Pilgrim's Pride, A Senator And Tax Complexity

The Democratic staff of the Senate Finance Committee published a report last month titled “How Tax Pros Make the Code Less Fair and Efficient: Several New Strategies and Solutions.”

I set it aside, because it was March, I am a tax CPA and I was, you know, working. I apparently did not have the time liberties of Congressional staffers. You know the type: those who do not have to go in when it snows. When I was younger I wanted one of those jobs. Heck, I still do.

There was a statement from Senator Wyden, the ranking Democrat senator from Oregon:

Those without access to fancy tax planning tools shouldn’t feel like the system is rigged against them. 

Sophisticated taxpayers are able to hire lawyers and accountants to take advantage of … dodges, but hearing about these loopholes make middle-class taxpayers want to pull their hair out.”

There is some interesting stuff in here, albeit it is quite out of my day-to-day practice. The inclusion of derivatives caught my eye, as that of course was the technique by which the presumptive Democratic presidential nominee transmuted $1,000 into $100,000 over the span of ten months once her husband became governor of Arkansas. It must have taken courage for the staffers to have included that one.

Problem is, of course, that tax advisors do not write the law.  

There are complex business transactions taking place all the time, with any number of moving parts. Sometimes those parts raise tax issues, and many times those issues are unresolved. A stable body of tax law allows both the IRS and the courts to fill in the blanks, allowing practitioners to know what the law intended, what certain words mean, whether those words retain their same meaning as one travels throughout the Code and whether the monster comes to life after one stitches together a tax transaction incorporating dozens if not hundreds of Code sections. And that is “IF” the tax Code remains stable, which is of course a joke.

Let’s take an example.

Pilgrim’s Pride is one of the largest chicken producers in the world. In the late 1990s it acquired almost $100 million in preferred stock from Southern States Cooperative. The deal went bad.  Southern gave Pilgrim an out: it would redeem the stock for approximately $20 million.

I would leap at a $20 million, but then again I am not a multinational corporation. There was a tax consideration … and it was gigantic.

You see, if Pilgrim sold then stock, it would have an $80 million capital loss. Realistically, current tax law would never allow it to use up that much loss. What did it do instead? Pilgrim abandoned the stock, meaning that it put it outside on the curb for big trash pick-up day.

Sound insane?

Well, the tax Code considered a redemption to be a “sale or exchange,” meaning that any loss would be capital loss. Abandoning the stock meant that there was no sale or exchange and thus no mandatory capital loss.

Pilgrim took its ordinary loss and the IRS took Pilgrim to Court.

Tax law was on Pilgrim’s side, however. Presaging the present era of law being whatever Oz says for the day, the IRS conscripted an unusual Code section – Section 1234A – to argue its position.

Section 1234A came into existence to address options and futures, more specifically a combination of options and futures called a straddle. . What options and futures have in common is that one is not buying an underlying asset but rather is buying a right to said underlying asset. A straddle involves both a sale and a purchase of that underlying asset, and you can be certain that the tax planners wanted one side to be capital (probably the gain) and the other side to be ordinary (probably the loss). Congress wanted both sides to be capital transactions (hence capital gains and losses) even though the underlying capital asset was never bought or sold – only the right to it was bought or sold.

This is not one of the easiest Code sections to work with, truthfully, but you get an idea of what Congress was after.

Reflect for a moment. Did Pilgrim have (A) a capital asset or (B) a right to a capital asset?

Pilgrim owned stock – the textbook example of a capital asset.

Still, what is stock but the right to participate in the profits and management of a company? The IRS argued that – when Pilgrim gave up its stock – it also gave up its rights to participate in the profits and management of Southern. Its relinquishment of these rights pulled the transaction into the ambit of Section 1234A.

You have to admit, there are some creative minds at the IRS. Still, it feels … wrong, doesn’t it? It is like saying that a sandwich and a right to a sandwich are the same thing. One you can eat and the other you cannot, and we instead are being wound in a string ball of legal verbiage.

The Tax Court agreed with the IRS.  Pilgrim appealed, of course. It had to; this was a $80 million issue. The Appeals Court has now overturned the Tax Court.

The Appeal Court’s reasoning?

A “right” is a claim to something one does not presently have. Pilgrim already owned all the rights it was ever going to have, which means that it could not have had a right as envisioned under Section 1234A.

The tax law changed after Pilgrim went into this transaction, by the way.

Do I blame the attorneys and accountants for arguing the issue? No, of course not. The fact that an Appeals Court agreed with Pilgrim means the tax advisors were right. The fact that the law was later changed means the IRS also had a point.

And none of the parties involved  – Pilgrim and its attorneys and accountants, the IRS , the Tax Court and the Appeals Court wrote the law, did they?

Although the way Congress works nowadays, they may have been the first ones to actually read the bill-become-law. There perhaps is the real disgrace.

Can A Land Fill Make A Charitable Donation?

I have a client on extension for their individual tax return. They donated real estate last year. I am waiting on an appraisal and a signed Form 8283 before sending in the return.  

Charitable contributions have become a “gotcha” area for the IRS. The rules border on the insane. Does it make sense to you that I need a letter from the charity for donations over $250 even if I have a cancelled check? The IRS will accept a cancelled check as proof of a travel expense or of a child-care payment, but not for proof of a donation. Fail to follow their rules and you may lose the deduction altogether.

Sure enough, someone thought they followed the rules. Let’s go through the story of Boone Operations.

Boone Operations owned a landfill (Speedway). Right next to them, the city of Tucson (Arizona) also owned a landfill (Tucson). Both were surrounded by commercial and residential development. 

Tucson must have been a mess. The flare in its collection system kept going out and water kept collecting because of poor drainage. Tucson stopped accepted waste materials, but there were issues closing the place down. The neighbors howled; hearings were held. Douglas Kennedy (Kennedy), Boone’s owner, was concerned that Tucson was going to drag him down. He offered to help. In 1996 the two parties were happy and holding hands. Boone agreed to:

·        Share the cost of an interim gas system

·        Negotiate a permanent gas system

·        Cooperate to extend Boone’s aquifer permit to Tucson

You also had the following text in an agreement the attorneys drew up:

6.  Acceptable Waste Fill and Soil Fill

[Boone] agrees to provide [Tucson] with, and [Tucson] agrees to accept, acceptable waste fill and soil.

6.1 Placement of Acceptable Waste Fill

Boone shall, at no cost to [Tucson], fill the *** with acceptable waste to the approved final grades.

Seems clear: Boone will provide waste fill.

The promising relationship between Boone and Tucson soon soured:

·        6/99 - Boone places waste on Tucson to comply with agreement

·        10/99 – the Department of Solid Waste Management wants to know why Boone placed waste on Tucson

·        11/99 – Tucson wants Boone to remove the waste  

·         03/00 – Boone sues Tucson for $20 million

·        04/01 – Tucson provides Boone a settlement offer

·        09/01  -  Tucson files civil and criminal charges

·        04/02 – Boone files with the Superior Court

Shame. They seemed like such a nice couple.

Anyway, in December 2002, they settle. Tucson agreed to a number of things, including (a) paying $450,000 for Boone to construct drainage, (b) helping with easements and (c) releasing Boone and Mr. Kennedy from lawsuits.

And then the magic words:

8.1 Prior Contribution.  [Tucson] acknowledges that as of the date of the Settlement Memorandum, it had accepted Boone’s charitable contribution of 95,000 cubic yards of Acceptable Fill.

8.2 Future Contribution.  Boone agrees to make another charitable contribution of an additional 105,000 cubic yards of Acceptable Fill.

To the uninitiated, it appears that Boone has made a contribution of 200,000 cubic yards of Acceptable Fill to Tucson, don’t you think?

Boone files tax returns showing a donation of $449,000 for one year and $706,000 for another.

The IRS disallows the deductions. It has two arguments:

           

(1)  Boone failed to obtain contemporaneous written acknowledgement.

(2)  Boone received significant cash and noncash consideration and failed to prove that the value of the fill provided exceeded the consideration received.

The IRS argued that a written acknowledgement must include the following magic words:

·        The amount of cash and a description (but not value) of any property other than cash contributed.

·        Whether the donee organization provided any goods or services in consideration, in whole or part, for any property described.

·        A description and good faith estimate of the value of any goods and services received, or, if such goods and services consist solely of intangible religious benefits, a statement to that effect.

What does Boone have? The Settlement Agreement from December 2002. Without the magic words, however, Boone does not have “written acknowledgement.”  Since the donation was over $250, no deduction is allowed without written acknowledgement.

The Court then went on the argument (2). It went through the appraisal process in painstaking detail. There appear to have been significant errors in the appraiser’s calculations, for example, leading to an overvaluation of the donated fill. The Court also pointed out that Boone and Mr. Kennedy were released from a potential lawsuit. That release could have a value. If so, should that value be taken into account?

I question why the Court did this. The Court had already disallowed the deduction for lack of written acknowledgement. Why keep going?

My thinking? The Court expects a challenge on issue [1], and it thinks it could be reversed by a superior court. The Court therefore kept going, reasoning that if was reversed on issue [1] it would be sustained on [2].

You know how this turned out: the Tax Court disallowed the charitable deductions under both arguments.

COMMENT: Please do not mess with IRS in this area. If you are thinking about a significant donation of anything other than cash, please call your tax advisor first.  Get your papers lined up and do not play “gotcha” with the IRS.

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.

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.

Your Accountant Makes the Mistake. Do You Owe Penalties?

If your accountant omits some of your income on your personal income tax return, is it fair that you should be penalized by the IRS?

Generally speaking, reliance on a tax preparer is “reasonable cause” to request penalty mitigation from the IRS. Generally, but not always.

Enter Stephen Woodsum (SW). SW has a bachelors degree from Yale and a masters from Northwestern. He was a founding director of Summit Partners, a private equity firm.

Note: Mr. Woodsum is financially savvy.

In 1998 SW entered a transaction described as a “ten year total return limited partnership linked swap.” This transaction involved Bankers Trust Company and Deutsche Bank and included a reference to paying interest at the “LIBOR rate” upon the “notional amount” of the “reference fund.”

        Note: Financially unsavvy people do not use these words.

So, the swap was to expire in 2008 – ten years. SW was unhappy with the performance of the swap and ended it in 2006. He received at that time a Form 1099 reporting the $3.4 million Deutsche Bank paid him and another 1099 for $60,291 of interest income.

SW gave all of his tax documents to his accountant. There were over 160 such documents. SW must have had a good year, as the $3.4 million was not the largest number on his tax return. It would however had been the third largest capital gain had the $3.4 million in proceeds been reported.

The accountant prepared the return, including the interest but excluding the $3.4 million.  Some accountant. SW and his wife met with the accountant on October 15, the day the return was due. They had to go over the federal return and 27 state income tax returns. The federal return alone was 115 pages.

Mr. and Mrs. Woodsum did not notice that the accountant had left out the $3.4 million.

The IRS did notice, of course, and wanted the tax and interest, as well as penalties.

Mr. Woodsum felt he did not have to pay penalties because… well, he relied on his accountant. I agree with SW.

The court made an interesting comment. It observed that courts have previously mitigated the penalties, but it continued …

It may be (and petitioners seem to expect the Court to assume) that the omission was the result of the C.P.A.'s oversight of one Form 1099 amid 160 such forms, but no actual evidence supports that characterization. The omission is unexplained, and since petitioners have the burden to prove reasonable cause and good faith, this evidentiary gap works against their defense.”

No actual evidence supports that characterization? I would have gotten a statement from the accountant clarifying that the accountant was provided but failed to include the 1099 on my return.

The court seemed unwilling to give SW as much latitude because of his financial sophistication. The court goes on…

Mr. Woodsum, however, makes no showing of a review reasonable under the circumstances. He personally ordered the termination that gave rise to the income; he received a Form 1099-MISC reporting that income; that amount should have shown up on Schedule D as a distinct item; but it was omitted. The parties stipulated that petitioners' “review” of the defective return was of an unknown duration and that it consisted of the preparer turning the pages of the return and discussing various items. Petitioners understated their income by $3.4 million—an amount that was substantial not only in absolute terms but also in relative terms (i.e., it equaled about 10 percent of petitioners' adjusted gross income). A review undertaken to “make sure all income items are included” (in the words of Magill)—or even a review undertaken only to make sure that the major income items had been included—should, absent a reasonable explanation to the contrary, have revealed an omission so straightforward and substantial.”

I have had clients who did the same as Mr. Woodsum. It did not occur to me that they were conducting an unreasonable review. They provided all documents, answered all questions, met with me and complained about the amount I told them they owed. These are wealthy people. This is not you or I, where the absence of our salary would be immediately noticeable on our return. Mr. Woodsum reported approximately $33 million of income on his return. Note that the sale was not even the largest number on a schedule to Mr. Woodsum’s return.

The court upheld the penalties.

Perhaps this is what happens when a private equity manager gets into a complex financial transaction with names like “ten year total return limited partnership linked swap.” This court was not willing to bend much on the reporting of a “Wall Street” transaction that requires a tax seminar to understand.
The penalties were over $100 thousand.

I wonder whether Mr. Woodsum is suing his accountant for malpractice.