Tax lawyers have been racking their brains for an explanation of the $916 million loss that Republican presidential nominee Donald Trump reported on his 1995 state tax returns -- floating theories ranging from the Gitlitz double dip to the qualified real property business indebtedness exclusion -- but new documents show he may have used a less validated strategy, raising tricky questions about tax planning.
The New York Times on October 31 reported that Trump may have used part of the $916 million loss to save tens of millions of dollars in federal personal income taxes through a partnership equity-for-debt swap strategy. Although Trump declined to comment on the article, the strategy is substantiated by recently discovered documents, including two early-1990s Willkie Farr & Gallagher tax opinions acquired during a search of casino bankruptcy filings.
The opinions address numerous significantly uncertain tax issues raised by two debt restructurings but conclude that there was substantial authority (a greater than one-third, but no more than one-half, chance of success) for the partnership equity-for-debt swap strategy.
While The Times seems to be focused on sorting out Trump's tax loss puzzle to aid the public in coming to sweeping conclusions about the man who would pursue what the outlet characterized as an "audacious tax-avoidance maneuver," the development is causing a rift in the tax bar, with some who spoke to Tax Analysts questioning the very foundations of tax planning and opinion writing.
Relying on the Experts
Howard Abrams of the University of San Diego School of Law stressed that while "the vast majority" of tax lawyers wouldn't have given a similar opinion in the early 1990s, "you don't have to poll every lawyer; you just have to find one that gives you what you want." Even the best lawyers "for enough money can rationalize a conclusion," he said.
"I'm not a Trump supporter. I can't stand the guy; I'm certainly voting against him. But that doesn't mean everything he does is bad," Abrams said. "It's not illegal to take an aggressive position on a tax return. You might lose; you might even pay penalties. That doesn't make it illegal."
Los Angeles tax attorney Terence F. Cuff also urged caution when it comes to assigning blame for tax planning. "We're dealing with very sophisticated stuff, and if we get to the point that a taxpayer can't rely on his attorney when he has sought first-rate representation, something's wrong," Cuff said. "The real question isn't was this a good transaction or not; it really is a question of should Mr. Trump be able to rely on the advice that he's receiving from one of the best law firms in the country."
Cuff was critical of those who are quick to second-guess the opinion of Willkie Farr & Gallagher "without having done all of the work that they did." He warned, "That's a very dangerous thing to do, because essentially somebody is saying one of the best New York firms, which has great expertise in tax, doesn't understand federal tax. And that is a very serious allegation."
Cuff added that "there's an awful lot of speculation" on the issue -- particularly since it hasn't even been established that Trump implemented the strategy in the opinions let alone benefited from the losses. Trump has bucked tradition by refusing to release any of his income tax returns, claiming that he is under audit by the IRS. His campaign recently appeared to quash any remaining hope that Trump would release his returns by Election Day.
A Questionable Strategy?
The strategy was the partnership equity-for-debt exception, which, like its sibling, the stock-for-debt exception, has since been explicitly repealed by Congress (in 2004 and 1993, respectively) at least in cases in which the value of the partnership interest transferred in exchange for the debt is less than the adjusted issue price of the debt that's being forgiven. As explained by James B. Sowell (now of KPMG LLP) in his 2001 article "Partnership Workouts: Is It That Time Again?," 42 Tax Mgmt. Memo. 414 (Sept. 10, 2001), "while a number of practitioners still believe that a partnership debt-for-equity exception exists in the law, the true answer as to the status of this exception appears to be unclear, at best."
Monte A. Jackel of Akin Gump Strauss Hauer & Feld LLP, speaking on his own behalf, said that the uncertainty is the government's fault. He said that in 1991 when Treasury was writing rules squarely on point with transactions such as the partnership debt-for-equity exception under reg. section 1.108-2(f) (Notice 91-15, 1991-1 C.B. 519 ), it decided not to change the treatment of such exchanges, even though "Congress and the IRS were aware of the transaction." He added, "If they thought it wasn't viable, they should have said so."
Regarding the legitimacy of using the partnership debt-for-equity exception back in the early 1990s, Jackel said he would have issued a more likely than not opinion, meaning that he would have thought there was a greater than 50 percent chance the strategy would successfully confer the promised tax benefits. Before the exception was carved back, its underlying reasoning -- "that you're essentially paying off the debt with equity and so there's no discharge or forgiveness" -- was sound, he said.
"Given the signals that the Treasury was giving at that time, it wouldn't have been unreasonable for someone to come to the conclusion that it was a potentially viable [strategy]," Jackel said.
But Karen Burke of the University of Florida Levin College of Law disagreed. She said the partnership debt-for-equity exception never had any statutory basis. "It was conjured up by analogy to a corporate debt-for-equity exception, and it would have been an aggressive strategy in the best of circumstances," she said.
The exception combined the flexibility of the debt-equity rules with what Burke described as the fiction that the debt wasn't canceled because it was exchanged for something that had a value equal to the canceled debt.
Various groups have weighed in over the years on the viability of the exception in general. In 1992 the American Bar Association Section of Taxation issued a report stating that "there is, under existing law, a partnership equity for debt exception" and that "sound economic and tax policy support the continued existence of the exception." In 1993 the New York State Bar Association Tax Section issued a report that was less bullish, concluding that "the status of such an exception is uncertain and that clarification, preferably legislative, is required."
Stretching the Exception
What made the strategy even more aggressive was something The Times didn't even report. According to Steven M. Rosenthal of the Urban-Brookings Tax Policy Center, who had access to all of the documents as an expert adviser to the newspaper, Trump inserted a funding corporation into the structure, meaning that the debt that was exchanged wasn't even debt of the partnership.
"They stretched this partnership equity-for-debt exception beyond any recognition," Rosenthal told Tax Analysts. "The partnerships took the creative view that the funding corporation was merely a nominee on behalf of the partnership and so it should be viewed as partnership debt." He said the strategy, which was used in at least three public debt restructurings, could have helped Trump avoid as much as $400 million to $500 million of cancellation of indebtedness (COD) income. Rosenthal's analysis of the strategy can be found in a November 1 Tax Policy Center blog post.
Rosenthal emphasized that if the partnership equity-for-debt exception ever existed, "it is not applicable to this fact pattern -- not when the debt is issued by a funding corporation," which was necessary in this case because of New Jersey casino regulations. "There's substance to why there's a separate corporation, and you can't just ignore it," he said.
Burke agreed. "Trump's basis for even trying to get into this loophole was based on disavowing his own corporation that he created for his own purposes," she said. "Even in the early 1990s that would not fly given all of the risks that his lawyers are pointing out to him in this opinion."
Burke added, "There are so many red flags in this opinion that anybody engaged in this strategy absolutely knew that it was risky, absolutely knew that if it was caught on audit they'd have a big problem."
The Times made the case that Trump's tax avoidance "violated a central principle of American tax law." But Abrams said that while there is a principle that if you don't make or lose money, your net taxes should be zero, "the system sometimes screws up, and that's not Trump's fault."
"Trump didn't violate a fundamental principle of our tax system," Abrams said. "If [the partnership equity-for-debt exception] works the way they described, that violates it."
Debt Discharge Avoidance
Stepping back a bit, the $916 million loss troubles many tax lawyers for two reasons. One, they're convinced it can't be real. And two, they don't understand how the losses weren't zeroed out when the debt connected to them was discharged. While provides that a debtor can avoid an income pickup when his debt is discharged in bankruptcy, he's required to reduce his attributes (such as net operating losses) by the same amount (section 108(b)(1)).
One of the primary ways Trump's debt was restructured in the early 1990s was through a series of public bond offerings. According to Rosenthal, those restructurings didn't generate any discharge of indebtedness that flowed through from the partnership level, which would call into question both the Gitlitz double dip (Gitlitz v. Commissioner, 531 U.S. 206 (2001)) and the qualified real property business indebtedness exclusion theories.
Instead, the restructurings may have avoided debt discharge altogether through the use of the partnership equity-for-debt exception. For example, in one of the restructurings, lenders to the Trump Taj Mahal casino agreed as part of a chapter 11 plan of reorganization to surrender their old bonds in exchange for new bonds and partnership interests by way of a section 721 exchange followed by a section 351 drop-down. While the lenders agreed to reduce Trump's outstanding debt (technically issued by Trump Taj Mahal Funding Inc., they got equity in a partnership (Trump Taj Mahal Associates, of which Trump was the 99.99 percent partner) to make up the difference. According to Rosenthal, even if the equity was worthless, the fiction of the partnership equity-for-debt exception deems the exchange to have satisfied the outstanding debt.
According to a Willkie Farr & Gallagher tax opinion dated June 5, 1991, because the bonds were formally issued by the funding company and not the partnership and because there is no "written nominee or agency agreement . . . evidencing the nominee relationship that in fact and substance existed, a conclusion that the Old Bonds and New Bonds are solely the debt of the Partnership for Federal income tax purposes is not free from doubt." The firm concluded that there's substantial authority to take the position that in general, Trump will not recognize any COD income as a result of the exchange.
"It's so clear why this loses," Abrams said. He explained that when debt is discharged, which it must be when the fair market value of the property received is less than the adjusted issue price of the debt, the COD is income, but it's not gain. "It's a kind of income that isn't gain," he said. "[Section] 721 only protects you from recognition of gain. People in my business know the difference, but amateurs don't."
Correction, November 2, 2016: Trump was the 99.99 percent partner of Trump Taj Mahal Associates, not of Trump Taj Mahal Funding Inc.