Romney, Marriott And Son Of Boss ---- For Dummies
Now that the question of Mitt’s knowledge of Son of Boss deals has been raised by CNN, I thought it might be a public service to explain Son of Boss deals. A lot of commentators seem to think that they are too hard to understand, but I don’t think so. I’ve told my friends at Dogs Against Romney that they might not want to bother filling in the beagles and the mastiffs , but I think the border collies and the poodles are ready for it.
Basis
I have previously explained Son of Boss using the ill fated tax shelter of EMC founder, Richard Egan, who got into the game in its waning days. His advisor, Stephanie Denby, commented on the beauty of the deals:
Secondly, some of the transactions focus on generating basis as opposed to capital loss. Basis is more discrete [sic] and less likely I believe to cross the IRS radar screen.
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We are taxed on income, not gross receipts. That means that when you sell something you get to deduct your basis. In its simplest manifestation basis is the amount of money that you paid for something. You buy something for five dollars and sell it for six, your income is a dollar. Of course it can be more complicated if you acquire assets in other ways, such as by gift or inheritance or in a like-kind exchange. The important point though is that when you sell something the higher your basis the less your gain or the greater your loss.
Once you own something though it is kind of hard to increase its basis. If it is a partnership interest you increase your basis by the income that flows through to you, so your gain will be less if you sell the partnership interest, but that is like hitting your head against the wall because it feels so good when you stop. If it is a tangible asset, you could spend money to improve it, but that doesn’t really feel that satisfying. Of course, if it is an appreciated asset, you could die, but that is kind of extreme. The way that the designers of the Marriott deal came up with involved combining two things each of which is only slightly complicated – short sales and the formation of a partnership. Here is a link to the decision if you want to follow along, but I’ll try to break it down for you.
Short Sales
When I was a kid, my father used to tell me jokes. There was a problem though. He worked on Wall Street. He did not have a particularly lucrative career (He was a senior order clerk) but he had a Wall Street sensibility to him . So the jokes that he told me were incomprehensible to an eight year old. One of them that I finally got when I was about thirty, was his little ditty about short sales “He who sells what isn’t hissen, buys it back or goes to prison.” The important tax principle is that the proceeds of a short sale are not gross income. You recognize gain or loss when you close the short sale.
Partnership Formation
When you put stuff into a partnership, the partnership’s basis in the stuff is your basis in it. You increase your basis in your partnership interest by your basis in the stuff you put in. Another important principle is that your share of the liabilities of a partnership is part of your basis in the partnership. If you increase your share of the liabilities it increases your basis, but if it decreases it reduces your basis, just as if you took out cash. Your basis can never go below zero. If a loss allocation would drive it below zero, the loss is suspended, but a liability decrease, like a cash distribution, will cause you to recognize gain. If you put leveraged property into a partnership and the liability shifts away from you or is paid down by the partnership, you may end up recognizing gain.
Now you are ready to do your Son of Boss deal. Here are the steps:
Marriott International sells short two-year Treasury notes and invests the proceeds in five-year Treasury notes. Marriott International, as a limited partner, and a third party, as the general partner, form a partnership. Marriott International contributes the five-year Treasury notes, subject to the short-sale obligations, to the partnership and the general partner contributes some cash. The partnership obtains additional assets and subsequently sells the five-year Treasury notes and closes the short sale obligation on the two-year Treasury notes.
Marriott International transfers its partnership interest to another Marriott subsidiary.
No gain or loss is recognized on the transfer, but the partnership-interest transfer results in a technical termination of the partnership which causes a deemed distribution of the assets to each partner and a re-contribution of the assets to a new partnership.
The tax basis of the assets takes on the “outside” tax basis of Marriott International’s interest, i.e., the value of the five-year Treasury notes Marriott International contributed to the first partnership, which value is not reduced by the short-sale obligation.
The remaining additional assets later are depreciated or are sold, and Marriott International recognizes the resulting tax losses.
I always had a hard time understanding these deals, because of my training as an accountant. You can’t get the damn thing to work without an unbalanced entry. Essentially though the money that Marriott got for the short sale allowed it to buy something that it had basis in. Marriott argued that the obligation to cover the short sale was not a liability as defined by Code Section 752. So even though it didn’t really have to come up with any money out of its own pocket, it had basis in the partnership interest. The rest of the maneuvers are a little technical, but essentially the free basis gets shuffled around until it is actually used. In Richard Egan’s version of the deal EMC stock was contributed to the partnership that had been created. The IRS and the Court’s didn’t put it the way a confused accountant would – “Ok, I have a debit, now what the hell am I supposed to credit ?”, but they essentially got to the same bottom line -
The initial short sale, which generates the cash proceeds, and the subsequent covering transaction are “inextricably intertwined,” because under Regulation T the proceeds are chained to the obligation to close the short sale. Thus, the proceeds of the first step in the short sale transactions are also subject to the uncertainties of closing the short sale. In short, if contribution of the proceeds of the short sale increased the partners’ outside basis, the contribution of the obligation to return the Treasury notes that had been sold short required a decrease in the partners’ outside basis.
I never ran into these deals in their heyday. If I had I would have scratched my head, but I might have bought into it because of the letters from the tax attorneys who are supposed to know this stuff better than I do even if they don’t know a debit from a credit. So I would not be shocked if Romney did one of these deals for himself. Presumably the statute of limitations would be closed. That didn’t stop Tim Geithner from paying for his mistakes though. If Romney did do a Son of Boss deal, it really does not tell us anything about him that we do not already know, but if we want to hold him to the Geithner standard, he should pay regardless of the statute of limitations.
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