In three cases this summer, the Tax Court ruled against purported stock loans that it said were sales. One case involved millions of dollars in built-in gain and IRS-asserted deficiencies totaling $30 million for Denver multibillionaire Philip Anschutz. Two other cases involved participants in the Derivium “90% stock loan” abusive shelter, both with similar findings on tax liability but opposite conclusions on the taxpayers’ liability for an accuracy-related penalty.
Anschutz was the sole owner of the Anschutz Co., an S corporation subject to built-in gains tax. Through a qualified subchapter S subsidiary, the Anschutz Corp. (TAC), Anschutz wanted to convert appreciated securities to cash to fund his real estate and entertainment companies, which included several sports teams and arenas. TAC engaged in a prepaid variable forward contract with Donaldson, Lufkin and Jenrette (DLJ), an investment bank. The company transferred title to the stock to a trustee for cash from DLJ equal to 75% of the current fair market value of the stock. TAC had to repay the loan in 10 years either in cash or with a percentage of the transferred stock based on its fair market value. If the value declined below the cash received, the company could settle the loan by giving DLJ all the stock. The company could retain up to 50% of any appreciation of the stock, with DLJ receiving any additional appreciation. The forward contract also required the company to enter into a share-lending agreement under which DLJ could sell the shares and the company would receive 5% of their value. The company received nearly $351 million from the forward contract and nearly $23.4 million from the share-lending agreement.
The IRS audited these transactions and reclassified them as either a current sale or a constructive sale under IRC § 1259. It determined built-in gains resulted in deficiencies for the Anschutz Co. of nearly $50 million and $63.8 million for 2000 and 2001, with adjustments to Anschutz’s distributive share causing deficiencies on his returns of $12 million and nearly $18 million.
The Tax Court treated the forward contract and the lending contract as a single transaction for tax purposes and said it was a sale and not a loan because DLJ received not only the title to the stock but also the benefits and detriments of ownership. The court noted that the company received the full value of the transferred shares and that DLJ would suffer all declines in value and would benefit from almost all of the potential appreciation. It was highly unlikely that the stock would be returned, the court said. The court also denied the taxpayer’s arguments that the safe harbor rule of section 1058 applied. Section 1058 provides nonrecognition of gain in securities transfer agreements that require the return of identical securities and that don’t reduce the risk of loss or opportunity for gain by the initial owner.
The Tax Court also denied stock loan treatment to participants in a scheme by Derivium Capital LLC that had been initially promoted as providing a strategy for small investors that had usually been reserved for the wealthy. For background, see U.S. v. Cathcart, docket no. 07-4762 PJH (N.D. Cal. 3/5/2010), and Nagy v. U.S., docket no. 08-2555-DCN (D.S.C. 12/22/2009). See also “Tax Matters: Stock Loan Treated as Sale,” JofA, Jan. 2009, page 66.
Between 1998 and 2002 Derivium engaged in approximately 1,700 transactions in which taxpayers transferred marketable securities to it in exchange for cash equal to 90% of their fair market value. Although its agreement gave Derivium the right to sell or re-loan the shares, in nearly all cases it sold them without disclosing the sale to the participants. Taxpayers reported these transactions as loans. The government concluded that these transactions were sales and that approximately $235 million in taxes owed were not paid. Derivium filed for bankruptcy in 2005, and a bankruptcy trustee has called the program a Ponzi scheme.
One participant was Albert Calloway, who in 2001 transferred to Derivium 990 shares of IBM stock he had accumulated as an employee of IBM. The court noted that the amount of the “loan” was determined by the sale price of the stock and not its value on the day it was transferred to Derivium. Also, the company stressed to Calloway that the transaction would pay him 90% of the value of his stock, whereas a direct sale would yield only 80% after payment of taxes. Furthermore, under section 1058, to have the opportunity to receive all gain and suffer all loss on the transferred securities, taxpayers must be able to terminate the loan at will, which Calloway was not allowed to do.
The Tax Court upheld the imposition of the accuracy-related penalty under section 6662(a), finding that, although Calloway was introduced to the program by his financial adviser, he presented no evidence of the adviser’s qualifications and relationship, if any, with Derivium. Similarly, although Calloway said his tax adviser, an accountant, gave him a copy of an opinion letter to Derivium’s president about a similar program operated by another company, he did not call the accountant as a witness and admitted he did not know anything about the letter’s author. Consequently, the court said, Calloway failed to establish that he reasonably relied upon a competent professional.
Another Derivium participant, Cecilia Shao, likewise held her technology company employer’s stock, which appreciated steeply and then nearly as rapidly lost value in the dot-com bubble and bust. While upholding the deficiency, the Tax Court distinguished her reasonable-cause, good-faith argument from Calloway’s. Shao was referred to Derivium by a certified financial planner, and the court accepted her testimony that she hadn’t understood it was significantly different with respect to her taxes from the margin loan she had previously obtained through a stockbroker, also at her financial planner’s recommendation. Calloway, the court said, had treated his transaction inconsistently with his claim it was a loan by failing to report dividends as income during its term and by failing to recognize gain or income from discharge of indebtedness when it was terminated. In Shao’s case, on the other hand, there was “no evidence of a wink-wink-nudge-nudge-say-no-more arrangement,” the court said.
By Edward J. Schnee, CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accounting, University of Alabama, Tuscaloosa.
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