get this truck going.

Let’s introduce National Cable & Telecommunications Association v Brand X. That case has to do with the internet and whether it is an information service or a telecommunication service.

Sounds boring.

Let’s look at the Ninth Circuit’s take-away from Brand X:

But [a] court’s prior judicial construction of a statute trumps an agency construction otherwise entitled to Chevron deference only if the prior court decision holds that its construction follows from the unambiguous terms of the statute and thus leaves no room for agency discretion.”

Let me translate that word salad:

Since the prior Court decisions (let’s use Anderson as an example) did not specifically say that the statute was unambiguous, the statute is therefore ambiguous.

Huh?

So, if I do not make clear that I am not a Robert Howard sword-and-sorcery, skilled, powerful and fearless giant weapon-wielding barbarian, then it can be deduced that I am that very said barbarian?

Cool!

Brand X lets me say that Section 7502 is ambiguous, at which point Chevron kicks-in and allows me to argue that the underlying statute means anything I want it to say.

There is an aisle for this at Borders. It is called “Fiction.”

The Baldwins did not get to rely on common-law. Since they could not meet requirements of Section 7502(c), they lost out altogether. No carryback refund for them.

Patents, Capital Gains and Hogitude

I have an acquaintance who has developed several patents.  He works for a defense contractor, so I suspect he has more opportunity than a tax CPA.

COMMENT: Did you know that tax advisors have tried to “patent” their tax planning? I suppose I could develop a tax shelter that creates partnership basis out of thin air and then pop the shelter to release a gargantuan capital loss to offset a more humongous capital gain…. Wait, that one has already been done. Fortunately, Congress passed legislation in 2011 effectively prohibiting such nonsense.

Let’s say that you develop a patent someday. Let’s also say that you have not signed away your rights as part of your employment package. Someone is now interested in your patent and you have a chance to ride the Money Train. You call to ask how about taxes.

Fair enough. It is not everyday that one talks about patents, even in a CPA firm.

Think of a patent as a rental property. Say you have a duplex. Every month you receive two rental checks. What type of income do you have?

You have rental income, which is to say you have ordinary income. It will run the tax brackets if you have enough income to make the run.

Let’s say you sell the duplex. What type of income do you have?

Let’s set aside depreciation recapture and all that arcana. You will have capital gains.

People prefer capital gains to ordinary income. Capital gains have a lower tax rate.

Patents present the same tax issue as your duplex. Collect on the patent - call it royalties, licensing fees or a peanut butter sandwich – and you have ordinary income. You can collect once or over a period of time; you can collect a fixed amount, a set percentage or on a sliding rate scale. It is all ordinary income.

Or you can sell the patent and have capital gains.

But you have to part with it, same as you have to part with the duplex. 

Intellectual property however is squishier than real estate, which make sense when you consider that IP exists only by force of law. You cannot throw IP onto the bed of a pickup truck.

Congress even passed a Code section just for patents:

§ 1235 Sale or exchange of patents.

(a)  General.

A transfer (other than by gift, inheritance, or devise) of property consisting of all substantial rights to a patent, or an undivided interest therein which includes a part of all such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than 1 year, regardless of whether or not payments in consideration of such transfer are-

(1)  payable periodically over a period generally coterminous with the transferee's use of the patent, or (2) contingent on the productivity, use, or disposition of the property transferred.

The tax Code wants to see you part with “substantial rights,” which basically means the right to use and sell the patent. Limit such use – say by geography, calendar or industry line – and you probably have not parted with all substantial rights.

Bummer.

What if you sell to yourself?

It’s been tried, but good thinking, tax Padawan.

What if you sell to yourself but make it look like you did not?

This has potential. Your training is starting to kick-in.

Time to repeat the standard tax mantra:

pigs get fat; hogs get slaughtered

Do not push the planning to absurd levels, unless you are Google or Apple and have teams of lawyers and accountants chomping on the bit to make the tax literature.

Let’s look at the Cooper case as an example of hogitude.

James Cooper was an engineer with more than 75 patents to his credit. He and his wife formed a company, which in turn entered into a patent commercialization deal with an independent third party.

So far, so good. The Coopers got capital gains.

But the deal went south.

The Coopers got their patents back.

Having been burned, Cooper was now leery of the next deal. Some sharp attorney advised him to set up a company, keep his ownership below 25% and bring in “independent” but trusted partners.

Makes sense.

Mrs. Cooper called her sister to if she wanted to help out. She did. In fact, she had a friend who could also help out.

Neither had any experience with patents, either creating or commercializing them.

Not fatal, methinks.

They both had full-time jobs.

So what, say I.

They signed checks and transferred funds as directed by the accountants and attorneys.

They did not pursue independent ways to monetize the patents, relying almost exclusively on Mr. Cooper.

This is slipping away a bit. There is a concept of “agency” in the tax Code. Do exactly what someone tells you and the Code may consider you to be a proxy for that someone.

Maybe the tax advisors should wrap this up and live to fight another day.

The sister and her friend transferred some of the patents back to Cooper.

Good.

For no money.

Bad.

The sister and her friend owned 76% of the company. They emptied the company of its income-producing assets, receiving nothing in return. Real business owners do not do that. They might have a career in the House of Representatives, though.

Meanwhile, Cooper quickly made a patent deal with someone and cleared six figures.

This mess wound up in Tax Court.

To his credit, Cooper argued that the Court should just look at the paperwork and not ask too many questions. Hopefully he did it with aplomb, and a tin man, scarecrow and cowardly lion by his side.

The Tax Court was having none of his nonsense about substantial rights and 25% and no-calorie donuts.

The Court decided he did not meet the requirements of Section 1235.

The Tax Court also sustained a “substantial understatement” penalty. They clearly were not amused. 

Cooper reached for hogitude. He got nothing.

How Choosing The Correct Court Made The Difference

I am looking at a District Court case worth discussing, if only for the refresher on how to select a court of venue. Let’s set it up.

ABC Beverage Corporation (ABC) makes and distributes soft drinks and non-alcoholic beverages for the Dr Pepper Snapple Group Inc. Through a subsidiary it acquired a company in Missouri. Shortly afterwards it determined that the lease it acquired was noneconomic. An appraisal determined that the fair market rent for the facility was approximately $356,000 per year, but the lease required annual rent of $1.1 million. The lease had an unexpired term of 40 years, so the total dollars under discussion were considerable.

The first thing you may wonder is why the lease could be so disadvantageous. There are any number of reasons. If one is distributing a high-weight low-value product (such as soft drinks), proximity to customers could be paramount. If one owns a franchise territory, one may be willing to pay a premium for the right road access. Perhaps one’s needs are so specific that the decision process compares the lease cost to the replacement cost of building a facility, which in turn may be even more expensive. There are multiple ways to get into this situation.

ABC obtained three appraisals, each of which valued the property without the lease at $2.75 million. With the lease the property was worth considerably more.

NOTE: Worth more to the landlord, of course. 

ABC approached the landlord and offered to buy the facility for $9 million. The landlord wanted $14.8 million. Eventually they agreed on $11 million. ABC capitalized the property at $2.75 million and deducted the $6.25 million difference.

How? ABC was looking at the Cleveland Allerton Hotel decision, a Sixth Circuit decision from 1948. In that case, a hotel operator had a disastrous lease, which it bought out. The IRS argued that that the entire buyout price should be capitalized and depreciated. The Circuit Court decided that only the fair market value of the property could be capitalized, and the rest could be deducted immediately. Since 1948, other courts have decided differently, including the Tax Court. One of the advantages of taking a case to Tax Court is that one does not have to pay the tax and then sue for refund. A Tax Court filing suspends the IRS’ ability to collect. The Tax Court is therefore the preferred venue for many if not most tax cases.

However and unfortunately for ABC, the Tax Court had decided opposite of Cleveland Allerton (CA), so there was virtually no point in taking the case there. ABC was in Michigan, which is in the Sixth Circuit. CA had been decided in the Sixth Circuit. To get the case into the District Court (and thus the Circuit), ABC would have to pay the tax and sue for refund. It did so.

The IRS came out with guns blazing. It pointed to Code Section 167(c)(2), which reads:

            (2) Special rule for property subject to lease

If any property is acquired subject to a lease—

(A) no portion of the adjusted basis shall be allocated to the leasehold interest, and

(B) the entire adjusted basis shall be taken into account in determining the depreciation deduction (if any) with respect to the property subject to the lease.

The IRS argued that the Section meant what it said, and that ABC had to capitalize the entire buyout, not just the fair market value.  It trotted out several cases, including Millinery Center and Woodward v Commissioner. It argued that the CA decision had been modified – to the point of reversal – over time. CA was no longer good precedent.

The IRS had a second argument: Section 167(c)(2) entered the tax Code after CA, with the presumption that it was addressing – and overturning – the CA decision.

The Circuit Court took a look at the cases. In Millinery Center, the Second Circuit refused to allow a deduction for the excess over fair market value. The Sixth Circuit pointed out that the Second Circuit had decided that way because the taxpayer had failed its responsibility of proving that the lease was burdensome. In other words, the taxpayer had not gotten to the evidentiary point where ABC was.

In Woodward the IRS argued that professional fees pursuant to a stockholder buyout had to be capitalized, as the underlying transaction was capital in nature. Any ancillary costs to the transaction (such as attorneys and accountants) likewise had to be capitalized. The Sixth Circuit pointed out the obvious: ABC was not deducting ancillary costs. ABC was deducting the transaction itself, so Woodward did not come into play.

The Court then looked at Section 167(c)(2) – “if property is acquired subject to a lease.” That wording is key, and the question is: when do you look at the property? If the Court looked before ABC bought out the lease, then the property was subject to a lease. If it looked after, then the property was not. The IRS of course argued that the correct time to look was before. The Court agreed that the wording was ambiguous.

The Court reasoned that a third party purchaser looking to acquire a building with an extant lease is different from a lessee purchaser. The third party acquires a building with an income stream – two distinct assets - whereas the lessee purchaser is paying to eliminate a liability – the lease. Had the lessee left the property and bought-out the lease, the buy-out would be deductible.

The Court decided that the time to look was after. There was no lease, as ABC at that point had unified its fee simple interest. Section 167(c)(2) did not apply, and ABC could deduct the $6.25 million. The Court decided that its CA decision from 1948 was still precedent, at least in the Sixth Circuit.

ABC won the case, and kudos to its attorneys. Their decision to take the case to District Court rather than Tax Court made the case appealable to the Sixth Circuit, which venue made all the difference.

Would You Like To Buy a Tax Credit?

Let’s talk about an esoteric tax topic: selling tax credits.

You didn’t know it could be done, did you? To be fair, we have to divide this discussion between federal tax credits and state tax credits. Some states by statute allow the sale of their tax credits. Massachusetts will allow the sale its “motion picture” tax credit and Colorado will allow its “conservation easement” tax credit.

The federal rules are a bit different. These transactions usually involve the use of partnerships and LLCs, and the purchaser takes on the role of a “partner” in the deal. The business problem commonly present is that the purchaser (the “investor”) has little interest in the project other than the credit and a great deal of interest in getting out of the project as soon as possible. It is somewhat like a Kardashian marriage. There are technical problems lurking here, not the least of which is the IRS determining that a genuine partnership never existed. Tax planners and attorneys have stretched this specialized area to unbelievable lengths, and – in most cases – the IRS has gone along. Congress has said that it wants to incentivize the construction of low-income housing, for example, and to do so it has provided a tax credit. Say that someone decides to develop low-income housing, and to make the deal work that someone decides to “sell” the credit. If the IRS come in and nixes the deal, there are negative consequences - to the participants, to the industry and to the advisors to the industry. The IRS may also be called in before a Congressional tax committee for a lecture on overreach.  

Which makes the recent decision in Historic Boardwalk Hall LLC v Commissioner unnerving to tax pros. The property in question was the Atlantic Center convention center (known as the Historic Boardwalk Hall or the East Hall). We know it as the home of the Miss America pageant. The Boardwalk was owned by the New Jersey Sports and Exposition Authority (NJSEA). The NJSEA solicited bids for the historic rehabilitation tax credit. The winner was Pitney Bowes.

They put a deal together. NJSEA would be the general partner with a 0.1% partnership interest.  Pitney Bowes would be the limited partner with a 99.9% partnership interest, including a 99.9% right to profits, losses and tax credits. Goodness knows that NJSEA – a government agency – did not need tax credits. Government agencies do not pay tax.

Pitney Bowes agreed to make capital contributions of approximately $16 million.  Each installment depended on attaining certain benchmarks. Pitney Bowes was to receive 3% preferred return on its cash investment and approximately $18 million in historic tax credits

In case Pitney Bowes and the NJSEA had a falling-out, the NJSEA could buy-out Pitney Bowes for an amount equal to the projected tax benefits and cash distributions due them. 

NJSEA also had a call option to buy-out Pitney Bowes at any time during the 12-month period beginning 60 months after East Hall was placed in service.  Pitney Bowes decided to make certain on this point, and they included a put option to force NJSEA to buy them out during the 12-month period beginning 84 months after East Hall was placed in service. 

To make sure they had beaten this horse to death, Pitney Bowes also obtained a “tax benefits guaranty” agreement.  This agreement assured Pitney Bowes that, at minimum, it would receive the projected tax benefits from the project.  The guarantee also indemnified Pitney Bowes for any taxes, penalties, interest and legal fees in case of an IRS challenge. 

The IRS challenged. Its principal charge was simple: the partnership had no economic substance. That arrangement was as likely as Charlie Sheen and Chuck Lorre spending a golf weekend together. The Tax Court did not see it the IRS’ way and decided in favor of Pitney Bowes. Not deterred, the IRS appealed to the Third Circuit.

The Third Circuit reversed the Tax Court and decided in favor of the IRS.

More specifically, the Circuit Court decided that Pitney Bowes had virtually no downside risk. Pitney Bowes was not required to make capital contributions until a certain amount of rehabilitation work had been done. This meant they knew they would be receiving an equivalent amount of tax credits before writing any checks.   Then you have the tax benefits guaranty, which gave them a “get out of jail free” card.

The Court did not like that the funds contributed by Pitney Bowes were unnecessary to the project. NJSEA had been appropriated the funds before it began the renovation. NJSEA had been approached by a tax consultant with a “plan” to generate additional funds by utilizing federal historic tax credits.

Still, Pitney Bowes could argue that it had upside potential. That is a powerful argument in favor of the validity of a partnership arrangement. Wait, Pitney Bowes could not argue that it had any meaningful upside potential. While It was entitled to 99.9% of the cash flow, Pitney Bowes had to wait until all loan payments, including interest, as well as any operating deficits had been repaid.  The put and call options also did not help. NJSEA could call away any upside potential from Pitney Bowes. The Court decided Pitney Bowes had no skin in the game. 

This tax pro’s opinion: The deal was over-lawyered. The problem is that many of these deals are constructed in a very similar manner, which fact has thrown the industry (rehabilitation credit, low-income housing credit, certain energy credits, etc.) and their tax advisors into tumult. The advisors have to back this truck up a little, at least enough to giving the illusion that a valid partnership is driving the transaction.

Do not feel bad for Pitney Bowes. Remember that they have a tax indemnity agreement with NJSEA. I wonder how much this tax case just cost the state of New Jersey.

The Estate of Marilyn Monroe

There is a saying among tax pros: “do not let the tax tail wag the dog.” The point is to not let taxes so influence the decision that the final decision is not in your best interest. An example is failing to sell a profitable stock position for the sake of not paying taxes. Seems a good idea until the stock market – and your stock – takes a dive.

This past week I was reading about the estate of Marilyn Monroe. Did you know that her estate was the third highest-earning estate in 2011?  Her estate earned $27 million and came in behind the estates of Michael Jackson and Elvis Presley. What is driving this earning power?

What is driving it is “rights of publicity.” For example, the website Squidoo.com reports that Marilyn Monroe posters remain one of the top-sellers for students decorating their dorm rooms. A “right of publicity” exists at the whim of state statute. There is no federal law equivalent. Indiana is considered to have one of the most far-reaching statutes, recognizing rights to publicity for 100 years after death.

Marilyn Monroe divorced Joe DiMaggio in October, 1954. She then left California for New York. In 1956 she married Arthur Miller, and the couple lived In Manhattan’s Sutton Place. Marilyn still considered this her home when she died in Brentwood, California in August, 1962.

The executors of her estate had a tax decision to make: was her estate taxable to California (where she died) or New York (where she maintained the apartment and staff). They decided it would be New York, primarily because California’s estate taxes would have been expensive. By treating her as a New York resident, they were able to limit California to less than $800 in taxes.

Let’s go forward three or four decades, and states like California and Indiana now permit celebrities’ estates to earn large revenues, in large part by liberalizing property interests such as publicity rights. Some states have not been so liberal - states such as New York.

You can see this coming, can’t you?

Let’s continue. In 2001 The New York County Surrogate’s Court permitted the estate to close, transferring the assets to a Delaware corporation known as Marilyn Monroe LLC (MMLLC). The licensing agent for MMLLC is CMG Worldwide, an Indiana company that also manages the estate of James Dean. Is the selection of Indiana coincidental? I doubt it, given what we discussed above.

Marilyn is an iconoclastic image, and her photographs – and the rights to those photographs – are worth a mint. Enter Sam Shaw, who took many photographs of Marilyn, including the famous photo of her standing over a subway grate with her skirt billowing. The Shaw Family Archives (SFA) got into it with MMLLC, with MMLLC arguing that it exclusively owned the Monroe publicity rights.  SFA sued MMLLC in New York, and the court granted SFA summary judgment. The court noted that Marilyn Monroe was not a domiciliary of Indiana at her time of death, so her estate could not transfer assets to Indiana and obtain legal rights that did not exist when she died. She was either a resident of New York or California, and neither state recognized a posthumous right of publicity at her time of death.

MMLLC had no intention of rolling over. It called a few people who knew a few people.

In 2007 Governor Schwarzenegger signed into law a bill creating a posthumous right of publicity, so long as the decedent was a resident of California at the time of death. Even better, the law was made retroactive. The law could reach back to the estate of Marilyn Monroe. Wow! How is that for tax planning!

Now the estate of Marilyn Monroe started singing a different tune: of course Marilyn was a resident of California at her time of death. That entire issue of making her a New York resident was a misunderstanding. She had been living in California. She loved California and had every intention of making it her home, especially now that California retroactively changed its law 45 years after her death.

You know this had to go to court. MMLLC did not help by aggressively suing left and right to protect the publicity rights.

Last week the Ninth Circuit Court of Appeals (that is, California’s circuit) ruled that The Milton Greene Archives can continue selling photographs of Marilyn Monroe without paying MMLLC for publicity rights. The court noted that the estate claimed Monroe was a New York resident to avoid paying California taxes. The estate (through MMLLC) cannot now claim Monroe was a California resident to take advantage of a state law it desires.

NOTE: This is called “judicial estoppel,” and it bars a party from asserting a position different from one asserted in the past.

The appeals judge was not impressed with MMLLC and wrote the following:

"This is a textbook case for applying judicial estoppel. Monroe’s representatives took one position on Monroe’s domicile at death for forty years, and then changed their position when it was to their great financial advantage; an advantage they secured years after Monroe’s death by convincing the California legislature to create rights that did not exist when Monroe died. Marilyn Monroe is often quoted as saying, 'If you’re going to be two-faced, at least make one of them pretty.'”

What becomes now of MMLLC’s rights to publicity? Frankly, I do not know. It is hard to believe they will pick up their tent and leave the campground, however.

I am somewhat sympathetic to the estate and MMLLC’s situation. It was not as though the estate made its decision knowing that property rights were at stake.  At the time there were no property rights. It made what should have been a straightforward tax decision. Who could anticipate how this would turn out?

On a related note, guess whose case will also soon come before the Ninth Circuit on the issue of post-mortem publicity rights?  Here is a clue: he was from Seattle, had a four-year career and died a music legend. Give up?

It’s the estate of Jimi Hendrix.

The Anschutz Company v. Commissioner

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 10^th 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 10^th 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.