Originally published on Forbes.com.
Lee A. Sheppard of Tax Analysts has come up with an interesting theory as to how Donald Trump might have been able to use an unintended quirk in the Internal Revenue Code to have a nice tax cake while eating it too. The article is titled The Donald Double Dip?.
Whatever Was Trump Up To?
Never in the course of human events have so many tax commentators said so much with so little data might be the ultimate verdict about the three pages from Donald Trump’s tax returns that were mailed to the New York Times last month and confirmed by Jack Mitnick to be the real deal. The data showed that Trump had negative adjusted gross income of over $916 million of which over $909 million was “other income”- most likely a carryover net operating loss from prior years.
The New York Times saw this as evidence of a brilliant plan to avoid paying taxes for many years, but tax professionals, like myself, were wont to put out that Trump would somehow have to deal with the debt that funded those losses. David Cay Johnston in a piece titled Art of the Steal theorized that Trump might have preserved his net operating loss in the face of debt discharge by electing to reduce basis in lieu of reducing the NOL and then pawned the low basis property off on public shareholders. The theory, while not entirely convincing to me, had the merit of being several hundred times more tax literate than what the New York Times had come up with.
Step Right Up
Lee Sheppard’s theory is also quite tax literate. It assumes that there was an S corporation somewhere in the mix and that Trump took advantage of a quirk that the Supreme Court recognized as being valid in 2001. In order to understand it, you need to understand basis, which some people have trouble with, so I’ll give it my best shot to give you the necessary background with as little pain as possible.
Leaving out some fine points and complications (like what happens when you loan money to your own S corporation), your basis in stock in an S corporation will generally start out at what you paid for the stock. Income of the corporation, including tax-exempt income, flows through to you and increases your basis. Distributions to you decrease your basis. Losses that flow through to you also decrease your basis – BUT (and as you can see it is a big BUT) – your basis can never, ever go below zero.
If a distribution would pull your basis below zero, you recognize gain. If a loss would pull your basis below zero it is suspended. Future increases in basis will free up the suspended losses.
An Illustrative Example
So let’s say you start an S corporation by contributing $100,000. In your first year, you do pretty well. You have a profit of $50,000 and you draw out $30,000. Your basis at the beginning of year 2 is $120,000. Then you get cocky. The corporation borrows $500,000 and you pour most of it into some crazy scheme. You lose $600,000.
Your personal tax return will have a loss of $120,000 flowing through to page 1. Further back there will be a Form 6198 that will show a loss of $480,000 to be carried to future years. What is the case now and what most people thought was the case back in the day is that if the corporation hands the keys to the bank and you just walk away, that carryover loss goes “poof”. And most accountants, who seem to believe that there is a big balance sheet in the sky, will tell you that is a reasonable result as if that matters. You started out with $100,000, recognized $50,000 in income, got $30,000 in cash back, so it is right and just that you be allowed a loss of $120,000.
A Different Way To Look At It
As it happens, there was a fellow named Gitlitz who read the law and thought it said something different. Using the numbers above, in the Gitlitz view on day one of Year three when you hand the keys to the bank, the corporation has debt discharge income of $480,000. Since the corporation is insolvent, it is not taxable income, but income does not have to be taxable to increase basis. The basis increase frees up your suspended loss, so in year three you get to deduct $480,000 in loss that was funded by other people’s money.
The IRS did not see it that way and the case ended up going to the Supreme Court, which ruled (8-1) that, regardless of how little sense it made and what a big unintended loophole it was, that is what the statute said.
……courts have discussed the policy concern that, if shareholders were permitted to pass through the discharge of indebtedness before reducing any tax attributes, the shareholders would wrongly experience a “double windfall”: They would be exempted from paying taxes on the full amount of the discharge of indebtedness, and they would be able to increase basis and deduct their previously suspended losses. Because the Code’s plain text permits the taxpayers here to receive these benefits, we need not address this policy concern
Did Trump Pull A Gitlitz?
The Supreme Court decision, which was covered by Janet Novack, came down in 2001, but the tax years covered were 1991 and 1992. That is significant because that is the period during which Trump was involved in one of his elaborate debt workouts. Lee Sheppard cites this 1992 article from Bloomberg titled The Donald’s Trump Card.
Sheppard makes a case for Trump having benefited from the theory that the Supreme Court ended up ratifying.
The Donald wouldn’t have been the only beneficiary of this highly literal reading of the tax law. Leaving aside casino cannibalization in Atlantic City, the early 1990s saw a commercial real estate bust proximately caused by overbuilding and the removal of tax benefits under the Tax Reform Act of 1986. There were a lot of bad loans, debt forgiveness, and debtors maneuvering around COD income hits.
Richard M. Lipton of Baker & McKenzie, who represents real estate developers, explained that an S corporation as general partner was a common setup at the time. He noted that more than one individual using an S corporation benefited from the Gitlitz interpretation — and was shielded from taxes for the rest of his life. Lipton contributed technical assistance to this article.
This drama is making me remember those days. It was not pretty.
A Missing Link
For whatever it is worth, I’m a little skeptical about Trump having pulled a Gitlitz, so to speak. In order for it to work a very large portion of Trump assets had to be in an S corporation and so far I have not been able to find the S corporation. In this 1994 SEC filing of Trump Plaza Holding Associates, I find Trump Plaza Associates, which is a partnership owned 99% by Trump Plaza Holdings Associates and 1% by Trump Plaza Holding Inc. Trump Plaza Funding Inc was not an S Corporation based on its financial statements.
I’ve been combing through other Trump-related SEC filings, but have had no luck coming up with a candidate for the S corporation through which Gitlitz magic could have been worked on Trump’s holdings. Documents from the early bankruptcy filings are not available on PACER so I can’t hunt there.
What strikes me as improbable is that there was an S Corporation that held enough of the Trump empire to facilitate a nearly billion-dollar free basis step-up that does not show up in the public record anywhere. Like the proverbial economist who stranded on an island suggests that he and his companions “assume a can opener”, Lee Sheppard assumes an S corporation. While it might be common to use an S corporation as a 1% general partner, that would not be enough to pull this off. At least in my experience, you don’t want to have the bulk of a real estate investment in an S corporation, because, unlike a partnership, you don’t have basis in the entity’s indebtedness making me less inclined to assume an S corporation, particularly since no one seems to be putting forth a candidate.
So What?
In the event that this turned out to be true, I don’t really see how it might change anybody’s evaluation of Trump. The IRS did not like the Gitlitz position and people attached to double-entry find it disturbing, but at the end of the day, the Supreme Court ruled that it was the law of the land so how can you criticize a businessman for living by it. As Learned Hand wrote:
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.
Oh The Irony
Something noted, as far as I can tell by only me is that Mike Pence would have benefited by the Gitlitz maneuver in 2006 or 2007 to claim a loss of $673,797 that flowed out of Kiel Brothers Oil Company, a gas and convenience store chain that his father and brother had been directly involved in. The Job Creation And Worker Assistance Act of 2002 had plugged the Gitlitz loophole by then. Congressman Pence voted in favor of the bill