This was originally published on October 13th, 2010.
Fidelity International has local gossip value too it I guess, but not because it has anything to do with the Boston firm that runs mutual funds. The name is not a coincidence either, but that's part of the story. The tax matters partner of Fidelity was Richard Egan, recently deceased. He was one of the founders of EMC, which has its headquarters in Hopkington, MA. He was also the US Ambassador to Ireland, which, is in part, what led to this drama.
This case will likely merit more than one post. Actually there are probably a couple of good novels in there, but for now I will explain one of the transactions and comment on the feature I find most intriguing. Mr. Egan owned approximately 25 million shares of EMC, which traded at over $100 per share (Back then at the dawn of the millennium it was a well established law of nature that EMC stock could only go up). His basis was approximately two cents per share. Given that he founded a company noted for memory storage, it would have not been reasonable to try invoking the Steve Martin Rule (That is not pay the tax and say "I forgot"). So he and his son Michael, who ran his family office, consulted with an attorney and some national firms. They wanted to find a way to eliminate capital gains and also shelter the income from the exercise of non-qualified stock options. In this post I will comment only on the former.
The plan for eliminating capital gains works like this. You write a very large option which entitles you to receive a large premium. You use that premium to buy a very similar option. When it unwinds you will most likely have a loss, particularly after fees, but not a very large loss relative to the notional amount of the options. Get ready for the magic and if you are passionately attached to double entry remain calm. Form a partnership and contribute these two contracts to the partnership. Slowly. Carefully. One at a time. First there is that option you bought for say 150,000,000 (Never mind where you got it from). That's easy. Your basis is 150,000,000, the partnerships basis in it is 150,000,000. Increase your basis in your partnership interest by 150,000,000. You probably want to take a break. Now you've got that other thing. The option that you wrote. Well you got a lot of money and it seems like it could require you to pay out a lot of money. In some ways it seems like a liability. But remember this is a partnership. You need to check Section 752. Well something that you maybe have to pay isn't going to pass muster as a liability under 752. So now you are done. Your basis in your partnership interest is 150,000,000.
Now you put in your stock in Bigco which is worth 150,000,000 and has effectively zero basis. After those options sort themselves out for some relatively negligible effect, you are ready for your next step. You contribute your partnership interest into an LLC and make a 754 election. You now have to allocate your basis in your partnership interest among the assets of the technically new partnership. Your basis is still 150,000,000 and the only thing to allocate it to is the Bigco stock. So now your partnership has basis in your Bigco stock. It can sell it at a small gain or no gain or, as worked out in this case, a loss. Mr. Egan's minions needed to put more and more EMC stock into the partnership to take advantage of all the shelter they had bought as the price of EMC collapsed.
There is something really really neat about this plan that I couldn't emphasize if I was presenting it to you as a client. You see I am a member of the American Institute of Certified Public Accountants and thereby subject to its Statements on Standards for Tax Service, which were issued around the turn of the millennium. Among the things I can't do is recommend a tax position that "Exploits the audit selection process of a taxing authority." But since you and I are just pals and I am certainly not recommending this position I can tell you the really neat thing about it. If it works as planned, you never have to put a really big ugly looking negative number anywhere on any return you file. The basis that you created, as if by magic, enters into computing the gain or loss on your sale of Bigco stock. If Bigco stock behaves like everybody thought EMC stock was going to behave it means you will be reporting a gain. Just not as big a gain. No tax shelter here just a hard working high tech billionaire paying more taxes than most people.
The only thing wrong with the plan is that creating basis out of thin air doesn't even make good nonsense.
This brings me to the part of the case I find most interesting. The low reporting profile of the transaction was a big attraction. What amazes me is how big a paper trail the advisers created discussing the low reporting profile of the transaction. Stephanie Denby, an attorney, wrote in a memo to Mr. Egan:
. The IRS is certainly aware that these transactions are out there. They have implemented new reporting requirements to try to stop these transactions. To date new reporting requirements have focused solely on C corporations. Although, they could have easily applied similar restrictions to individuals, they have failed to do so.
These transactions clearly take advantage of “loopholes.” The reporting is consistent with tax law although the results are unintended. The promoters will provide tax opinion letters to avoid penalties if audited. It appears that there is a very low chance that these transactions would ever be picked up by the IRS. The promoters I have talked to have not had any audits
You see that's the neat part that I couldn't use to recommend the deal.
She also investigated insurance for the plan then sent an e-mail to James Reiss, CFO of Carruth Associates, Mr Egan's family office :
So they fired KPMG and got McGladrey to prepare the returns. I have never seen a case go into as much detail on the minutiae of return preparation. I'm hoping to write more on it in the weeks to come.
The end result of the case was to blow up the transaction and subject it to a 40% gross overstatement penalty. All the lesser 20% penalites were also found applicable, but they are not cummulative. The letters from attorneys saying that positions were reasonable and disclosure was not required were of no avail.
When this case was announced in the media earlier this year there was some villification of Mr. Egan, which I really think was misplaced. Mr. Egan was part of the team of people that helped put men on the moon. His team of adivsers believed that there were geniuses in the national firms that had figured out a legitimate capital gain strategy. In retropsect, it is easy to say that they should have realized the game was up when KPMG told them they had to disclose. That was like the real life case of Second Lieutenant Hiroo Onoda on Lubang Island in the Philliphines. When his former commander Major Taniguchi told him the war was over he came out of the jungle with his rifle, 500 rounds of ammo and some hand grenades. It was 1974. He was lucky not to have a letter from a law firm to contradict him.