47 Tax Notes 1009

Tax Notes

MAY 21, 1990

LENGTH: 1290 words

DEPARTMENT: Letters to the Editor (LTE)

CITE: 47 Tax Notes 1009

HEADLINE: 47 Tax Notes 1009 - SEEKING SHELTER: OPPORTUNITY LOST IN PLEASANT SUMMIT.

AUTHOR: Johnson, Calvin H.

Arnold, White & Durkee

TEXT:

To the Editors:

In a letter to the editor (Tax Notes, May 14, 1990, p. 869), John Taggart of New York expresses his 'dismay' at my Front End of the Crane Rule special report, (Tax Notes, April 30, 1990, p. 583). Mr. Taggart was counsel for the taxpayer in the successful endeavor to prevent the Supreme Court from taking certiorari in Pleasant Summit Land Corporation v. Commissioner. My special report arose from a brief prepared to be filed on the other side of the case. Thus, I am not very surprised that I have failed to persuade him, at least for now. But he reiterates some arguments that should not stand, merely by dint of reiteration, so this is my reply brief to the points in his letter.

In Pleasant Summit, the Third Circuit gave tax shelter investors a partial, FMV basis in depreciable garden apartments beause of nonrecourse debt owed to the sellers, which the investors could not be expected to pay. The outstanding nonrecourse liability was always very considerably in excess of the value of apartments; a rational investor would let the apartments go rather than pay the debt even in part when due. Since the investors' tax benefits were worth a lot more to them than the cash that they needed to pay to get into the deal, the investors were perfectly happy with the situation. They liked the inflation of the debt. Taggart calls this a problem of 'real' debt. It was not. It was play money. Debt that the debtor will never pay and rationally wants to inflate is not a cost, even in part.

The taxpayer's brief in opposition to the writ of certiorari misled the Supreme Court in a number of ways, which the government on reply should have picked up on. The brief gave the false impression that the debt was legitimate because it was ultimately paid on sale of the property by the partnership. In fact, at the sale by the shelter partnership, the outstanding principal had grown exponentially, was far in excess of value, and had no prospect of turning around and being paid. The shelter partners neither paid any of the mortgage at sale nor received any distribution from the sale of 'their' building. When Taggart says that the partnership 'never defaulted, but ultimately sold the property,' he is using 'defaulted' in a technical and misleading sense having no bearing on the legitimacy of the debt. The debt was not paid upon sale or ever paid.

Taggart also argues that the debt was legitimate because there was a first mortgage (of about a third of the total debt) owed to a third party. A third party lending cash on a nonrecourse liability to the prior owner of the property can be expected to have demanded that the cash was likely to be repaid. But the shelter investors bought the property, subject to the first mortgage, with such added liabilities that the total debt concededly exceeded the value of the property and under that condition they had no motive to pay any of the debts for the purpose of buying the property. It would not help the investors to pay a third or some fraction of the total debt on the property because paying some bit or just one of the mortgages when they are ultimately due never entitles the buyer to keep anything. Nonrecourse liability is all or nothing to the owner. The seller who would expect to get the property back on default and who might well pay off the first mortgage, in fact claimed the first mortgage as part of their basis. But the first mortgage was not any cost to the shelter.

Taggart also gives the false impression that the debt was legitimate because some payments were made on the mortgages. Under the sale-leaseback of the apartment, the seller seized the rents from the apartment to pay the debts before the investors ever saw them; those rents were not payments from outside sources by the investors that legitimate the transaction. What payments the investors did make from outside sources are fully consistent with the theory that the investors were buying only tax savings. The value of their tax benefits far exceeded the value of the payments they needed to make. None of the payments imply there was any value to the investors' net interest in absence of tax.

Taggart miscited Odend'Hal (4th Cir.), Estate of Franklin (9th Cir.) and Brannen (11th Circuit), which cannot be fairly cited for the proposition that the sham nonrecourse debts there involved generated basis up to the fair market value of the properties. The holdings (and language) of the three cases fully support the rule that nonrecourse liability, in excess of the value of collateral, is not basis even in part. Most charitably described, the taxpayer's brief stretched dicta, quoted out of context, addressing other issues. Less charitably, the brief misinformed the Court by misdescribing the cases. Neither taxpayer nor the government, moreover, informed the Supreme Court of the more than 40 applicable Tax Court cases that made application of the rule contrary to Pleasant Summit so routine.

Taggart argues that other similar shelters got settlements that were at least as generous as the result reached by the Third Circuit. During the years in which the Tax Court was facing trials on billions of dollars of deficiencies from tax shelters, the government's settlement offers were indeed quite generous. The government, moreover, did not, upon settlement, always have the best theories nor understanding of the law and facts. Thus, while we can all regret that other abusive shelters got off too easy on settlement, those settlements are not good proof of the legitimacy of the Pleasant Summit shelter.

Taggart finally argues the nonresource liabilities were part of the amount realized by the Pleasant Summit Land Corporation, which sold the apartments to the shelter. But the selling corporation paid tax only on payments. The corporation reported the sale under the theory of Burnet v. Logan that it did not have to pay any tax until total payments exceeded its basis. Even as corrected by audit, the corporation used the installment method, which requires that tax be paid only for cash received. An increase in amount realized increases the part of any payment that is considered gain under the installment method, but given the shelter investor's motives, it was reasonable to treat all cash received by the seller as gain from the sale of tax loss benefits. In any event, a seller should have an amount realized under Tufts to correct prior excess depreciation deductions the seller has not paid for, even when the debt is sham debt for the buyer. There is thus nothing in the treatment of the corporation selling the apartment that implies that the buyers had any cost basis.

Taggart is a hard and clever advocate. The Supreme Court denied certiorari in Pleasant Summit, at least in part because of his legal craft. But his pitches work, like the pitches of an aging junk-ball pitcher, only because they give false impressions. His words appear to prove his point only if the reader misunderstands what he is literally saying. I am sorry that he succeeded in convincing the Supreme Court not to take Pleasant Summit, because the case was wrongly decided in the Third Circuit. It would have also been fun, for the sake of truth and justice, to argue on the other side.

________________________________________________________________________________

Sincerely,

Calvin H. Johnson

Arnold, White & Durkee

Centennial Professor of Law

University of Texas

May 17, 1990

________________________________________________________________________________