Every so often, Brunson and Herzig carve out a day to swap long-winded emails, then those emails are published on the Internet.
I am sure you have seen by now the NY Times story about Donald Trump’s purported tax positions from the 1990. The NY Times has been following up on a story they originally published about a month ago reporting that Mr. Trump reportedly had a $990 million net operating loss (“NOL”). After the story, there was rampant speculation about the loss.
If Mr. Trump used exclusively all of his money to buy properties or casinos or whatever and those assets were used in a trade or business and those assets went down in value, Mr. Trump would suffer a real economic loss. This real economic loss would then generate a real tax loss. At the time, most tax experts thought that Mr. Trump may have used some of his money but all used loans. I think I was quoted as saying this was likely given his prior statements about being the king of debt.
The problem for Mr. Trump is if he used debt to buy the properties, then he would have an economic loss and tax loss. But, when the debt was forgiven or reduced, then Mr. Trump should have income. There is an old tax case, Crane v. Commissioner, when the Supreme Court had to make an important decision early on in the tax Code. When you borrow money do you have income? Crane said, “no”, you did not have more wealth because you were expected to repay the money. Crane could have said yes you have income and corresponding deductions when you paid they loan back, but, the Court went the other way.
Here, since it was assumed that Mr. Trump did not pay back the loans, he should have a loss and income. For most of the last month, most pundits were focused on exotic tax plans that allowed Mr. Trump to avoid the corresponding income most assumed were associated with the NOL. Both of us were skeptical of these exotic plans. For example, I thought Lee Shepard’s structure was rather unlikely given that not many real estate partnerships were organized as S Corps in the 1990s.
All this background gets to yesterday’s story. The NY Times seems to have dug up an old Willkie Farr tax opinion letter to the Trump Taj Mahal entities. I would love talk about a couple points that seem to resonate about the letter:
- The NY Times thinks this structure was illegal and I have heard the same from David Cay Johnston. I not convinced that we know enough about the structure or the facts to opine on the illegality of the structure. Congress after all did not act until 2004 to ban this debt/equity swap. Hard to believe it was illegal if Congress needed to act to solve the problem.
- My understanding of the late 1990s was that pre-Enron, most taxpayers took very aggressive tax positions. Remember this was a tax shelter heyday. Pre-Enron and Circular 230, a taxpayer could avoid penalties if you had a more likely than not opinion and the courts and IRS would respect the opinion. If that is true, then this opinion seems to follow more in the category of penalty insurance than real tax advice.
- With that said, I am shocked at the total lack of analysis on complicated legal issues. Debt/equity is a truly complicated and fact specific analysis. How could the law be stated and it concluded in two pages that there was no equity? That seemed rather short winded.
Do you want to talk about any of this or do you have your own topic?
Thanks for starting this. In the interest of full disclosure, before I dig into your questions, I should mention that after my 2L year, I summered with Willkie, and after law school I worked as an associate in the Willkie tax department for four years. I have nothing but good things to say about Willkie’s attorneys—while I was there, they were thoughtful, ethical, and professional. And now to the questions raised by the Times story:
To your first question, I think you’re right. It was almost certainly an aggressive position, but from what little information we have, it’s hard to say the position was illegal. The Times article makes hay of the fact that the justification for Trump’s transaction was “conjured from ambiguous provisions of highly technical tax court rulings, [and] clearly pushed the edge of the envelope of what tax laws permitted at the time.”
I’m going to leave aside the second clause for a second to say: the first part is precisely what tax attorneys are supposed to do. They take ambiguous provision of the tax law and interpret them, to the best of their professional ability. It’s clearly not optimal to have ambiguity in the tax law, but once ambiguity is there, taxpayers have to know how to navigate that ambiguity as they transact. I think it’s clear that we don’t want taxpayers to have to avoid whole sets of transactions just because the tax law surrounding them is ambiguous and highly technical. Moreover, where taxpayers get it wrong, Congress, the IRS, and the courts have the ability to rein them in.
Which gets to the second clause of the quoted sentence (and to your second question): legal or not, was it aggressive? And the answer is, clearly yes. I mean, Willkie could only say that one part of the transaction was more likely than not to be upheld by courts if it were challenged; the other parts had about a 1-in-3 chance of holding up.
Now, I’m not entirely comfortable laying out the context of how aggressive these opinion letters were in 1991 and 1992; back then, I was still a high school student with dreams of being a famous rock musician. According to Confidence Games, though, the end of the 90s was a world of super-aggressive positions being blessed by tax opinions, sometimes even from reputable firms.
So why would Trump want an opinion about an aggressive position that his attorneys told him had less than even odds at winning if challenged? You hint at it in your second question: at the time, reliance on a “substantial authority” opinion would eliminate most penalties. So if the IRS challenged Trump’s transaction and it went to court, the court might order him to pay the underpayment amount, and interest on that amount, but by flashing his opinion, he could probably avoid paying a penalty of 20% of the underpayment.
Which frankly made the governance of tax opinions an important locus for the IRS. One of my first assignments when I started at Willkie, in fact, was to read the 2004 version of Circular 230 (which governs practice in front of the IRS) and figure out what it required us to do. (Because it required significant factual and legal explanations in written advice, it created a mid-2000s world where every email from a tax attorney—and sometimes every email from a law firm, period—had a “Circular 230 disclaimer” as boilerplate at the end; the disclaimer informed clients that they couldn’t rely on anything in the email to avoid penalties.)
Finally, the debt/equity thing: of course it’s way more complicated than two pages. It took Treasury what, 47 years to issue the debt-equity regulations that Congress told it to issue, and those regulations are 500 pages long. When I was in practice, I had a photocopy of Plumb’s 200-page Tax Law Review article “The Federal Tax Law Significance of Corporate Debt: A Critical Analysis and a Proposal” (26 Tax L. Rev. 369 (1971), if you’re interested) on my shelf at work, and I used it as my starting point every time I had to deal with a debt-equity question. For at least 35 years, it was the last word on the subject of debt and equity. Of course, it seems to have been the 2004 Circular 230 that required tax opinions to include all relevant factual and legal analysis in the opinion itself; prior to that, I understand, tax opinions—especially when they were for penalty protection or because the terms of a deal required a tax opinion—were significantly shorter and less detailed.
All of that leads me to one question: how do we ensure that tax attorneys don’t bless too-aggressive positions? Even if it was aggressive, like you said, if Congress felt the need to explicitly solve the problem in 2004, it wasn’t clearly impermissible. Still, we want tax attorneys to stop things that, while not explicitly illegal, stretch the tax law beyond where it should go. One thing that Confidence Games makes clear is that, in the 90s and early 2000s, clients who wanted to participate in a tax shelter would push their attorneys to give them an opinion, with the implied or explicit threat that, if their attorneys didn’t give the opinion, the client would go to a law firm that would. And there was always a law firm somewhere that, for the right price, would.
Yes, tax attorneys have ethical obligations, to the client, the IRS, and the tax system itself. But if we want tax attorneys to stand as one guardian of the tax system—and we do!—we need to figure out how to help them do that (or are we already there, post-2004?).
Looking forward to your thoughts.
The rules as it turns out were very unclear. In summary, in 1990, Congress repealed section 1275(a)(4).
In 1990, Congress also enacted new section 108(e)(11), which provided that, for purposes of determining COD income in a debt-for-debt exchange, the debtor corporation would be treated as though it had discharged the old debt for “an amount of money equal to the issue price” of the new debt. Moreover, the exception wouldn’t apply to basically preferred stock (the functional equivalent of debt). Treasury also issued controversial regulations under section 108(e)(8) that made it even more difficult for debtors to rely on the stock-for-debt exception.
Then, Cottage Sav. Ass’n. v. Commissioner, 499 U.S. 554 (1991), was decided. Under Cottage Savings, many modifications of outstanding debt are treated as debt-for-debt exchanges.
Finally, in 1992, a provision repealing the stock-for-debt exception was included in a bill that passed but was vetoed by President Bush. The repeal of both section 1275(a)(4) and the stock-for-debt exception changed the tax incentives in bankruptcy workouts and restructuring.
In fact, it was the 2004 change to the Code by Congress that finally closed this loophole. So, actually, in 1990-1995 the transaction probably was not aggressive if we needed a legislative fix.
When Willkie opines in 1991 that there is more likely than not or another standard, how could the law be perceived as clear? Not only was this a time of aggressive opinions, but, here specifically, the law was less than certain.
Why is that not factored into the normative position that what Mr. Trump did was somehow inherently bad? I find that of all his troubles, this seems to be the least troublesome. Bankruptcy and tax people were both trying to figure out the contours of the law at the time.
Does the fact that this was truly unsettled change your perception of the transaction?
Finally, this is why Mr. Trump should actually follow tradition and disclose his tax returns. Here we have the NY Times trying to make a mountain out of a molehill because there is nothing else to investigate. I don’t know what else is in his returns. But we do know when no one was looking he was willing to push the boundary of the law. His returns could show if this is a trend or a one-off scenario.
I think it could affect my opinion on how aggressive the position is. If this question was truly and completely unsettled, and Congress didn’t do anything to settle it for another dozen years or so, it seems unfair to treat it as clearly wrong just because Trump did it.
But, like you said, he has the ability to clear this up. All he has to do is release his tax returns, and the public can see if he takes tremendously aggressive positions as a matter of course. Without that context—a context he controls—I suspect that whatever tax information leaks out into the general public will be seen as borderline criminal. The only thing is, it may be too late for him to change that perception, even if he does, in the final week of his campaign, release his tax return.
UPDATE: There is now a podcast (https://surlysubgroup.com/2016/11/02/cooking-the-books-podcast-on-trumps-taxes/) on this topic for those interested.