Copyright (c) 1995 Tax Analysts
AUGUST 14, 1995
LENGTH: 5281 words
DEPARTMENT: SPECIAL REPORT (SPR)
CITE: 68 Tax Notes 879
HEADLINE: 68 Tax Notes 879 - WHAT'S A TAX SHELTER?
AUTHOR: Johnson, Calvin H.
University of Texas
Calvin Johnson is the Andrews and Kurth Centennial Professor of Law at the University of Texas. This article was delivered as a speech to the annual banquet of the Graduate Tax Society at Capital University, Columbus, Ohio, on May 16, 1995.
Professor Johnson argues that the Tax Reform Act of 1986 intended to get rid of tax shelters, but that no one defined what a tax shelter is. The major remedy in the 1986 act, section 469 of the code, defined a shelter as a 'passive activity,' but that, Johnson argues, is not a viable diagnosis of the problem. Johnson argues that passivity, activity, and material participation do not help identify whether tax losses are real or artificial. Congress has also diagnosed the tax shelter problem in other ways over the last 25 years. While some of the diagnoses have merit, he finds, there are too many definitions and they do not fully capture the problem. The diagnosis in the courts -- that tax shelters are not-for-profit activities -- he finds not to be viable.
Section 469 should have included debt in its definition of its target. Johnson argues that in an 'abusive' tax shelter, the face amount of the liability, reported as a cost on the tax return, significantly overstates the true cost of the debt to the taxpayer. In the heyday of tax shelters, he argues, we commonly saw 'confetti debt,' worth no more than two cents on the dollar from the day it was created. The debt was so cheap, he argues, because of errors in the time value of money and because of foreseeable contingencies (including nonrecourse features) under which payment might be avoided. Johnson argues that liabilities need to be ignored as costs, unless their value is very close to the claimed face value of the liability.
Tax shelters also arise, Johnson argues, from legitimate cash borrowing. He argues that the best definition of a tax shelter is that it is an investment worth more after tax than before tax. Negative tax arises because of a mismatch between debt and favorably taxed investment. The negative tax allows investors to profit privately from investments that return less than the prevailing interest rates, which wastes precious capital. The negative tax, moreover, is a rate-dependent subsidy that gives more value to high- bracket taxpayers than to low, Johnson argues, so that high-bracket taxpayers drive up the price of favorably taxed assets and drive out all competitors in lower-tax brackets. A comprehensive consumption tax, he concludes, which would raise the tax on investments up to zero, would end tax shelters.
Table of Contents
Other Statutory Diagnoses.......................881
TEXT: 14 AUG 95
We are these days re-examining the Tax Reform Act of 1986 on many fronts and the tax shelter aspects of the 1986 act are properly up for discussion, on the merits. To do so, however, we need to answer the question, 'What's a Tax Shelter?' and that is not so easy to do. For a number of years now, I have collected definitions of 'tax shelters' -- my butterfly collection -- and it is surprising how varied the collection has become.
There is no consensus definition of a 'tax shelter' in the law or legal literature. The most authoritative definitions, alas, also make the least sense. A good definition of a tax shelter is not a sermonette, but it does have to serve as a diagnosis, much like a medical diagnosis, which makes sense of a number of symptoms and suggests how we might find a cure. My own theories focus on the special role of debt, especially debt in which the reported face amount significantly overstates the cost. First, however, we need to look at the official definitions and the context out of which they arose.
The Tax Reform Act of 1986 was a grand compromise between strange and hostile bedfellows. On one side, there was a tax-reform, anti-loophole, base-broadening approach, traditionally a Democratic approach. On the other side, there was a cut-the-tax-rate approach, traditionally Republican. The 1986 act plopped them together and cut both rates and loopholes. Both in cutting rates and in making taxes less avoidable, the 1986
improved the economic efficiency of the tax system. The high-tax- rate, pretend taxes that everybody avoids and nobody pays do economic harm without helping the deficit or anything else.
The deal that made the 1986 act possible was revenue neutrality for the top. Tax collected at the top would not go up or down. There would be a temporary truce in class warfare. Top-bracket taxpayers were to get a real rate cut. The target was for a 25 percent top rate, down from 50 and 70 percent. In return they would have to confess their real income. Alternatively stated, high-bracket taxpayers would have to give up tax shelters. /1/
The indictment against those pre-1986 tax shelters had two counts:
Count 1: Tax losses were not real. Supposedly, shelters were
artificial accounting losses by which rich people avoided tax on
their luxury consumption. Once luxury consumption was freed from
tax, then tax revenue had to come from less optimal sources.
Count 2: Caused waste. Supposedly, tax shelters caused lots of
economic damage by channeling resources into junky investments:
jojoba beans in Costa Rica, windmills in the Mojave desert,
garden apartments outside of Dallas put up and then torn down,
see-through office buildings put up just for the tax shelter. We
gave up billions of dollars of tax revenue to buy junk.
On both counts, I think that the indictment was mostly right.
The siege gun in the assault on tax shelters in 1986 was passive activity loss limitations of section 469. Section 469 says that you cannot use losses from 'passive activities' against your regular income. You can use losses from one of these passive activities against income from another one of these passive activities. It is as if to say that the Indians can kill each other off out there, but we are going to circle the wagon trains around regular income. Until you terminate the passive activity and tote up the cash, we are not going to believe you. We are going to treat the losses as phony paper losses. You cannot shelter proper income inside the wagon trains with phony paper. /2/
Section 469 seems to have worked, beyond anybody's expectations. Before 1986, individuals could buy into a syndicated partnership. A tax shelter partnership was like a black hole. It sucked in tax base and radiated tax losses. The tax losses were not free; you had to pay for them. But the price that you had paid to the promoter was less than the tax bill you would have paid otherwise. Shelters were being marketed to ever lower tax brackets: The shop stewards and assembly line people were buying them. The marketed tax shelter seems now to have ended.
The success of the 1986 act on this count was a big surprise. Roger Mentz, the assistant secretary of the Treasury for tax policy in 1986, told me at the time that he thought that the passive activity losses were bandaids, there for cosmetic reasons. They would not hold.
And on the other side, I heard a tax shelter promoter in January 1987 tell us that tax shelters were doing fine:
We survived the Tax Reform Act of 1969, and we survived the Tax
Reform of 1976, and we survived the Tax Equity Act of 1982 and
the Deficit Reduction Act of 1984. We are going to survive the
Tax Reform Act of 1986 and we shall survive a nuclear holocaust.
He was certainly right about those earlier acts in 1969, 1976, 1982, and 1984. I do not know how he would have done in a holocaust. But he was wrong about the 1986 act. His stuff was about to hit the fan. The 1986 act killed the tax shelter industry.
The trouble with the 1986 act is that nobody seems to have known what a tax shelter was. The definition used in section 469, 'passive activity,' is a terrible diagnosis. There is nothing wrong with being active, noth-
ing wrong with passive, and nothing wrong with combining the two. If some kid comes up to me and says, 'What's a tax shelter?,' I cannot tell him it is a passive activity. There is nothing in that that tells me why the accounting was bad, why the lossses are artificial. I get the feeling in the pit of my stomach that our sovereign and highest authority on tax law, Congress, did not know what it was talking about. Congress wanted to end tax shelters, but no one around the place knew what a tax shelter was.
The opposite of 'passive activity' is 'material participation.' Material participants may take losses, free from the limitations. /3/ Their exemption comes from Russell Long, who argued that a person who lost money in business should be able to deduct losses immediately. 'It is not,' he said, 'a general tax avoidance scheme for people to go broke in order to claim tax deductions.' /4
I want to root for the orthodonists and oral surgeons on this one. The outsiders. They do not want to go broke either. The purpose of a tax shelter was never to go broke or to lose real money, ever. If you leave a couple of hundred dollars on a park bench, I suspect that you will eventually get a theft loss. But that's not the point. In Texas, that is called an 'Aggie Shelter.' /5/ The point of tax shelter is to report the couple of hundred dollar tax loss, without losing the couple of hundred.
On the other side of the coin, for that matter, it is my experience that businessmen are perfectly willing to go into tax avoidance schemes if they work. The paper losses from shelters work, once you understand the mechanism, as well in the business arena as for the outsiders. The status of 'businessman' has never been good proof of a willing desire to pay tax. Whether the taxpayer is participating or passive does not help identify whether the losses are real or not. There must be some dark secret underneath section 469 because what it says on the surface does not make any sense.
One plausible theory is that section 469 is, at its core, protectionist legislation, trying to keep the bad accounting as the exclusive privelege of insiders. /6/ Only the insiders get the artificial losses. You need to be a real real estate man to get the nonreal real estate tax losses. You have to have manure on your boots to get the cow-pod farm tax losses. Section 469 is unfair.
If we just repealed the active participation exemption, that would be fair enough. Presumably, section 469 would then say that no losses would be allowed from 'activities,' whether active or passive, until the cash is toted up at the end. /7/ But then, oddly enough, there would be no diagnosis of the target within the words of section 469, and we would have no idea of what Congress was talking about. What could be wrong with 'activities' and why should losses from 'activities' be ignored in tax? Rejecting the section 469 'passive activities' definition leaves us with the same underlying problem: What then is a tax shelter?
Other Statutory Diagnoses
The 1986 definition is not the only definition of tax shelters in the law. Congress has been writing antitax shelter legislation for over 25 years now, and it defined the target on each round of legislation in a different way. We might perhaps diagnose the disease, by looking for the antibodies, much as we diagnose mumps or TB by finding the antibody reactions.
The difficulty is that the 25 years of the Tax Shelter Wars produced too many definitions of 'tax shelter.' The recapture remedy from the 1969 Tax Reform Act, for instance, defines a tax shelter as converting ordinary income into capital gain. /8/ The at risk remedy from the 1976 act defines a shelter as arising from nonrecourse liability. /9/ The penalties, the injunctions, and tax shelter registration provisions of the 1982 act diagnose a shelter as a tax compliance problem and define a shelter as a ticket to 'play the [tax] audit lottery.' /10/ The original-interest-discount and economic perfor-
mance rules from the 1984 act define shelters as arising from blindness as to the time value of money. /11/ Many of these definitions have some merit and some of the remedies even took some chunks out of shelters. But there are just too many definitions. Congress has acted like the blind men feeling at the elephant and come up with too many diagnoses of the problem and too many remedies. As our promoter properly said, moreover, tax shelters did survive the 1969 act and the 1976 act and the 1982 act and the 1984 act.
The other source of legal authority besides Congress is the courts. The courts treat tax shelters as a branch of the section 183 hobby loss rules. Deductions from hobbies can be used only against income from other hobbies. /12/ In the Tax Court, a 'generic' tax shelter is a 'not-for-profit activity.' /13/
The theory, I guess, is that coal mining, jojoba beans, or real estate construction are pleasurable activities, like horse racing or photography or butterfly collecting. The investor is so caught up in the pleasure of coal mining that he does not have the 'requisite greed' /14/ to get into the section 212 profit-motivated category. Insufficient greed has never been a problem in tax shelters in my experience, but then I do not make up this stuff, I just write it down.
Shelters are explained by debt. My own theories about shelters focus on the special role of debt. All tax shelters involve liabilities, treated as costs. We can divide shelters into abusive- debt or legitimate-debt shelters depending upon whether the debt is abusive or real. Both abusive-debt and the real-debt shelters represent ill health in the tax system, although for different reasons.
Abusive shelters. The abusive tax shelters arose and still can arise because tax law respects liabilities as costs, even when the liabilities were worth nothing like their stated face amount. Traditional tax law has treated all promises to pay as if they were as good as gold. The stated or face amount of the promise was deducted or included in depreciable basis immediately. In an abusive tax shelter, however, the real detriment or economic cost of the promise to pay was far less than its face amount. What we commonly saw was 'confetti debt,' worth no more than two cents on the dollar from the day it was created, but reported for tax as if it were a dollar on the dollar. /15/
One of my favorite examples was the CORAL Research and Development Shelter. /16/ In CORAL, a partner would deduct a $600,000 promise to pay purportedly owed for the expenses of research to create a 'monoclonal conjugate' or some such thing. /17/ The promise was due to be paid over a period 7-11 years
away, together with 10 percent interest. The trick was that the liability was denominated in Brazilian cruzeroes, which were inflating with respect to the dollar by up to 1,000 percent per year during the period. Assuming a mere 100 percent inflation, the obligation would halve every year, dropping from $600,000 to $300,000, then $150,000, then $75,000, then $37,500 and so on. By the time the debt was due, it could be paid, the court found, with $184 in dollars. The CORAL shelter purported to give you $600,000 in immediate deductions for a liability that had a cost of $184, even ignoring present value discounting and the possibilities that payment might be avoided. The accounting claimed in the tax return would have snookered the tax system about the taxpayer's true cost, but only by an order of roughly 3,000 to 1.
Liabilities with a real cost below face amount happen sometimes because of the time value of money, as in CORAL, and sometimes because of foreseeable contingencies under which payment might be avoided. Nothing will destroy the value of a debt so fast as doubts about whether it will be paid. Nonrecourse liability is liability in which the sole remedy is reseizure of the collateral. Nonrecourse liabilities have especially large range when the 'risks' of nonpayment infect value, often fatally. /18
Something magically happens when the real economic cost of a liability drops below the tax value generated by the liability. In CORAL, investors were getting tax deductions from a $600,000 liability that were worth a couple hundred thousand dollars, paid for with a $184 economic cost. The debt is not even a cost at all after tax, if the shelter had worked, because the tax value from the debt is higher than the debt is really worth. When that happens the debtor will pay any amount of debt for the shelter property. Debtors deeply love liabilities like those. You would pay me $100,000 for a plain old drinking glass, for instance, provided that you can pay it off with nonrecourse liability and can deduct the 'cost.' If all I could do to you was reseize the drinking glass, then hey, what's $100,000 or more among friends like us. The secret is that the owing was not gold.
There is in the literature a fine definition of a very abusive tax shelter that I wish were cited more. An abusive tax shelter is well-described 'as a transaction designed to give deductions in an amount large enough to reduce...taxes in a sum greater than the net consideration or cost...of the entire operation.' /19/ Tax benefits greater than pretax cost is the reducio ad absurdum of the transaction. Transactions with a cost less than the tax benefit have no economic meaning except for tax and no economic constraints except by the courts ripping away the tax benefits.
Many of the confetti debt cases can be handled by the courts just by more skepticism about the real detrimental cost of a liability. The fact that there is a piece of paper that says that there is an IOU to the promoter for $l million does not mean there exists a cost that is anything like $l million out of pocket. We need to throw liabilities out of basis entirely when their value is not pretty darn close to the $l million stated face value. It would not take much of a penalty structure to control the abusive tax shelters, once we know the secret. Liabilities that both parties know are cheap or free leave a lot of traces.
Cash borrowing. Tax shelters can also be built out of perfectly legitimate debt, arising from cash borrowing. I assume here, whatever the facts, that for cash borrowing from a bank, the cost or detriment of the debt is legitimately going to equal at least the amount of cash borrowed. Banks tend to protect themselves. We had some minor problems in the 1980s with cash borrowing from the savings and loan associations, in which the stated cost of the debt was not worth anything like the real face amount, but here, ignoring that little $2 trillion episode, /20/ we will assume that all cash borrowing generates a debt with a pretax cost equal to the face amount of the debt.
My favorite definition of a tax shelter is that it is an investment that is worth more after tax than before tax. There is a negative tax or subsidy, better than mere tax exemption. A tax shelter saves the investor tax that would otherwise be paid on consumed amounts or other outside income. A tax shelter has a higher rate of return because Uncle Sam tries to run a tax system than it would have if Uncle Sam let the taxpayer go.
Negative taxes usually arise because of a mismatch between our treatment of debt and our treatment of investments. /21/ Debt is taxed as the mirror image of savings accounts or bonds. There is a terrible double tax on savings accounts: In savings accounts you get to make the investment only after you have paid tax on the capital that goes into the account and you have to pay tax on the interest earned in the account annually. The mirror image for liabilities is you get to deduct principal and deduct current interest too: there is
a double untax. That treatment of debt fits only investments in bonds or savings accounts. /22/
There is mismatch when debt is used to buy advantageously taxed investments. The debt-financed investment will generate artificial tax losses. The interest deduction, combined with generous tax of the investment, will yield the tax losses. The tax losses are what cause the subsidy. The tax losses arise not from any real or pretax situation, but solely because of the mismatch between debt and favorably taxed investment. Sometime the market may capitalize the benefits, dropping the pretax return so that the investor gets nothing special after tax, but not so far in my lifetime. /23/
Commonly, we need to take away the negative tax by deferring interest deductions, until the investor reports the income from the investment, which, incidentally, is the remedy that section 469 applies. /24/ I suspect we need to apply section 469 even to active participants or at least we need to defer the interest deduction more readily.
The negative tax in tax shelters is unfortunate because it allows investors to profit privately from investments that return less than the prevailing interest rates. That is too bad, because when that happens we waste capital in lousy projects -- jojoba beans and the like. We are currently borrowing capital on net from the Japanese and other non-U.S. suppliers and the capital is very expensive. We have too little capital domestically to waste it on junk projects.
The subsidy in tax shelters, moreover, is also rate-dependent, meaning that it gives more of a subsidy to high-bracket taxpayers than to low-bracket or loss-position taxpayers. High-bracket taxpayers tend to drive up the price of favorably taxed assets. They can accept a lower return pretax. When they drive up the price they drive out low-bracket investors, like young entrepreneurs, start-up companies, and ailing companies, simply because they have too low a tax bracket. /25/ With farm shelters, for instance, you would have to be a 41 percent-bracket individual just to survive as a mom-and-pop farmer.
Another way of describing tax shelters is to say that they are investments treated better than a consumption tax would allow. Consumption tax theory says that we should have a zero tax on investment returns. /26/ Tax shelters go beyond zero tax on investment returns to yield a negative tax on investment returns. A true consumption tax would do nasty things to debt. It would disallow the interest deductions, or it would tax borrowed amounts, or it would tax consumption even if it's funded out of borrowed amounts. /27/ If we at least taxed all consumption, from whatever source derived, that would end tax shelters.
The diagnosis of a tax shelter problem that one wants to use depends in large part on the remedy that one is willing to apply. I am not sure that there is any important constituency calling for the end of negative tax. But then I am not sure that there is even an important constituency willing to defend the tax system on any issue. Tax professors do not constitute a constituency. It is thus tempting to adopt some narrow definition of tax shelter, just so that something useful can be done. A diagnosis that is too morbid or too threatening is not a diagnosis anyone wants to hear. Still, understanding that tax shelters arise because debts are treated as costs tells us something useful about the effect of taxes on investments. Section 469 is not really about passivity, activity, or participation, although that is what it says. It is about the negative tax from debt-financed investments and especially about phony debt. When section 469 does in phony debts or negative tax, it does good. I just wish that the section 469 definition of its target had mentioned something about debt.
/1/ See, e.g., Jeffrey Birnbaum and Allan S. Murray, Showdown at Gucci Gulch: Lawmakers, Lobbyists, and the Unlikely Triumph of Tax Reform 23-31, 204-208, 218-222 (1987); Daniel Moynihan, 'A Death Knell for Tax Shelters?' N.Y. Times, July 7, 1986 at A17, col. 2 (shelter limits are as much at the heart of tax reform as the tax rate reduction itself); 'An Interview with John Colvin,' Tax Notes, Dec. 1, 1986, p. 792, 794 (passive loss rules were necessary by- product of low rate proposals, to protect the tax base for higher- income people). The progenitor responsible for the revenue neutrality argument that drove the 1986 act was Senator Bill Bradley of New Jersey. David Brockway, 'Comprehensive Gift and Estate Tax Reform,' Tax Notes, May 22, 1995, pp. 1089, 1093.
/2/ See, e.g., Cecily Rock and Daniel Shaviro, 'Passive Losses and the Improvement of Net Income Measurement,' 7 Va. Tax Rev. 1, 38 (1987)(section 469 based on pessimism about the feasibility of annual accounting). Two important precursers to the passive activity losses were Donald Schapiro, 'Sheltering the Revenue from Shelters: A Legislative Proposal Involving the Minimum Tax and Accounting Provisions,' Tax Notes, Feb. 27, 1984, pp. 811, 815, and Depart. of the Treas., Proposals for Tax Change 94 (April 30, 1973) (Limitation on Artificial Losses proposal). A number of critics have criticized section 469 either because it impedes capitalization of tax benefits (Lawrence Zelenak, 'When Good Preferences Go Bad: A Critical Analysis of the Anti-Tax Shelter Provisions of the Tax Reform Act of 1986,' 67 Tex. L. Rev. 499 (1988); Joseph Bankman, 'The Case Against Passive Investments: A Critical Appraisal of the Passive Loss Restrictions,' 42 Stan. L. Rev. 15 (1989); Theodore Sims, 'Debt, Accelerated Depreciation, and the Tale of a Teakettle: Tax Shelter Abuse Reconsidered,' 42 U.C.L.A. L. Rev. 263, 271 (1994), or because it creates untenable distinctions between participating and not participating (Robert J. Peroni, 'A Policy Critique of the Section 469 Passive Loss Limitations,' 62 S. Cal. L. Rev. 1, 72, 81 (1988)) or between debt and equity. Daniel Shaviro, 'Selected Limitations on Tax Benefits,' 56 U.Chi L. Rev. 1189 (1989). Cf. George Mundstock, 'Accelerated Depreciation and the Interest Deduction: Can Two Rights Really Make a Wrong?' Tax Notes, Dec. 23, 1985, p. 1253, (arguing that restrictions on debt financing, prior to section 469, were irrational).
/3/ Section 469(c)(1)(B), (7). Material participation is defined by section 469(h) and Treas. reg. sections 1.469-5 &-5T(1992).
/4/ Tax Reform Act of 1986: Hearings Before the Senate Finance Comm., 99th Cong., 2d. Sess., pt. 2 at 73 (1986).
/5/ The actual cause for this phrase is the score, Texas A&M 34, Texas 10 (Nov. 13, 1994).
/6/ See Boris Bittker, Statement, Tax Reform (Invited Panelists): Panel Discussions Before the House Comm. on Ways and Means, 94 Cong., 1st Sess. 59 (1975) (calling the 'limitation on artificial losses' anti-shelter remedy an 'internal tariff').
/7/ An activity would presumably be any discrete investment decision. The narrower an 'activity' is defined, the more likely the loss limitations would bite.
/8/ Daniel Halperin, 'Capital Gains and Ordinary Deductions: Negative Tax for the Wealthy,' 12 B.C. Ind. & Comm. L. Rev. 387 (1971) (reviewing recapture provisions of the 1969 act). Calvin Johnson, 'Financial Impact of the 1986 Act on Real Estate Investments: A View from the Spreadsheets,' Tax Notes, July 20, 1987, p. 309, (arguing that 1986 reform cut the value of real estate shelters about in half and that ending differential rates on capital gain was the strongest single explanation why.)
/9/ Tax Reform Act of 1976, Pub. L. 94-455 section 204, enacting section 465 (at risk limitations). See, e.g., Calvin Johnson, 'The Front End of the Crane Rule,' Tax Notes, Apr. 30, 1990, p. 593 (nonrecourse liability explains inflated purchase price tax shelters).
/10/ Tax Equity and Fiscal Responsibility Act of 1982, Pub. L. 97-248 sections 320, 322, 324, 402, 403, enacting sections 6031, 6221-6232 (facilitating IRS litigation of partnership taxable income), sections 6700, 6701 (penalties on promoting abusive tax shelters), section 7408 (injunction against promoters of abusive tax shelters), section 6703 (penalty for substantial understatement of income) explained by Staff of Joint Comm. on Tax., Gen. Expl'tion of the Rev. Prov. of the Tax Equity and Fiscal Responsibility Act of 1982, 14-15, 211-230, 267-282 (1983). See Jerome Kurtz (former IRS commissioner), 'Notes to New Commissioner of Internal Revenue,' Tax Notes, June 1, 1981, pp. 1195, 1197 (abusive shelters are just 'ticket on the tax lottery'); Abusive Tax shelters: Hearings Before the Subcomm. on Oversight of House Com. on Ways and Means, 97 Cong., 2d Sess. 59 (1982) (statement of Jerome Kurtz, chairman, Tax Shelter Comm. ABA Section of Taxation) (distinguishing abusive from nonabusive shelters on basis of IRS's litigation success). There is a tendency for the IRS to define tax shelters as a compliance issue, since shelters that are available under sound law are outside the jurisdiction of the IRS.
/11/ Tax Reform Act of 1984. Pub. L. No. 98-369, sections 41, 91 adding sections 461(h) & 1274. See Daniel Halperin, 'The Time Value of Money-1984,' Tax Notes, May 14, 1984, p. 751; Calvin Johnson, 'Silk Purses from a Sow's Ear: Cost Free Liabilities Under the Income Tax,' 3 Amer. J. of Tax Policy, 231 (1984).
/12/ See, e.g., Marine v. Commissioner, 92 T.C. 958, 89 TNT 102- 15 (1989), aff'd 921 F.2d 280, 91 TNT 7-4, (9th Cir. 1991) (real estate); Porreca v. Commissioner, 86 T.C. 821, 843, 86 TNT 85-85 (1986) (television video master); Herrick v. Commissioner, 85 T.C. 237, 255, (1985) (tire gauges); Driggs v. Commissioner, 87 T.C. 759, 774, 86 TNT 197-90 (1986) (computer translation program); Elliot v. Commissioner, 84 T.C. 227, 236 (1985), aff'd 782 F.2d 1027 (3d Cir. 1986) (gothic novel); Sutton v. Commissioner, 84 T.C. 210, 221 (1985), aff'd. 788 F.2d 695 (11th Cir. 1986) (truck trailers); Est. of Baron v. Commissioner, 83 T.C. 542, 553 (1984), aff'd 798 F.2d 65 (2d Cir. 1986) (master recording); Dean v. Commissioner, 83 T.C. 56, 73 (1984) (rights to paperback book); Surloff v. Commissioner, 81 T.C. 210, 232 (1983); (coal mine): Fox v. Commissioner, 80 T.C. 972, 1010 (1983), aff'd 742 F.2d 1441 (2d Cir. 1984) also aff'd sub nom Bernard v. Commissioner, 731 F.2d 230 (4th Cir. 1984) (book); Flowers v. Commissioner, 80 T.C. 914, 919 (1983) (master recording). Adam Chinn, Note, 'Attacking Tax Shelters: Section 183 Leaves the Farm and Goes to the Movies,' 61 N.Y.U. L. Rev. 89 (1987) quite soundly describes the cases as explained by the nonrecourse liability used to purchase the activity.
/13/ Rose v. Commissioner, 88 T.C. 386, 412-414, 87 TNT 25-11 (1987), aff'd on other grounds 868 F.2d 851 (6th Cir. 1989), criticized in Cranston R. Williams, Note, 'The Tax Court's Rose Test: More Thorns in the Sides of Taxpayers,' 8 Va. Tax Rev. 905, 931 (1989).
The idea that investments designed to generate tax losses for a number of years might be subject to the hobby loss rules apparently comes from an SEC-sponsored advisory group in 1972. (Barry D. Thorpe, SEC Disclosure Practices in Tax-Sheltered Offerings, Special Supplement to Sec. Reg. L.J. & Real Estate L.J. 15 (1973)), later picked up by SEC in its instructions for SEC-mandated prospectuses. Sec. & Exh. Comm., 'Industry Guide 5: Preparation of Registration Statements Relating to Interests in Real Estate Partnerships' (1973).
/14/ 'Requisite greed' comes from the title of George Carey & Thomas Gallagher Jr., 'Requisite Greed: The Section 183 Regulations,' 19 Loyala L. Rev. 41 (1973). In Surloff v. Commissioner, 81 T.C. 210, 232 (1983) the underlying activity was a coal mine.
/15/ See, e.g., Levin v. Commissioner, 832 F.2d 403, 407 (1987) (Easterbrook, J.) (debts payable in superinflationary currency became confetti, not worth collecting, by the time it was due).
/16/ Agro Science Co. v. Commissioner, T.C. Memo. 1989-687, 89 TNT 262-8, aff'd without opinion 934 F.2d 573, 91 TNT 73-10 (5th Cir. 1991). In the case, a unit involved $525,000 of debt, not $600,000, which makes no difference to the point. The hypothetical in text does ignore the $75,000 cash paid immediately to the promoter, which gives the promoter enough to put the deal together.
/17/ Section 174 authorizes deduction of research and experimental costs, even if they are what would otherwise be thought of as capitalized investments.
/18/ See, e.g., Calvin Johnson, supra note 9 (arguing that nonrecourse liability is not a cost cognizable in tax, unless the down payment is larger than the value of the tax savings).
/19/ Emmons v. Commissioner, 31 T.C. 26, 31 (1958) (disallowing interest deduction.)
/20/ See Jim Carlton, 'Interest Swells Cost of Thrift Bailout,' Wall St. J. at B1, June 10, 1992 (reporting estimate of complete cost of thrift bailout as $2 trillion).
/21/ See William Andrews, 'A Consumption-Type or Cash Flow Personal Income Tax,' 87 Harv. L. Rev. 1113, 1121, 1136-1139 (1974); Calvin Johnson, 'Tax Shelter Gain: The Mismatch of Debt and Supply Side Depreciation,' 61 Texas Law Rev. 1013 (1983).
/22/ Debt is also no advantage when any tax benefits are so fully capitalized that the investor gets nothing better after tax than returns available from normal savings accounts. Theodore Sims, supra note 2, But see Calvin Johnson, 'Is an Interest Deduction Inevitable?' 6 Va. Tax Rev. 121, 165-168 (l986) (arguing that supply overhang is too great to allow market to fully capitalize existing tax advantages). Fully capitalized tax benefits, moreover, are also very expensive for the government to provide. With a fully capitalized shelter, for instance, a high-bracket investor can consume now paying at an after-tax interest cost that is lower than it costs the government to lend after tax.
/23/ See supra note 22.
/24/ Section 469(b)&(g)(1), carrying over the tax loss suspended by subsection (a) into next year, ad infinitum, and allowing the loss when taxpayer disposes of entire interest in the activity.
/25/ See, e.g., Calvin Johnson, 'Three Errors in the 'Neutral Cost Recovery System' Proposal,' Tax Notes, May 29, 1995, pp. 1229, 1230-1231 for an algebraic explanation.
/26/ See, e.g, William Andrews, supra note 21, at 1121, 1123-28, 1167-1168 (1974).
/27/ See, e.g., id. at 1153-1155, 1158.