Jerry Curnutt has a story about the IRS ignoring billions of dollars in blatant failures to report income. It concerns the President’s favorite deduction, depreciation and something called nonrecourse debt. If you don’t think in double entry, it is a little hard to understand. If you do think in double entry, it is hard to believe. We’ll deal with the understanding part first.
Jerry explained it in a recent letter to Tax Notes.
“IRS enforcement has the software required to produce listings of the negative tax capital accounts that exit the IRS Business Master File without an offsetting income event (the “unaccounted-for tax gains”) by partnerships/ limited liability companies for any tax year, and also for any dollar range it chooses ($25 million or greater, $50 million or greater, $100 million or greater, etc.). It could then track these properties to their next destinations to determine if, and to what extent, the partnership minimum gains were reported as taxable income. To date, the IRS has declined to deploy this top-down capability” (Emphasis added)
Partnership minimum gain requires a bit of explanation. It is the result of two things – our President’s favorite deduction, depreciation and something called nonrecouse debt.
President Trump’s Favorite Deduction
Then developer and media personality Donald Trump gave us an excellent lesson on depreciation in the Art of The Deal.
Put simply, depreciation permits you to pay lower taxes on your earnings. For example, if the cost of our facility in Atlantic City was $400 million and we were permitted to depreciate at the rate of 4 percent a year, that would mean we could deduct $16 million from our taxable profits each year. In other words, if we earned a pretax profit of $16 million, our earnings, after depreciation, would actually be reported as zero.
Most shareholders and Wall Street types only look at the bottom line, which shows a profit reduced by depreciation. As a result, corporate managers don’t like depreciation much. It only makes them appear less successful. But I don’t have to please Wall Street, and so I appreciate depreciation. For me the relevant issue isn’t what I report on the bottom line, it’s what I get to keep.
Nonrecourse Financing And Basis
In the context of real estate nonrecourse financing is not that hard a concept to understand. If nonrecourse debt is secured by property, instead of paying it off, you can hand the bank the keys, which is what you might be inclined to do if the property is upside down and not producing positive cash flow.
There are two very important Supreme Court decisions about nonrecourse debt. First, there is Crane v Commissioner in 1947. Mrs. Crane had inherited a property from her husband that was subject to a mortgage she did not assume – i.e. nonrecourse debt.
She depreciated the property by including the mortgage as part of her basis, but when she sold the building she only reported the amount she received for her equity. The ruling was that she did get the basis but the mortgage balance had to be included as sales proceeds.
The Crane decision included what might have been the most famous footnote in tax history. Footnote 37:
“Obviously, if the value of the property is less than the amount of the mortgage, a mortgagor who is not personally liable cannot realize a benefit equal to the mortgage. Consequently, a different problem might be encountered where a mortgagor abandoned the property or transferred it subject to the mortgage without receiving boot. That is not this case.”
If you google “footnote 37” and nothing else, your hits will be overwhelmingly about the Crane decision. Essentially the Supremes were telling us that if Mrs. Crane had been upside down, the answer might have been different, but that was not the question they had been asked.
Nonrecourse Financing The Dark Side
When I was a lad of thirty or so, I heard about footnote 37, but it never made much sense to me. It seemed obvious that if you invested $10,000 and took $100,000 in losses, which is what the combination of depreciation and nonrecourse debt allowed, you had $90,000 in income if you handed in the keys. That’s the “minimum gain” if you have no proceeds.
That’s because I thought in double entry, like most competent accountants.
There was a phrase for it, usually in the partnership context “negative basis”. “Negative basis” was a practical accountant’s term, a Subchapter K nerd would never utter it.
What would happen in a real estate partnership is that the depreciation deductions funded by nonrecourse debt would create deficit capital accounts. If principal payments were being made on the mortgage the partnership would come to the dreaded crossover point where there would be taxable income in excess of positive cash flow.
It was called a burned-out shelter. You could either sit with it and be tortured by “phantom income” or liquidate and have a capital gain with cash, if any, less than the gain. You would still be ahead overall, since there was a big spread between the capital gain and ordinary income rates, but if you had not put some of the savings aside you would not feel like you were ahead.
The Escape Hatches
There were three ways out of a burned out shelter without biting the bullet, paying the piper – i.e. recognizing gain. There was a complex trust technique that did not actually work, the more extreme step of giving it to your spouse and getting a divorce, and the even more extreme step of dying. Dying worked really well, because if the partnership made a 754 election your heirs got to start depreciating again.
But then there was Footnote 37. The shelters I was working were still fresh, so I never got to think about Footnote 37, because in 1983, the momentous year in which the Commonwealth of Massachusetts issued CPA License Number 7715, Commissioner V Tufts was decided by the Supreme Court. It held:
“When a taxpayer sells or disposes of property encumbered by a nonrecourse obligation exceeding the fair market value of the property sold, as in this case, the Commissioner may require him to include in the “amount realized” the outstanding amount of the obligation; the fair market value of the property is irrelevant to this calculation.”
I don’t recall the decision making a really big impression on me, possibly because it merely confirmed the double-entry thinking of practical accountants who could not believe that deficit capital accounts were a free lunch.
Well, that is as good as I am going to get it on the hard to understand part. Tony Nitti, who is even more of a Subchapter K geek than I am gives you a more detailed explanation of Crane and Tufts than I ever will in this 2014 piece. That might help.
Let’s go on to the hard to believe part of Jerry Curnutt’s story, but we will start with some background on Jerry.
About Jerry Curnutt
Jerry Curnutt is from Oklahoma and now lives in Texas. During his years of government service, he sometimes lived near Washington DC. After a bachelor’s in marketing, he received an MBA in accounting in 1964. His dream was to be an FBI agent, which is what motivated the accounting degree, but he was held back by asthma.
So he went to work for the IRS. The wage and price controls of the Nixon administration somehow sent him to the Department of Energy, where he was working in the early eighties when a family tragedy required him to leave the workforce to take care of his son.
In 1990 when it was time to go back to work he got on board with the IRS as a consultant in the Aramco case, which was a really big deal, but not anything somebody like me, a new partner in a large local firm, would know anything about.
He was hired back full time and became a real estate industry specialist and then the sole partnership industry specialist, finishing his federal government career in 2000 as a GS 14.
Nobody Is Watching The Store
Back in 2000 and possibly even now, not every field in a partnership return was stored in machine readable form. There is this huge computer file called the Business Master File. Jerry had the partnership piece of it to fool with. He could request that more fields be transcribed from partnership returns, but each additional field meant $15,000 off the travel budget.
That might be a bit of a shocker that not everything is available in machine-readable form. It has improved in the last twenty years, but maybe not that much. Here is the real shocker. That “negative capital” that builds up over time thanks to depreciation and sometimes due to loan proceeds that are distributed – the IRS has not been keeping an eye on it according to Jerry.
Working with a computer expert, Jerry designed an algorithm. The algorithm would look for partnerships with large deficit capital accounts. He was in the big time in Washington so it was a big cutoff. He put out $50 million as the threshold.
And then he traced them into the next year. What he found was that some of them disappeared. There was no final return recognizing gain to bring the deficit up to zero, which is what most practical accountants think is supposed to happen.
I probably was involved with around a hundred real estate shelters. Most of them were single apartment complexes between 25 and 300 units. They tended to have a not for profits sponsor. Some of the sponsors were grassroots neighborhood groups without much in the way of accounting infrastructure.
I remember one that after its deal pumped out losses to partners for five or six years pretty much fell apart. There was gain for those partners to recognize, but no K-1 to tell them to recognize it. I worried about it a little but nobody was hiring my firm to do a return so it was “not my circus, not my monkeys”.
What Do People Do When A Partnership Goes Poof?
I did one of my unscientific surveys of what individual preparers will do when that happens. Here are the results along with a comment from Not That Karen
The hold of double entry on the minds of practical accountants comes through. Almost a third would recognize income based on there not being a K-1. Personally I am with the dog sleepers, but it is really not a good answer either.
I imagine that that other Karen would hunt the sponsors down and make them talk – or else.
This Is For Real
I think Jerry is right about the IRS blindspot with regard to large partnership deficits just fading away. He is very credible and I can supplement his story with a significant amount of evidence. It is anecdotal and circumstantial, but it convinces me.
I will give you one piece of evidence that is inspired by the Sherlock Holmes story The Adventure of Silver Blaze
“Gregory (Scotland Yard detective): Is there any other point to which you would wish to draw my attention?
Holmes: To the curious incident of the dog in the night-time.
Gregory: The dog did nothing in the night-time.
Holmes: That was the curious incident.”
Sometimes a deficit capital account funded by nonrecourse debt will be worked off through something called a “minimum gain chargeback”. If you google “minimum gain chargeback”, you will find many many hits discussing this concept. Read a bunch of them and you will be qualified to draft partnership agreements and LLC operating agreements. If you want to pretend to be a CPA, say you focus on partnerships and start spouting some of what you read. Not only will they believe you are a CPA, they will think you are smart.
At any rate, you would think that something that complicated with that much interest would be generating IRS adjustments, some of which would be litigated. Litigation is the barking dog that we bystanders can “hear”. How many decisions, ever, mention “minimum gain chargeback” ? There is one, two if you count the appeal.
Despairing of getting the IRS to take the matter seriously, Jerry started approaching state revenue departments. Pennsylvania bit. Suzanne Leighton, then Director of the Pass Through Business Office wrote to other state tax administrators praising his efforts and the revenue it brought to the Keystone State.
“His extensive experience with the IRS Business Master File has allowed PTBO to accurately identify complex partnership issues. This has proven particularly effective with respect to real estate tax shelters. The assessments generated by his identification of partnerships involved in complex issues has provided the PA Department of Revenue with a ten fold return on investment. Recently, Mr. Curnutt assisted PTBO in the review of a complex partnership issue. Without his assistance, our staff would have spent numerous hours getting to the crux of the issues. This case resulted in the taxation of over $700 million in unreported income.”
I spoke with Ms. Leighton, now with the Warrendale PA office of CPA firm HBK, last week and she was very positive about the good results that Jerry’s algorithm had yielded.
I also spoke with Thomas Pilske of the Tax Whistlebower Firm in Chesterlield MO. Mr. Pilske was an IRS attorney at the district level supporting revenue agents and representing the IRS in Tax Court. He left the IRS to set up a firm dedicated to whistle blowers. Apparently there are very few attorneys focused on this area.
He found Jerry credible, which means a lot to me, since he cannot be wasting his time on nonsense. He did not get any traction with the IRS though, which is the way it goes with many, if not most, whistle blowers.
The Implications For Scoundrels
The world is a much better place thanks to my chaotic good alignment, because I think I would have made a consummate villain. I have been cooking up schemes based on the assumption that the IRS will not notice deficit partnerships winking out of existence.
Here is how to sell an appreciated building without recognizing most if any of the gain. Put it in a LLC, with one of your kids or some other natural object of your bounty, not your spouse, having an interest, making it a partnership for income tax purposes. Borrow as much of the value as you can on a nonrecourse basis and take that as a distribution.
The return on December 31 will show you with a whopping deficit. First thing in the morning on January 1 turn in your LLC interest which is not worth all that much. Voila! It is not a partnership anymore. There is only one owner. The new owner has basis because of the nonrecourse debt.
Don’t get me wrong. You are supposed to recognize gain. Be sure to switch accountants and don’t clue them in. Whatever you do, don’t let them see the old K-1. Or maybe you do your own return. Regardless, there is arguably no required filing alerting the IRS to what happened. (I don’t think Form 8308 is required here).
If the IRS really is not looking, I have to think that shenanigans of this sort are going on and that Jerry’s algorithm will identify many promising audit targets.
I should note that there are situations where a partnership would wink out without immediate gain recognition. An UPREIT would be an example.
Never Give Up
Jerry reminds me a lot of Robert Baty, who I wrote about here. Baty, while with the IRS, was outraged at a basketball coach getting a clergy housing allowance which traced back to a Revenue Ruling that was issued under political pressure. In retirement, he sparked litigation on the constitutionality of cash housing allowance for “ministers of the gospel” that shook the religious establishment. You can read about his role in that here.
The IRS is looking for partnerships to provide clearer information that will highlight minimum gain. Maybe they have been listening to Jerry.
The IRS has not responded to my request for comments.