Stock Loan Treated as Sale

The value of a couple’s stock securing a loan could not be deducted as a theft loss, even though the stock was sold without the borrowers’ knowledge, the U.S. District Court for the Northern District of California ruled. Other claims, including whether, as the government argued, the loan was really a sale resulting in a taxable gain, remained in litigation.

Stock loans allow shareholders to borrow as much as 90% of the value of a traded stock, using the stock as collateral. They are typically classified as nonrecourse loans because the borrower’s personal assets are not at stake. They tend to operate as a built-in hedging transaction because if the stock drops, the borrower can simply walk away. If the stock appreciates, the borrower can pay back the loan and the stock is returned. Most stock loans have no margin calls, and the money can be used for anything except purchasing more stock.

In June 2000, Carl and Nancy Schlachte entered into two 90% stock loans with Derivium, an investment company, and received loans totaling approximately $2.3 million for a term of three years. At the end of that period, the taxpayers were notified by Derivium that both their loans were maturing, so they opted to surrender their shares in full satisfaction of their loans. Derivium allegedly told more than 1,700 clients nationwide they could avoid paying income taxes on the proceeds of the loans, saying they were not sales. The government, however, called the loans a sham and in 2007 sought an injunction against Derivium’s principals for allegedly operating a tax fraud scheme. According to the complaint (U.S. v. Charles Cathcart et al.), also in the U.S. District Court for the Northern District of California, Derivium helped its clients improperly avoid paying tax on the sale of more than $1 billion in assets.

In February 2004, the California Franchise Board took the position that the Schlachtes’ stock loans were sales on the date the loans were signed. The IRS subsequently took the same position and collected $842,782 in taxes for the tax year 2000. In the couple’s continuing dispute with the California Franchise Board, the Superior Court of California ruled in the Schlachtes’ favor that the stock loans were not sales for purposes of state tax treatment. The couple submitted amended federal returns for 2000 claiming a refund and for 2003 reporting the sale in the year when the stock was forfeited.

In June 2006, the IRS processed both requests, rejecting the year 2000 refund request (declaring the transaction was a sale disguised as a loan) and accepting the taxpayers’ amended 2003 return reflecting the stock sale. Thus, tax on the stock loan at this point was to be collectible twice. For that reason, the Schlachtes petitioned the district court. Later in the proceedings, they also claimed that they qualified for a theft loss deduction for 2000 because Derivium had sold their stock without their knowledge.

According to IRC § 7422(a), no suit for the recovery of any tax can be made until a claim for refund or credit has been duly filed. Furthermore, Treas. Reg. § 301.6402-2(b)(1) also requires that a claim for refund “set forth in detail each ground” for which a claim for refund is requested. If the claim for refund on its face does not call for an investigation into a concern, the issue cannot be later raised by the taxpayer in a refund suit. Boyd v. U.S. (762 F.2d 1369, 1371-72 (9th Cir. 1985)).

While the taxpayers did file a claim for refund in 2006, they never formally disclosed the theft loss issue on their original claim that was filed with the Treasury Department. Although they did informally discuss it, as evidenced in handwritten notes taken by the reviewing IRS agent and in a nine-page letter sent to Treasury officials, the court ruled they did so after the original claim was denied. Moreover, the court noted that an informal claim raising new grounds after an initial claim is filed is not considered timely filed for purposes of a refund claim. Consequently, the IRS was not properly made aware of the theft loss claim, and such a claim could not have been reasonably investigated. Accordingly, the court dismissed the taxpayers’ theftloss claim theory.

By Steven C. Thompson, CPA, Ph.D., McCoy Professor in Accounting, and Robert L. Severance, CPA, CIA, CFP, lecturer in accounting, both at Texas State University, San Marcos, Texas.