It's bizarre that a single page of a two-decade-old New York state income tax return could provide a Rosetta stone explanation of Republican presidential nominee Donald Trump's tax situation, but it appears to do so.
The New York Times, which revealed the leaked state tax return pages, presented two theories for the $916 million loss reported on the return: net operating loss carryovers and abandonment (The New York Times, Oct. 2, 2016, p. A1). Neither is an adequate explanation, which is more likely to have to do with debt forgiveness and S corporation rules. This is because of where the bulk of the loss was reported on his New York state income tax return.
New York state return income lines parallel federal income tax return income lines. There is a line for current NOLs and a line for losses passed through from partnerships and S corporations (which shows a $16 million loss). Of Trump's total loss, $909 million appears on the "other income" line, which is where cancellation of debt (COD) income and unused NOL carryovers are reported. What he may well have is a big slug of unused NOLs freed up by a big COD income item.
In the 1990s, Trump had three Atlantic City, New Jersey, casinos and an airline, all of which were hemorrhaging money. There was $3 billion of debt on these assets, $885 million of which was personally guaranteed by him. Trump and his lenders spent the early 1990s working out these debts (The Wall Street Journal, Jan. 4, 2016, and Bloomberg, Mar. 23, 1992).
In 1993, lenders agreed to reduce Trump’s personally guaranteed debt from $885 million to $115 million. In about 1995, the remaining $115 million was settled with the lender. All this relief from his personal guarantees would have produced a huge COD income item, which might have been excluded. Putting together the loan workout with the similar size of the number on the other income line, loan-related NOL carryover is a likely explanation. The NOLs themselves could represent many prior years of operating losses, interest expense, and depreciation.
Why doesn't the COD income appear on the state return? Most of the relief occurred in years before 1995. Here's what we assume would have been his structure, because it was a common structure at the time. We assume that he entered the partnerships that owned the casinos using his own S corporation as partner. That S corporation probably was the general partner. An S corporation is a corporation under state law.
As general partner, that S corporation may have been allocated more losses in the form of interest expenses, operating expenses, and depreciation deductions than it could use against the three casinos' insufficient income. Once the income was exhausted, losses could be applied to reduce the owner's basis in the S corporation shares, but it is likely that basis was small. Passthrough of losses is limited to the shareholder's basis in S corporation shares (section 1363(d)).
When the debt was forgiven at the S corporation level, it would have produced a basis bump to Trump as sole shareholder so that unused losses could be used, even if the S corporation qualified for a COD income exclusion because it was insolvent or filed bankruptcy. It probably would have invoked one of those COD income exclusions (section 108(a)(1)(A), (B)). That basis bump would have enabled him to use the resulting loss overhang in perpetuity to offset his income. Essentially, the basis increase allowed the unused NOLs to flow through to the shareholder and avoided attribute reduction because the NOLs were no longer in the corporation.
Gee, shouldn't there have been a suspension of related tax attributes? Not under the law at the time. The Supreme Court held in 2001 that the law literally permitted this apparent double dip result (Gitlitz v. Commissioner, 531 U.S. 206 (2001)). Congress reversed the decision in 2002, grandfathering basis bumps incurred before the date of enactment, so Trump would have been grandfathered (section 108(d)(7)).
What happened to the taxpayer in Gitlitz helps explain what probably happened to Trump. Gitlitz and another individual were shareholders in an S corporation that incurred $2 million of COD income in 1991. Because the S corporation was insolvent, it was allowed to exclude the COD income. The two shareholders increased their bases in their shares by the amount of the excluded COD income (section 1366(a)(1)(A)). They used the basis increase to offset income from prior years (section 1366(d)). That is, COD income that had been excluded was replicated in a basis increase.
The IRS argued that the COD income should reduce the S corporation's basis in its assets -- effectively confining it to the corporate level (reg. section 1.1366-1(a)(2)(viii)). But the Court stuck with the literal wording of the law, which did not spell out that result at the time. The excluded COD income was not specifically removed from income items of an S corporation, so it would have caused a basis bump (section 1367(a)). The shareholders could use associated NOLs (section 1366(a)(1)(A)).
The requirement that tax attributes be reduced also did not apply at the corporate level (sections 108(b), (d)). As the Court noted, S corporation losses would be reduced eventually, at the shareholder level, but in the meantime the shareholders could use their bumped-up basis to offset income. And because the basis increase equaled the associated losses, which were passed through to the shareholders, there would be no NOLs left to reduce in the future, as the Court explained. The Court recognized that it was not a desirable policy result, but it was Congress's job to change it.
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.
How could Trump continue to live like a king while his casinos were in bankruptcy and he was working out debts with his lenders? His lenders put him on an allowance of $450,000 per month, understanding that his lifestyle was important to the maintenance of the Trump brand. Like Ralph Lauren, Trump sells a fantasy version of his own lifestyle. (The Wall Street Journal, Oct. 2, 2016.)
That's not to say that this isn't political fodder even if it was completely within the law at the time. Speaking in Toledo, Ohio, as this article was being written, Democratic presidential nominee Hillary Clinton promised punishment for those who rip off the tax code. She added that letting Trump rewrite the tax law would be like letting a fox guard the henhouse. Zero is still zero, even if it is normal for real estate developers.
Correction, October 5, 2016: Of the $3 billion of debt on Trump's assets, $885 million was personally guaranteed by him, not $832 million as originally reported. The article has also been updated to more accurately reflect the timing and details of the debt relief provided by Trump's lenders. A previous clarification regarding the assumption of Trump's debt in a public offering of the casinos was also inaccurate. The additional facts do not affect the article's thesis about the tax treatment.