23 Tax Notes 765

Tax Notes

MAY 14, 1984

LENGTH: 1918 words

DEPARTMENT: Current and Quotable (CQT)

CITE: 23 Tax Notes 765

HEADLINE: 23 Tax Notes 765 - A NEW WAY TO LOOK AT THE TAX SHELTER PROBLEM.

AUTHOR: Johnson, Calvin H.

TEXT:

Reprinted below is the full text of a letter from Calvin H. Johnson, professor of law at the University of Texas at Austin to David H. Brockway, Chief of Staff of the Joint Committee on Taxation. Johnson explains that tax shelters have a negative tax (reducing the investors' taxes on other income) because of the 'tax float' phenomenon, created by the tax law's inconsistent treatment of obligor and obligee. Johnson's letter has been placed in the May 14, 1984 Tax Notes Microfiche Data Base as Doc 84-3560.

Dear Mr. Brockway:

As we talked on the bus in Austin on April 16, I suggested a new way of looking at tax shelters as a problem of 'tax float debt.' You asked me to write you.

Tax shelters are investments with negative tax: they bear no tax themselves but save tax the investor would otherwise pay on income from other sources. They give a higher return after tax than before tax. The factor most commonly responsible for negative tax is an asset that might be called a 'tax float.' The tax float phenomenon is simple, but it is powerful enough to wipe out the tax base.

Tax float defined. The tax law commonly treats two party debt inconsistently. The obligor -- the debtor of a two party debt -- get immediate tax deductions as if unpaid debt were already paid. However, the obligee -- the other party to the debt -- does not pay tax on the debt until it is actually paid. The debt saves tax on one side before the concommitant tax must be paid on the other. The parties therefore create and share an asset at government expense, a 'tax float,' by creating two-party debt.

Assume for instance that a tax shelter investor owes $100,000 management fees to a cash method shelter promoter and that the parties are otherwise unrelated. The fee liability is to be paid 12 years after it becomes fixed. Both investor and promoter are in the same 50 percent bracket. If the investor incurs his obligation through an accrual method partnership, the investor will be able to deduct the $100,000 liability when it becomes fixed and will save $50,000 tax 12 years before the cash method promoter receives the fees and must pay back $50,000 tax. The parties to the debt, viewed as a partnership vis-a-vis the government, have created a 12 year interest free loan from the government. They are richer by the value of the 12 year use of $50,000 than they would be had the debt not arisen. Alternatively stated, the parties have succeeded in delaying the collection of $50,000 in taxes for 12 years and the government must look elsewhere for its revenue.

The tax float can be more valuable than any nontax economic aspect of the transaction. For instance, the present value of the use of $50,000 for 12 years is $34,068, assuming a 10 percent discount rate. The present value burden of the $100,000 debt payable in 12 years is only $31,863, using the same discount rate. Whatever the importance of the management fee to the parties in the hypothetical, it is less important than the tax float they have created.

Interest is no cure. Interest on debt will affect how the value of a tax float is shared between the parties but it does not reduce the value of the underlying tax float. Any interest paid by the investor will be taxed in the promoter's hands, but it will save an equal amount of tax for the investor. The government will not receive any compensation from the interest and the interest will not reduce the value of the tax float. Interest on a tax float is like the sharing of partnership profits which does not change the value of the partnership asset. In fact additional interest will compound the problem in the hypothetical if it is accrued interest that is deducted but not paid; the added interest will increase the amount that is deducted before it is taxed.

ACRS debt. Big tax floats also arise when depreciable property is sold for the buyer's promise to pay for the property in the future. Under Crane a buyer's basis for depreciation and ITC includes debt he gives the seller to purchase depreciable property, but under the installment sale provisions of IRC section 453, the seller ignores the buyer's debt until it is paid. ACRS commonly gives tax savings at least as valuable as deducting the debt immediately. Thus the buyer will get tax savings which are earlier and more valuable than the tax the seller must pay on the debt. The tax float occurs without regard to whether buyer or seller is on cash or accrual method. (An exception to the tax float idea often has to be made to reflect the seller's basis at the time of sale: The tax float advantage arises when taxes saved by the buyer come before the seller pays tax, but the seller's basis sometimes represents tax that the seller has previously paid. Still tax floats are common on ACRS property in so far as the sale debt exceeds the seller's basis). Tax floats explain much of the incentives for churning.

Cash borrowing distinguished. Tax float debt is different from borrowing cash -- even though both can give a debtor a deduction. First the lender of cash or some predecessor has usually had to pay tax on the cash to have it to lend. The cash borrower can then be viewed as stepping into the shoes of the lender and getting only a refund of his predecessor's tax. Secondly cash paid immediately to the recipient causes immediate tax, notwithstanding the installment or cash method. The government thus recaptures the borrower's tax savings from the other party receiving payment. The tax the cash borrower saves, in sum, is more than made up by tax paid before or just after his borrowing. Cash borrowing does not create an asset vis-a-vis the government.

Cost-free debt. In the most virulent form of the tax float, the tax savings an obligor gets from debt is worth more to him than paying the debt hurts him. Thus the debt is cost-free or better after tax. As noted an interest free obligation of $100,000 payable in 12 years could be satisfied by setting aside $31,863 now. But the liability saves tax now of $50,000. In present value terms, the payor is better off with the debt, after tax, than he would be if he never incurred it.

Once the obligor of the debt has cost free debt, he will want the debt to expand. The courts in general rely on private bargaining to produce reasonable results, but both sides will be trying to justify cost-free debt that is as large as possible. The larger the debt, the larger the pie to split. It is difficult to see why cost- free debt is not more common now. We could see $10,000,000 management fees with debt. When the alchemy of cost-free debt is available, it is difficult to see why anyone pays tax. A tax float, deferred sufficiently long, would just wash out tax due.

Without the inconsistency between treatment of the obligor and the obligee, cost-free debt would not be possible. If an obligee were taxed when the liability is fixed, debts that were cost-free to the obligor would symmetrically require the obligee to pay tax that is higher than confiscation in present value terms. Taxable obligees would not arrange such debt.

Tax floats short of the cancer of cost-free debts still do damage. There is more private debt in the economy than there would be in absence of the tax floats and less revenue can be collected. The tax burden falls disproportionately on industries that cannot arrange tax floats or individuals who cannot or have not. There are no efficiency gains in the arrangements and plausibly quite substantial efficiency losses.

Tax Reform Act of 1984. Several provisions of current bills affect tax floats, without seriously impeding the ability of any group of taxpayers to create one. H.R. 4170 section 91, as reported by the Ways and Means Committee, would add IRC section 461(h) to deny accrual deductions before the promoter in the hypothetical has given the 'economic performance' of his management services, but the proposal would not affect the tax floats created for past or current services. H.R. 4170 section 41, enacting new IRC section 1275(b) would impute interest under a compound schedule on low or noninterest bearing notes given for services if the compensation exceeded $250,000. The new section if applicable would delay the time to take deductions on interest-free debt and that would have a salutary effect. Still the provision, even where applicable, allows deduction of all of the compensation at some time before the promoter must include the compensation in tax. Moreover, as noted, interest paid between the parties does not compensate the government for the tax float nor reduce its value.

The most important proposal is Senate bill section 172 adding IRC section 453(j) to require that recapture on an installment sale of real or personal property would occur immediately upon sale, rather than over the periods in which the installments are paid by the buyer. Tax floats would still be possible on depreciable property with respect to appreciation and still be possible because real property recapture is so weak. Tax floats would also still be possible with expenses or with sales of property not affected by IRC section 1245 and section 1250. Still the tax float concept emphasizes the importance of preserving the immediate recapture of proposed section 453(j) in Conference.

Remedies: A tax float can be defeated by imposing consistency on either side. The obligee, for instance, could be required to recognize income upon creation of the debt, notwithstanding the cash or installment methods, if his obligor is getting credit for the debt. It seems better theory, however, to deny the obligor deductions. The law treating debts as if they were immediate payments is a vestige of nineteenth century accounting that was blind to the time value of money. The payment is the economic burden of the liability; the debt is at best a reflection of the future burden. The assumption that bargaining will create debts that have a detriment similar to payments of cash does not hold for tax floats. Giving the taxpayer advance credit for future payments misdescribes the taxpayer's position.

As explained elsewhere, moreover, even cash borrowing will generate negative taxes under ACRS. Depreciable property purchased for its fair market value with debt will always generate artificial tax losses. See Johnson, Tax Shelter Gain: The Mismatch of Debt and Supply Side Depreciation 61 Texas Law Review 1013 (1983). As Secretary Regan testified in 1981, such negative taxes are an unintended result (1 Tax Reduction Proposals, 97th Cong., 1st Sess. 9,35 (1981)). ACRS implies that the correction of the tax float should be to deny the advance credit given to debt.

Conclusion. Tax shelters are not the inescapable product of tax planners beating the system nor of congressional intent. They come largely from identifiable anomalies including, quite prominently, tax floats. A tax float is an anti-revenue whipsaw in which the parties to debt are treated inconsistently -- though the debt has only a single reality. The inconsistency creates wealth, at the expense of the tax system, where no economic substance resides. The anomaly can and should be corrected.

Please call on me if I may be of further help to you on this issue.

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Sincerely,

Calvin H. Johnson

Professor of Law

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