Donald Trump’s refusal to release his tax returns has led to intense interest in and speculation concerning his tax positions. His dealings relating to his charitable foundation have been perceived as dubious in some circles. Moreover, a month ago, the New York Times discovered he had nearly a billion dollars of net operating loss on his 1995 tax returns, reducing his taxable income for years to come.
Many tax commentators tried to figure out how Trump had received such a huge loss, as he should have had “cancellation of debt” income (discussed below) which would reduce the loss. Some commentators proposed that he used the “qualified real property business indebtedness” exclusion from cancellation of debt income, while others proposed an illegal tax shelter technique and others yet proposed an S corporation technique that clearly worked, but would have been unusual for a real property business to have used (because such businesses were typically organized as partnerships).
Finally, just yesterday, the New York Times discovered the apparent method used, while implying the method was quite dubious. But was it? To answer this, we must first review the facts of the matter, and then we can provide a quick analysis based on the available facts.
Background of the Matter
In the early 1990s, Donald Trump lost considerable money on his real estate ventures, such as the Taj Mahal. He borrowed heavily to finance the projects. These enormous economic losses, by themselves, would have given Trump the losses we now see on his returns.
However, Donald Trump faced a challenge. In order to refinance his debt, Donald Trump demanded and apparently received modifications of his debt. Under normal tax rules, a dollar of cancelled debt is taxed just like any other dollar of income. Thus, it would appear Donald Trump would have received an enormous tax bill for income from the refinancing. This income should have offset any losses he otherwise had. From a policy perspective, this offset result makes sense; you should not be able to deduct losses economically belonging to your creditors. (This result does create some economic hardship, as people receiving cancellation of debt income are often insolvent, but there are rules to ease this pain.)
 Insolvent or bankrupt taxpayers have an exception for reducing their cancellation of debt income, but it forces them to reduce their positive tax attributes, such as their net operating losses; Trump did not use this exception.
But, there appeared to be a potential way out of Trump’s income offset problem. Once upon a time, if a corporation paid off its debt via issuing equity (i.e., stock), it would not receive any “cancellation of debt” income. By 1993, this technique had been banned specifically for corporations. However, it was (at the time) not clear what would happen if a partnership did the same technique. Perhaps the old corporation trick preventing cancellation of debt income would apply? Trump decided to take the position it would, and planned to issue equity from his real estate investment partnership to pay off the debt.
But there was another major hurdle not discussed in the New York Times article. Specifically, in most circumstances, when entities issued equity to pay off debts and avoid cancellation of debt income, they paid off their own debts. But in this case, the debt being paid off was debt of Trump’s related financing corporations (guaranteed by Trump’s partnerships), which existed because of New Jersey casino regulations. Still, Trump was undeterred, and took the position that the corporations’ debt was really the partnerships’ debt, as the corporations were mere agents or nominees of the partnerships. This is often a difficult position to sustain in tax law, which is biased towards treating legal entities as separate and holding taxpayers to the form they select for a transaction.
Before taking this debt position, Trump made sure to reinforce his defenses: He requested a tax opinion from the law firm of Willkie Farr & Gallagher. Tax opinions are routinely requested by parties performing major transactions, particularly where there is tax uncertainty present. Such opinions provide various legal benefits, including (importantly here) mitigating potential tax penalties. That is, when someone underpays or misreports their taxes, they will always be liable for missed taxes and some level of interest (as the unpaid taxes are essentially “loans” from the government). The IRS may also apply penalties, intended to scare taxpayers into compliance. However, a tax opinion provides analysis and a confidence level which, if accurate, may help to reduce or eliminate many such penalties. A higher confidence level means more penalties will likely be mitigated. Further, the mere act of obtaining competent-seeming professional advice can help mitigate certain penalties.
The confidence levels expressed by tax opinions translate to the following probabilities:
|Confidence level||Probability of being upheld|
|More likely than not||Greater than 50%|
|Not frivolous||Some amount lower than reasonable basis, but not clear how low|
|Frivolous||Extremely unlikely, to the point special penalties are likely to apply for frivolousness|
 It should be noted that what these “probabilities” mean is somewhat opaque and uncertain. See http://danshaviro.blogspot.com/2016/11/latest-on-trumps-tax-scam.html?m=1.
In the case of Trump’s transaction, Willkie identified 8 key areas of tax uncertainty. It offered a more likely than not opinion on one issue, and a substantial authority level of confidence for the remainder of the issues. This meant that Trump was highly unlikely to face tax penalties for his position. But it also meant that, for many of Trump’s positions, the law firm thought the most likely outcome was that Trump would lose against the IRS. Some tax experts speculate Trump had opinion shopped to get the most favorable opinion he could, as was common in the 1990s. Opinion practice has since been legally forced to become much more legitimate and thorough than it was in the 1990s. If the Willkie opinion, with its low confidence level, was the best he could do, perhaps his position was even less justifiable than it appears to be.
In 2004, Congress (including Sen. Hillary Clinton) explicitly removed from the Internal Revenue Code the ability to issue partnership equity for debt in order to avoid cancellation of debt income while recognizing a loss. Some see in this amendment an indication that Trump’s position regarding the exchange of partnership equity for debt had some legitimacy, since Congress felt it had to step in to explicitly change the law.
Was Trump Wrong to Act this Way?
The New York Times is unambiguous in its verdict: Trump’s technique was legally dubious, and deserves our scorn.
But there is a different way of looking at it. Trump appears to have made a calculated decision: The tax benefits from his tax position would be enormous, and the Willkie opinion appeared to cover him from the downside of penalties. All he was likely risking was the additional interest he might owe. Trump apparently felt this was worth a shot. While the outcome doubtlessly violated good and fair tax policy, it appears Trump’s position worked out for him in the end.
Even so, was the position too aggressive, and was Willkie wrong for issuing that position? It’s unclear from the facts provided. The fact Congress needed to step in to amend the Code to eliminate the partnership-equity-for-debt rule does suggest this key ambiguity Trump exploited was a real, unforced reading of the law. But we cannot say for all the other ambiguities Trump exploited.
Thus, while we cannot know if Trump’s actions were truly as dubious as the New York Times says, we do know that Trump’s risks and the expiration of the applicable statute of limitations saved him from heavy income taxation and stiff sanctions. Trump’s result, in short, shows what good tax lawyering and ambiguous tax law may allow.