This morning a number of news outlets, including Bloomberg, Reuters, and even Politico, are reporting on a tax case involving Wells Fargo, where the IRS denied a tax refund of about $148 million. Wells Fargo lost at the lower court level, and had appealed to the U.S. Supreme Court. Yesterday, in a victory for the IRS, the Court denied the appeal.
It just so happens that I had recently written a brief piece about this case. So I thought I'd take the opportunity to explain in layman's terms exactly what Wells Fargo (WF) did, and why it lost. It is also a lesson on how well-intentioned provisions of the tax law - in this case, Section 351 - can be taken advantage of by sophisticated tax planning.
Section 351
Section 351 is designed to permit the incorporation of a business without recognizing a taxable gain. Assume, for example, that someone who owns and operates a retail store wants to incorporate his business. He does so by transferring the property of the business - the building, furniture and fixtures, equipment, supplies, inventory, etc. - to the corporation. In exchange for the property, the business-owner will get back stock in the corporation. Usually, the corporation will assume obligations relating to the business, such as the mortgage on the building or a credit line from a bank.
Now a corporation is a separate person under the tax law. Ordinarily, if I transfer property to another person and receive property back, I have to recognize gain equal to the difference between the value received and my cost for the property. It's as though I sold my property for cash, and used the cash to acquire the property I received in the exchange. In special circumstances, however, the tax law says I don't have to recognize the gain. One of those is provided in Section 351, which says that if I transfer property to a corporation in exchange for its stock and after the transfer I control the corporation, I don't gain or loss on the exchange. This Section allows people to incorporate their business without recognizing gain.
Now, when you incorporate a business like this, the corporation that acquires the business generally "steps into the shoes" of the person that transferred the business. In other words, the corporation will compute income from the business in virtually exactly the same manner as the individual did before he incorporated. For example, when the corporation sells inventory received in the exchange, its profit on the sale depends upon the cost of the inventory. The tax law says the corporation's cost is the same as it was for the transferor, so that the profit on the sale is the same as the individual owner of the business would have made if the business had not been incorporated. If one of the assets transferred to the corporation is a lease (suppose the store was a leased building rather than an owned one), the corporation will generally be able to deduct rent on the lease in the same manner as the individual did prior to the transfer.
Oh, and one more thing. What happens if the individual later sells his stock in the corporation? When you sell stock, you have to report a gain or loss equal to the difference between your cost (basis) for the stock and the amount you receive on the sale - if you receive more than your basis you have a capital gain, and if you receive less than your basis you have a capital loss. The tax law says that the individual's basis for the stock is the same as the basis of the assets transferred to the corporation. If the corporation assumes obligations associated with the business, the basis is reduced by the amount of the obligations. For example, if I transfer a building that cost me $100,000 with a mortgage of $80,000 (my equity is $20,000) to the corporation for its stock, my basis in the stock is $20,000 - my cost for the property minus the mortgage taken over by the corporation.
Now, Section 351 does not just apply to a transfer of a business. It applies to a transfer of any property to a corporation in exchange for stock, even if the property is not part of a business. As long as the person transferring the property controls the corporation immediately after the exchange, gain or loss is not recognized on the exchange of property for stock.
The Wells Fargo Case
Wells Fargo had engaged in several mergers with other banks, and after the mergers it consolidated a lot of the operations. As a result, it ended up with a lot of real property that it didn't need for its business anymore. Most of the property was not owned by WF, however. It was leased from other owners. WF had legal obligations to pay the rent on the leases but the properties were idle and, at most, they were able to sublease them for short periods of time at rentals that were not sufficient to cover the lease obligations. In other words, the properties were losers.
If you have a lease on property that you no longer need, you can (assuming the landlord permits) transfer that lease to another person. If the rent due under the lease is less than the rental value of the property, a transferee will ordinarily pay the transferor an amount which represents the future value of the difference. For example, if the lease has 10 years left to go, the rent is $1,000 per month but the rental value is $1,200, a transferee is getting the benefit of 120 months at $200 per month, and will pay the transferor an amount equal to the present value of that benefit. In that case, the tax law says the transferee can deduct the amount paid over the term of the lease.
On the other hand, if the rental value of the property is less than the rent under the lease, then the transferor may pay the transferee to get rid of the lease. In other words, if the numbers above were reversed, the transferor is getting a benefit of $200 per month by getting rid of the lease, and will pay the transferee for that benefit. In that case, the transferor is making the payment, and gets to deduct the full amount when the lease transfer occurs.
However, Wells Fargo decided to get greedy, and use Section 351 as a way to get a double deduction. Here's how it worked. WF had 21 leases on properties at various locations in the United States on which it paid rents that were greater than the rental value of the property. In fact , the rents were substantially greater - they calculated the amount it would have to pay to terminate the leases at $426 million. They transferred these leases plus $430 million worth of government securities to a subsidiary corporation named Charter in exchange for stock. As you can see from these numbers, the net value of the transfer was $ 4 million.
Now leases are funny animals under the tax law, because they represent a future obligation to pay for a future benefit. This is different from, say, a loan, which is an obligation to pay in the future for a benefit provided in the past (like the mortgage on the building I discussed above). So WF stated that the lease obligations weren't the kind of obligations that should reduce the basis (cost) of the stock. It claimed that the basis for the stock was $430 million.
So, according to WF, the stock they received in the exchange had a "cost" of $430 million, even though it was worth only $4 million. Naturally, they sold the stock for $4 million, and claimed a $426 million loss.
Now, some people may say, what's the big deal? I said above that WF calculated it would cost them $426 million to terminate the leases and that if they paid that amount to somebody to take over the leases they would get a deduction for it. So what's the big deal if they get the same loss by selling stock?
Well remember I said that the corporation "steps into the shoes" of the transferor? In this case, Charter will be able to continue deducting rent on the leases. And it does not take much in the way of tax planning for the buyer of Charter stock to be able to use those deductions to reduce its own taxable income. Stated differently, the buyer paid WF $4 million in order to receive $426 million of tax deductions.
There's the double deduction - WF deducts the loss on the stock, and Charter deducts the loss on the leases.
Epilogue
Just a couple of additional notes about this.
First, the idea for getting this kind of double deduction was very popular in the 1990s. WF paid a fee to a tax advisor of $3 million for assistance in putting this transaction together.
When Congress caught wind of it, they amended the tax law to stop it. The amendment essentially provided that lease obligations like those transferred by WF to Charter would reduce the cost basis of the stock received in the exchange. Under current law, then, WF would not be able to claim that its cost for the stock was $430 million - its cost would be $4 million. But that was not the law in the year that WF sold the stock and tried to deduct the loss.
So how did the IRS win the case, if technically the law was on the side of WF? Well, there's a long line of cases dating back to the early thirties that says that if a transaction has no economic substance and its only purpose is to generate a tax benefit, the transaction can be ignored as a sham and the benefit can be denied.
This concept, known as the "economic substance doctrine," drives a lot of people crazy. They think that if they're bright enough to find technical loopholes, they ought to be able to take advantage of them. Today I looked at the docket for the Supreme Court case and saw that there were about a dozen amicus curiae briefs filed, all on behalf of the bank. Among those filing briefs were the American Bankers Association, the Chamber of Commerce and the Cato Institute. Reading the brief of the Chamber is particularly fun. They are apoplectic that the lower court found for the IRS. They must be pulling their hair out that the Supreme Court - as business-friendly as it is - declined to take the case.
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