35 Tax Notes 1019

Tax Notes

MAY 25, 1987

LENGTH: 1459 words

DEPARTMENT: Current and Quotable #3

CITE: 35 Tax Notes 1019

HEADLINE: 35 Tax Notes 1019 - JOHNSON SAYS IRS SHOULD DEVELOP DIFFERENT APPROACH TO SETTLE TAX SHELTER CASES.

AUTHOR: Johnson, Calvin H.

University of Texas at Austin

TEXT:

Set forth below is the full text of a May 26, 1987 letter to IRS Chief Counsel William F. Nelson from Calvin H. Johnson, Arnold, White and Durkee Centennial Professor of Law at the University of Texas at Austin. Johnson suggests that the IRS concentrate on developing a per se rule to settle tax shelter cases involving two-party nonrecourse liability. The letter also has been placed in the June 8, 1987 Tax Notes Microfiche Database as Doc 87-3275.

Dear Mr. Nelson:

The Internal Revenue Service needs to coordinate its litigation strategy with its settlement strategy in the tax shelter area so that its litigation victories serve quick and reasonable settlements. IRS case victories under the 'sham' or 'hobby loss' or 'profit motive' doctrines are in fact IRS losses overall because the IRS cannot reasonably litigate the facts and circumstances of each case. But the IRS is one or two victories away in the Tax Court from a helpful per se or presumptive rule against two-party nonrecourse liability that is based on the real economics of two party nonrecourse liability. Those victories would allow the IRS to capture most of the money at stake in the tax shelter deficiencies quickly and efficiently.

Most of the recent tax shelter cases are explained economically by the fact that the purchaser is paying for the property with play money, that is, nonrecourse liability to his seller that he cannot be expected to pay. The buyer and seller, bargaining over two party nonrecourse liability, commonly both want the liability to be as high as possible. A seller is happy to accept inadequately secured liabilities because side fees and down payment will be higher and because he can expect to get the property back in any case. But buyers want inflated debt too because higher liabilities give greater depreciation deductions and interest. The key to understanding the cases is that the purchaser is bargaining quite well, it is just that he is deriving tax deductions from two-party nonrecourse liability that he will not rationally pay. The bargaining leads to $100,000 depreciable liabilities for a dog house and resembles the old joke:

A man walked into a bar announced that he had just sold his dog for $500,000. 'For that flea-bitten mongrel?' the bartender asked in astonishment, 'In cash?' 'Of course not,' the man replied, 'but I got two $250,000 cats.'

A purchaser trying to preserve some equity in the property he is purchasing will try to bargain down, paying as little nonrecourse liability as possible. But if the present value of the tax savings that the purchaser can expect from his transaction is greater than the present value of the cash he has committed, then the purchaser will be better off with higher liabilities, not lower ones. He will have the economic motive to inflate the debt. The purchaser would not want the debt to inflate so much as to be obvious on audit to the IRS, but with audit coverage so low, the fear of getting caught will not keep the inflated liability reasonable in amount, given the parties' self interest in inflating the liability.

It is relatively easy on the facts of any case to determine the present value of the tax savings that the purchaser can expect from his nonrecourse liability and compare it to the present value of the cash he has committed. (The tax benefits expected from the cash can be taken into account either in looking to overall present value of the tax savings or as a net reduction in the present value cost of his cash. The comparison will remain the same either way). In those cases in which the tax savings are the predominant value, the IRS in settlement and the courts in doctrine should presume the liability is unduly inflated. Those taxpayers who want to prove such liabilities were sufficiently secured, notwithstanding Adam Smith and the inevitable hand of economic self-interest, will be trying to prove that water ran uphill, and they should carry an extraordinary burden.

Nonrecourse financing from a third party such as a bank is different. A seller who provides the nonrecourse loan will just get his property back if the liability is inflated, but a bank will get its cash back only if the security is adequate. Thus banks at least have a motive to prevent inflation of liabilities beyond the value of the collateral.

Cash borrowing from a third party is also distinguishable from two-party debt for reasons internal to tax. When a taxpayer borrows cash he steps into the shoes of his lender and achieves no more tax basis than the lender or his predecessor could get; the taxpayer then uses the cash to pay for the property and that creates immediate tax to the seller. The Treasury collects tax both before the borrower gets his basis and immediately after the borrower gets basis. Two- party loans, by contrast, are often a 'tax float' creating basis by the sale. The seller commonly has no basis to pass over to the buyer; with the installment elections and cash method, the seller commonly has to pay tax on the two-party liability only many years after the purchaser has depreciated or deducted the liability.

Under established court doctrine, none of the inflated nonrecourse liability is included in basis nor can it support interest deductions. That rule just describes the nature of the liability and is not penal. Purchaser cannot keep property subject to a high liability just by paying up to the amount of the fair market value of the property. The liability must be satisfied in full or it does no good to satisfy any of it. Thus purchasers will pay nothing on an inflated liability--except for small interim payments to keep their options open and defer Tufts recapture if the nonrecourse liability is greater than the fair market value of the collateral. The all or nothing rule for nonrecourse liability is just a description of the transaction.

Once it is determined that the nonrecourse liability is inflated, even the cash actually paid should not be deductible. Since the inflated liability precluded the purchaser from retaining any equity or return from the property, it follows that the cash payments were made to save or avoid Federal income tax. Federal income tax is not deductible in computing taxable income and Federal income tax saved is consistently not an item of tax savings. The out of pocket costs must be treated as costs of tax-exempt income. Alternatively the costs are payments in lieu of tax. In either case, the cash payments draw their appropriate tax treatment from the nondeductibility of the Federal taxes they were meant to replace or recover. At the end of the taxable year, when tax character is set, the out-of-pocket cash was a nondeductible cost.

Inflated nonrecourse liability will remain a problem into years covered by the at-risk rules. Section 465 suspends deduction of losses, but after a ceiling under which deductions are allowed only the ceiling is too high. The at-risk suspension occurs only after the taxpayer has sheltered all income from the entity he is investing in, and expensed all cash and personal liabilities. In Rose v. Commissioner, 88 T.C. No. 18 (1987) (Jackie Fine Arts shelter), for instance, the promoter created an inflated two-party nonrecourse liability just to allow the purchaser to expense a liability he would eventually be expected to pay. The inflated nonrecourse liability allowed the purchaser to deduct his basis caused from at-risk liability long before normal depreciation schedules would allow it.

The Service in conclusion should reach settlements by computing tax ignoring two-party nonrecourse liabilities, where the down payment is less than the present value of the tax savings, and should disallow at least some percentage of the cash payments in compromise. Before the Tax Court, the IRS should stop making kitchen sink arguments that include sham, hobby, not-for-profit, and other arguments that require costly full litigation. The IRS should instead insist that the next tax shelter cases be decided strictly according to the economics of two-party nonrecourse liability and nothing else. The Tax Court has repeatedly taken inflated nonrecourse liability out of basis and as shown by Rose (the Jackie Fine Arts shelter), it is getting sick of subjective or nebulous sham tests. It is ready to have the economics of two-party nonrecourse liability explained to it and to adopt an economic test that will lead to quick and easy pro- IRS settlements.

Please call on me if I can provide any further service to you on this matter.

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Very truly yours,

Calvin H. Johnson

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