Originally published on Forbes.com Oct 8th, 2013
Don Corleone told his son that “Lawyers with a briefcase can steal more than a thousand men with guns.” The godfather lacked vision. He didn’t conceive of how much lawyers in concert with the Big 4 accounting firms could steal. That is probably like going from a thousand men with guns to several mechanized infantry divisions and a wing of fighter planes – stealth fighters.
The recent Court of claims in the case of BASR Partnership has me contemplating what happened in the nineties and around the turn of the millennium. While folks were worrying about Y2K and calling COBOL programmers out of retirement the Big 4 and some of the not quite Big 4 were teaming with some law firms to run what Jack Townsend calls a raid on the treasury. Most notable among the law firms was Jenkens and Gilchrist who were the masterminds behind the BASR partnership. The case is of interest for several reasons among them is that it gives one of the clearest explanations as to how these things worked.
Debit By The Window, Credit Out The Window
There is an old accounting joke about somebody keeping a little note in his desk that said “Debit by the window, credit by the door”. It is similar to the story of Civil War recruits being taught how to march having a wisp of hay tied to one foot and straw to the other foot and the sergeant calling out “Hayfoot, strawfoot“. Fundamentally the basis inflation that allowed you apparently to pay a Big 4 firm 3% rather than paying the government 20% when you had a capital gain was based on an unbalanced entry. The BASR case gives a nice summary:
(1.) A Family General Partnership will be created.
(2.) A short sale of Treasury securities is conducted by each family member.
(3.) stock of and the short sale will be contributed by the four family stockholders into the family partnership.
(4.) An S-corporation will be created.
(5.) The partnership interests will be contributed to the S-corporation.
(6.) Such contribution triggers the IRC §754 basis step-up for the Page stock.
(7.) The short sale is closed out, creating a minor gain or loss.
(8.) The Page stock may then be sold to your printing business buyer by the family partnership
It reminds me a bit of the classic “mathematical proof” that 1 = 0.
x = y
Then x2 = xy
Subtract the same thing from both sides: x2– y2 = xy – y2.
Dividing by (x-y), obtain x + y = y.
Since x = y, we see that 2 y = y.
Thus 2 = 1, since we started with y nonzero.
Subtracting 1 from both sides, 1 = 0.
Spotting The Flaw
I know a lot of very smart people whose eyes glaze over when you get into the x’s and y’s. In the fourth step of the “proof” you are dividing by zero. That is what makes the proof invalid.
When you combine debits and credits with Subchapter K, almost everybody’s eyes glaze over. The linchpin of the scheme was the third step when the short sale was contributed to the partnership. When I was a kid, my father, a senior order clerk for a Wall Street firm, taught me this little ditty “He that sells what isn’t hissen buys it back or goes to prison”. I don’t know what the old man expected an eight year old to make out of that, but I finally got it when I was about thirty.
The thing is that “goes to prison part” is a contingency that arguably did not qualify as a liability under Code Section 752. So when you contributed the “short sale contract”, the argument was, you got basis in the partnership interest in the amount of the proceeds even though you never went out of pocket. After the short sale is gone, that outside basis is still there, so when the contribution to the S corporation happens, the 754 election requires you to do something with all that basis and the only place for it to go is on that stock you contributed.
The Stealth Part
What is beautiful about the plan compared to other tax shelters is that there is no requirement to put a big ugly negative number on anybody’s return. No tax shelter here, just a lower than anticipated gain. A lot lower.
Cast In Concrete
The IRS generally has three years to find any “mistakes” you may have made on your return. If your “mistake” is that you “forgot” to report a goodly chunk of income (like 25%), they get six years. I think the principle is that it is harder to spot an income omission than a phony deduction. The IRS argued that overstating basis was like omitting income, so they should get six years to ferret out these deals also. There was a long drawn out battle about that. It ended up with the Supremes deciding in a case called Home Concrete, that overstating basis was not the same as omitting income.
Fraud Is A Different Story
There is no statute of limitations if the returns are fraudulent. That is what the IRS was arguing about the BASR partnerships. It gets a little sticky though. The Court did not have any problem agreeing that the professionals involved in the scheme were as Holden Caulfield would say “phony bastards”. The actual partners, though, were just plain folks, they were relying on the professionals to do the right thing.
As a result, the Government insists that the fraudulent intent of an agent of the taxpayer should trigger the statute of limitations extension in I.R.C. § 6501(c)(1), because the taxpayer is responsible for filing a return and paying any tax due.
There is a rather lengthy, lawyerly analysis, but ultimately the Court of Claims did not go along with the Government, although they admitted that there were some pretty persuasive arguments there. It almost seems that this decision gives taxpayers an incentive to not look to closely into schemes that professionals cook up for them.
Other Coverage
I think that my explanation of the debits and credits of these deals adds a glimmer of light to a pretty murky area. As I note the decision is pretty lawyerly so you may want to check out Jack Townsend’s discussion and that of Leslie Book.
You can follow me on twitter @peterreillycpa.