Originally published on Forbes.com on August 31st, 2012
Some time in the far future, scholars will study my body of work and compile the definitive list of Reilly’s Laws of Tax Planning. The recent Ninth Circuit decsion in the case of Kurt Sollberger illustrates the most counterintuitive of the Laws – “Sometimes it is better to just pay the tax.” I know, it borders on heresy, but it has much merit. When the Green Lantern suits up and goes to charge his power ring, he recites an oath
If I had to do the same thing when I powered up my laptop. My oath would be the one composed by Learned Hand:
Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.
Still when I look at the scheme that Kurt Sollberger got involved in, I think it might have been better for him to have just paid the tax even if the scheme had worked.
Here is the deal.
Sollberger is president of Swiss Micron, Inc. (Swiss Micron). On June 1, 1999, Swiss Micron adopted the Swiss Micron, Inc. Employee Stock Ownership Plan (the ESOP). On January 1, 2000, Sollberger sold 340 shares of Swiss Micron stock to the ESOP for $1,032,240. Because his original basis in the stock was $47,749, he earned a profit of $984,491. Instead of recognizing the capital gain from the sale of Swiss Micron stock, Sollberger exercised his option under 26 U.S.C. § 1042(a) to defer paying taxes on the profit by using the stock sale proceeds to purchase FRNs issued by Bank of America, with a face value of $1,000,000.
So far so good. By reinvesting in the floating rate notes Mr. Sollberger had maybe $200,000 extra working for him. And in those bygone days, children, money actually earned interest which was a major reason to consider means of deferring gain. At any rate sometime in 2004, Mr Sollberger decided that he would rather have the money. The case does not tell us what he used the money for, which would enrich our analysis, but we will get back to that. Rather than sell the note and pay the tax he entered into a deal with a company called Optech. Optech agreed to loan him 90% of the value of the FRNs on a non-recourse basis. Optech would apply the interest earned on the FRNs to the interest that Mr. Sollberger owed Optech and he would pay the difference, if he felt like it. He could not pay the principal and get the FRNs back for seven years. Optech was allowed to sell the FRNs.
Before we race to the end of this sad story, I would like to point out why this might not be such a great plan, even if it had worked. Assume that the extra interest that Mr. Sollberger had to pay was de minimus. If the plan were to be actually followed through in detail, the interest earned on the FRNs would not simply wash the interest owed to Optech. The FRN interest would be includible in gross income and the interest to Optech would be deductible or not based on how Mr. Sollberger had spent the money he received from Optech. Best case would be trade or business interest in a business which Mr. Sollberger materially participated. That would be a wash and conceivably a small additional benefit in reduced SE tax. If it went into investments though the Optech interest would be deductible as investment interest, which when you consider all the computations tied to AGI makes it not a wash. If it went into personal expenditures, like a boat for examples, it would not be deductible at all. When I have evaluated schemes that are somewhat analogous to this one, but actually seemed to work, I was always the one to point that out.
As it happens the Optech scheme did not work at all. Nothing helps a poor plan fail so much as poor execution:
After Sollberger obtained the aggregate funds from Optech, he received quarterly account statements from Optech for the third and fourth quarter of 2004, and for the first quarter of 2005. The statements listed the FRNs as collateral (although they had already been sold) and showed the quarterly interest purportedly earned on the FRNs (which were shown as a credit against the loan interest). Initially, Sollberger paid the difference between the interest accruing under the loan and the interest from the FRNs. After the first quarter of 2005, Sollberger stopped receiving account statements, and he stopped making interest payments.
It seems pretty clear that Mr. Sollbeger was not planning on paying off the loan in seven years and getting his FRNs back, since it would have been disturbing to him that the statements stopped if he had. Also, it seems that despite what I just explained about the interest tracing rules, he had been treating the FRN interest collected and the Optech interest paid as a wash for income tax purposes, which makes the ending kind of puzzling.
The Internal Revenue Service (the IRS) determined that Sollberger sold the FRNs in 2004, earning a long-term capital gain of $852,251 (the amount of the $900,000 loan in the aggregate, less Sollberger’s basis of $47,749). Accordingly, the IRS found that Sollberger owed $128,979 in additional taxes, plus interest.
Unless I’m missing something here all that Mr. Sollberger would have gotten out of the plan, if it had worked, was the use of a little less than $50,000 for seven years. Maybe there was something ideological going on and he felt good about the $100,000 being in the hands of the job creators at Optech rather than the government, but it just does not seem to have been worth the risk. The Ninth Circuit upheld the decision of the Tax Court in favor of the IRS position:
Sollberger’s and Optech’s conduct also confirms our conclusion that the transaction was, in substance, a sale. Although interest accrued on the loan, Sollberger stopped receiving account statements and making interest payments after the first quarter of 2005, less than one year into the seven-year loan term. Thus, neither Sollberger nor Optech maintained the appearance that a genuine debt existed for long. The total amount that Sollberger paid to Optech was de minimis compared to the size of the loan. The FRNs were also sold before Sollberger received the loan from Optech, which suggests that Optech funded the majority of the “loan amount” with the proceeds received from the sale of the FRNs.
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