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BUILT-IN LOSSES - HERE TODAY, GONE TOMORROW UNDER THE NEW LAW

October 27, 2004

The deduction for "production" activities is the star of the recently-enacted ETI repeal bill. The new law's dramatic changes to the rules for tax-free incorporations and partnership formations have passed nearly unnoticed. These rules, designed to thwart tax-shelter promoters, also sow the seeds of tax disaster for honest but unwary taxpayers.

OLD RULES: NO GAIN, NO LOSS, CARRYOVER BASIS

While the long-standing rules for tax-free incorporations ("Section 351 transactions") and partnership formations ("Section 721 transactions") have their complications, the basic pattern is simple. If the transaction qualifies as a tax-free incorporation or partnership formation:

- No gain or loss is recognized by a party contributing property to the entity.
- The entity recognizes no gain or loss when it issues stock (or partnership interests) in exchange for property.
- The entity inherits the contributor's basis in the contributed property.
- The basis of the contributor in the contributed property becomes the basis of the contributor's stock (or partnership interest).

NEW RULES: THE CASE OF THE VANISHING BASIS

The tax shelter industry takes advantage of this pattern to strip value from assets. They find ways to allocate value, and gain, to tax-exempt US entities or foreign corporations, leaving a loss for the use of American taxpayers.

This was used to disastrous effect by Long-Term Capital Managment (LTCM), the giant hedge fund whose liquidity crisis threatened a worldwide financial panic in the '90s. The basic pattern: a tax-shelter promoter has an English company purchase trucks subject to leases. They sublease the equipment to an accomodating taxpayer, who "prepays" the sublease using financing from a friendly banker. This strips the value from the trucks, because a truck that will generate no additional cash for five years is worth a lot less than a new truck. Yet - and this is critical - the basis of the trucks hasn't changed.

The promoter then contributes the trucks (but not the lease payment) to a US partnership - like LTCM. The partnership now owns low-value, high basis trucks. After a decent interval, the promoter is redeemed; his proceeds cover his transaction costs, and then some.

The partnership now sells the low-value trucks to another friend of the promoter for their reduced value. The resulting artificial losses are deducted by the partnership, and the remaining partners. (The real LTCM facts had an additional set of transactions in the series; describing it would lengthen this already too-long post without shedding much light).

This shelter has not worked out for LTCM; a U.S. District Court disallowed the deductions as "shams" and slapped LTCM with negligence penalties. Still, the pattern has proved irresistable to shelter promoters, and Congress has now intervened.

CORPORATE CONTRIBUTIONS: LOSE YOUR BASIS NOW

The new law changes the carryover basis rules for property that is worth less than its basis when it is contributed to a corporation in a Section 351 transaction. While the contributing taxpayer still recognizes no loss in such a deal, the basis of the property is reduced to its fair market value. (No changes are made to the rules covering appreciated property contributons). The taxpayer may instead elect to allow the corporation to instead reduce its basis in the stock it receives in the Section 351 transaction. This basis is gone forever, and nobody gets to take deductions that would otherwise result from the basis.

The corporate basis reduction applies if the value of all property contributed by a shareholder is less than its basis. If a shareholder contributes some gain property and some loss property, the basis reduction is limited to the net loss contributed, if any.

PARTNERSHIPS: WHAT YOU LOSE BEFORE YOU CONTRIBUTE STAYS WITH YOU

The new law takes a different approach when loss property is contributed to a partnership. The law doesn't reduce the basis of loss property contributed to a partnership to its value; nor does it reduce the basis of the contributing partner's partnership interest.

Instead, the new law causes the basis of the contributed loss property to disappear forever if the partnership interest is transferred to another partner. This would have thwarted LTCM by reducing the basis of the trucks inside the partnership when LTCM bought its partnership interest. There would then be no taxable loss on the sale of the trucks.

THE MORAL:

New corporate or partnership formations face a new tax hazard. Careless formation of new entities could mean deductions forever lost. If you start a new corporation or partnership, make sure you know both the tax basis and the value of what you put into it.

Both the corporation and partnership provisions took effect when the president signed the bill Friday.

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