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The tax geek crowd is really ganging up on Donald Trump for his over $900 million loss in 1995.    Professor Calvin Johnson of University of Texas at Austin Law School has weighed in with “Were Trump’s Fake Losses Legal as Tax Deductions? (download).  Fake losses! That is pretty harsh.  Practically locker room talk.  Professor Johnson’s frames the issue this way.

A crowd source of talented people who know a lot of tax are trying, without much success, to figure out how Trump could claim a $916 million tax loss on his 1995 tax return. Trump did not lose anything like the billion dollars he claimed on his tax return in real terms because he never put that much of his own money into the transactions. If he never put it in, he did not lose it. Was the loss, fake in economic substance, also fake under tax law?

I have some issues with the analysis, but let’s look at the rest of the article first.

Background

In case you are new to this topic, it goes back to a New York Times story in which Donald Trump’s former accountant, Jack Mitnick, confirmed that a few pages from Trump’s 1995 returns were in fact legitimate.  The fragments from his state returns indicated that he had $6 million in net loss in 1995 and in the “Other Income” category over $900 million in loss.  The only plausible explanation for that would be a carryover from earlier years.

The $900 million-plus got rounded up to a billion-dollar loss in the debates and created speculation that Trump might have gone decades without paying income tax.  Trump has not exactly denied that rather indicating that not paying taxes proves he is smart and also knows how to reform the Code or something like that.

Some Theories

Professor Johnson covers two of the theories about how Trump could have such huge loss carryovers given that losses funded with borrowing eventually turn around on you, one way or another – unless you give the underlying assets to your spouse and get divorced or die.

There is a really good discussion of the “Gitlitz theory” put out by Lee Sheppard and Richard Lipton.  I have covered that in some detail in a previous post.  The idea is that debt discharge can step up your basis in an S Corporation without your having to recognize income.  Like me, Professor Johnson is skeptical that Trump took advantage of that quirk. He notes:

Sophisticated real estate developers did not voluntarily use S corporations in the 1990’s because the S vehicle trapped otherwise available tax losses inside an S corporation that could not use them. The strongly preferred vehicle for ownership of real estate was a partnership.

There is more.  The one thing that he overlooks is the possibility that Trump Shuttle, Inc might have been an S corporation.  It seems like that should be confirmable one way or another, but I have not had any luck yet.

The other theory that Professor Johnson discusses is that Trump might have taken a basis step down to avoid recognizing debt discharge income.

The basis reduction remedy takes away the ordinary section-1231 loss that Trump would have reported for tax had the basis not been stripped by the basis reduction. If it works as intended, basis reduction should an adequate remedy against the inconsistent goofy accounting of reporting discharged debt as if it were a cost.

A Little Carried Away

From there I think Professor Johnson gets a little carried away.

Given the awfulness of the abuse in Trump’s fake billion tax loss , Trump would probably lose before a well-informed court, even if he has a fairly good technical tax case. The claim for a billion dollar loss has no economic substance. Trump has no cash in the game, and hence no real losses when all is settled.

And:

But it is a workable surviving hypothesis that the Trump $916 million tax loss is
not legal. And if it were legal, the loss is still fake, so we need to do something to make sure that nothing that awful should ever happen again.

I had a little correspondence with Professor Johnson in which he started mentioning the sentencing guidelines, but like I said I think he is getting a little carried away.

Another View

Since the Times story, I have spent more time than I have cared to looking at documents from Trump’s restructuring in the early nineties.  Professor Johnson alludes to a Wall Street Journal story back in January – Trump and His Debts: A Narrow Escape.  Professor Johnson’s reading of the article was

Between 1990 and 1996, Trump persuaded creditors to restructuring agreement again and again, with complications intended to provide camouflage for what he was doing. Most of Trump’s $3.4 billion debt was never paid.

Better To Owe It To You?

I did not get that from the article. Another reading might be that things were stretched out. It is possible that Trump with refinancing and like-kind exchanges might have been able to avoid gain recognition almost indefinitely.

One of the few sayings from my days at Joseph B Cohan and Associates that would not violate the contributor guidelines is one of Herb Cohan’s that I never quite understood back then – “I’d rather owe it to you than cheat you out of it”.  I’m still not sure what Herb meant, but the principle has application here.  When you are upside down it can be better to just defer foreclosure rather than get an outright debt discharge.

Net Operating Losses Get Checked When They Are Used

There is something else to consider.  Apparently, that 1995 Trump return was one of the last ones prepared by Mitnick. Given Trump’s involvement in public companies, there is a pretty good chance that his return has like Romney’s been done by one of the major national firms since then.

And here is the thing about net operating losses.  Trump did not deduct the loss in 1995, he got to carry it forward and commentators assume that he must have used it in subsequent years.  The net operating loss is a deduction in the year that it is used.  Even if the statute is closed on the year of the loss, the IRS gets a bite at it in the year that it is used. More importantly, for this discussion, the preparer of the return can’t just rely on the prior accountant having it right.

Professor Johnson is suggesting that for the nearly billion-dollar loss to have been there in 1995, there had to be some funky accounting. I’m not entirely convinced of that, as I noted.  But even if I were to accept that the loss is “fake”, Trump has not done anything wrong until he uses it, and taking a bit of a leap here, a national firm would not have just accepted Mitnick’s carryover number.

There would have to be some vetting of the returns that accumulated the losses and a few hundred million of debt going poof would probably show up somehow. Regardless, although his boasting about his deep tax knowledge might hurt his defense, I think Mitlick’s statements that Trump did not understand his returns and future reliance on a national firm would prevent Trump from forfeiting his liberty.

Not A Trump Apologist

All my writing on this subject might make me seem like a Trump apologist, but you might want to check out this post in Going Concern, before you come to that conclusion.

Other Coverage

Someone in my brain trust pointed this out to me on the Tax Prof’s blog. (If I were not on vacation, I probably would have caught it without help)  There are some good comments there, but I think the best may be by Mike Livingston

Did Trump do anything different than other developers? If not, what is the fuss about?

Tax Notes has something on this, but it is behind a paywall and if you are a regular reader you know what a cheapskate I am.  Trump has already cost me over fifty dollars on PACER,  I have not seen much else. Most of the other tax bloggers don’t pay a lot of attention to SSRN.  Don’t tell them about it.  I get some good stuff there.