Law & the Courts

Was Trump’s Tax Loss Trump’s Tax Loss?

(Dreamstime image: Ravi Sayfullin)
It may have been a case of being more lucky than shrewd

So much has happened in the last week, it seems like eons have passed since Donald Trump’s leaked tax-return information was all the rage. The big story was a few pages of the mogul’s 1995 state income-tax returns, which showed a gargantuan loss of $916 million.

As a tax story, the revelation was less than met the eye.

It seemed like a big deal to the Clinton camp because the Left worships the state and defines patriotism as paying the progressive income tax. Tax avoidance is therefore treasonous, at least when accomplished by well-to-do Republicans. In the real world beyond partisan narrative, of course, there is no shortage of moneyed Democrats, and they aren’t exactly tripping over themselves to “pay their fair share.” Recall, for example, John Kerry, then-senator from Massachusetts, dodging a tidy half-million bucks in excise taxes by docking his $7 million yacht on the Rhode Island side of the border, rather than in a harbor near one of his Bay State homes. But when rich Republicans are caught in the act, as Trump was, we hear about how they are betraying our troops in battle, putting welfare programs in jeopardy, and denying the “quality” education our public schools so skillfully provide.

Yet to most Americans, especially Americans who pay attention to the profligate and often nefarious uses the government makes of our tax dollars, tax avoidance is what one should do when the legal opportunity presents itself. (Our idea of supporting the troops is more along the lines of, say, rooting for them to defeat America’s enemies.) So most people don’t much care that Trump seems to have avoided paying much, if any, income tax for the last two decades. After all, when we pile up the array of other taxes and fees (sales tax, property tax, licensing costs, etc.) involved in holdings and income of this size, plus the mammoth accounting and attorneys’ fees incurred in legal compliance, we quickly realize that Trump pays more in taxes than most of us can dream of earning in a lifetime.

Lawfully avoiding income tax is perfectly normal behavior. Where most of us part company with Trump, however, is in his Trumpian boast that it shows he is “smart.” This gets to why, as a business acumen story, the revelation of a $916 million loss was so damaging.

Trump does not have a record of achievement in the political arena to run on. His claim of qualification for the world’s most important job rests entirely on the claim that he is an extraordinarily savvy businessman. The stratosphere in which he operates, the story goes, gives him a unique understanding of global economics, finance, debt management, trade, currency, etc. But this presumes a record of business success. The image is not burnished by a loss so colossal that it evidently wiped out his taxable income for 20 years.

Now comes the kicker: The losses he wrote off were probably not even his losses. More likely, they were losses to his creditors. To him, they were a boon — as if nearly a billion dollars fell out of the sky and landed in his lap.

That is not to suggest that Trump did not rack up huge losses in the early 1990s. Perish the thought. The Trump Taj Mahal in Atlantic City had to file for Chapter 11 bankruptcy in 1991 because it was billions in the red — and in the restructuring, Trump gave up half his ownership interest. The Trump Plaza Hotel, also in Atlantic City, declared bankruptcy in 1992, when it owed $550 million; Trump ended up turning 49 percent of the hotel over to Citibank. In the interim, the Trump Shuttle flopped. Trump had purchased the Eastern Airlines Shuttle in 1989, through a $380 million loan from a syndicate of 22 banks. Eastern’s shuttle service had been popular not for glitz but for convenient flights between Boston, New York City, and Washington. Trump’s vision, to the contrary, was luxury travel. From a know-thy-customer perspective, this was non-starter; it became a rout when war in the Persian Gulf sent fuel prices skyrocketing. By late 1990, having never turned a profit, Trump defaulted on the loan, forfeiting ownership to his creditors.

With these major, heavily leveraged businesses now either failed or in bankruptcy proceedings, the big losers were the banks that had lent Trump and his companies hundreds of millions of dollars. This, however, is where an anomaly of the IRS Code comes in, as expertly explained by Janet Novack of Forbes. Prior to 2002, you see, the federal tax code allowed a debtor to deduct his creditor’s losses as if they were his own.

Prior to 2002, the federal tax code allowed a debtor to deduct his creditor’s losses as if they were his own.

This was an unintended consequence of rules that permit owners of closely held corporations (known as “S corporations,” after subchapter S of the IRS Code’s first chapter) to deduct corporate losses on their personal income-tax returns. The limitation is that an owner can deduct losses only to the extent of his investment (or “basis”) in the S corporation.

Now, common sense says that when a business goes belly-up, the owner has no more investment — it has been lost. But another principle (a competing principle, as it turns out) comes into play: debt forgiveness.

Usually, debt forgiveness is the functional equivalent of income. As Ms. Novack observes, if you owe $50,000 but your creditor agrees to take $40,000, that is like getting a $10,000 payoff. In bankruptcy, though, the idea is to get the tapped-out borrower back on his feet. That couldn’t be done if the borrower had to come up with funds to pay income tax on forgiven debt.

To escape this conundrum, the forgiven amount is deemed non-taxable income. So now you may be thinking: What’s the big deal, then? After all, none of this is real except on paper, right? Well, the unintended consequence was that this untaxed “income” increased the borrower’s basis in the failed business. Okay, but the business is a corpse, so what’s the value in having a bigger investment in it? Lots. Remember: Under the rules, the owner of the S corporation is allowed to deduct the corporation’s losses to the extent of his investment. The forgiven loans were deemed additional investment. They allowed the owner to write off an equivalent amount of loss — and loss tends to be substantial when a business has failed. To summarize: The bank’s loss became its debtor’s “loss” — in effect, a windfall that could be used to cancel out other taxable income the debtor might have.

It was not by design that Congress and the IRS authorized this scheme. Indeed, the IRS fought the windfall in the courts for years, with mixed success. Lawmakers finally amended the code in 2002 to do away with the windfall, but only after the Supreme Court declined to legislate a fix from the bench the previous year. The amendment, moreover, was mainly prospective; debtors from 1995 kept their windfalls.

Given that Trump has not released his tax returns, notwithstanding his promise to do so, we cannot know for sure that this is what happened. But the odds that it did are better than anything you could get at Trump Taj Mahal — or at least could have gotten until this last Monday, when it finally closed down. (Though the casino still bore his name, Trump had had little connection to it after the 2009 bankruptcy of Trump Entertainment Resorts, the company through which he operated it — a company that went into bankruptcy again in 2014, before being purchased by Carl Icahn.)

Was Trump’s huge tax write-off the result of a legal quirk that yielded a $916 million windfall from the losses of creditors who had bet on his business acumen? It sure looks that way . . . and if so, maybe it’s better to be lucky than smart.

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