Dont Let Capital Accounts Go Negative

The proposal would prevent negative capital accounts as a remedy to prevent tax shelters. It would suspend deductions that would otherwise result in the taxpayer’s adjusted basis being lower than the outstanding debt. When capital accounts are negative, the transaction is a tax shelter in which tax is negative, that is, tax increases the pretax return. Limiting deductions to prevent negative capital accounts will prevent negative taxes. A negative capital account, strictly speaking, is only a partnership account describing a situation when a partner’s adjusted basis in his interest in the partnership is less than his share of partnership liabilities. The proposal would also apply to assets owned by a single corporation or an individual, by suspending deductions that would otherwise drop adjusted basis in assets to an amount less than the debt outstanding.

The negative taxes that increase pretax returns are subsidies that warp investments away from their pretax values. The government is facing an impending revenue crisis. Before increasing tax rates on economic transactions that now produce tax, government revenue would be met better by ending the revenue-absorbing negative tax transactions. The proposal affects only tax shelter transactions when tax increases the internal rate of return (IRR) from the investment, and it has no effect on ordinary business transactions that are not tax shelters.

Negative capital accounts require that a partner- ship is a tax shelter because debt and the interest deduction are inconsistent with favorable depreciation and with expensing of the debt-financed in- vestments. Our treatment of debt, allowing both an interest deduction and also deductible basis arising from the borrowed principal, is consistent only with a pure income tax. In a pure income tax, investments would be deducted only as the investment is lost. In a pure income tax in which the tax account- ing described the economic income from the investment, the taxpayer’s adjusted basis would never be allowed to drop below the remaining net present value of the investment. Under the existing federal income tax, however, investments are often expensed or allowed depreciation deductions that exceed economic losses. Adjusted basis drops below the remaining value of the investment. The expensing or generous depreciation deductions mean that the tax system reduces the pretax IRR by less than the statutory tax rate. When a low (IRR-reducing) effective tax rate is allowed for investing and interest deductions are also allowed for the borrowing to fund the investment, the combination creates tax shelters — meaning that tax increases the pretax value of the activity. The proposal would allow the low IRR-reducing effective tax rates when the tax- payer has equity, determined under the regular rules of tax accounting, but when capital accounts go negative, the tax-account equity is gone, and the situation is entirely that of debt-financing and tax shelters. The proposal would end the tax shelters.

The negative capital proposal would prevent adjusted basis below debt not just for partnerships but also for corporations and individuals. The rules would apply not just to specific assets but also to enterprises as a whole, without regard to whether the costs are deducted as depreciation or expenses. The assets whose basis would count in determining whether the capital account is negative would gen- erally be all of the assets the creditors can reach for payment. But no future income, or other values without basis would be considered. Losses would be suspended pending repayment of more of the loan, or contributions of more basis by the taxpayer. The suspension of losses could occur even when a large range of assets are at risk to secure repayment, but the basis of those assets would be considered in calculating the capital account.

An administrative rule, however, would deny use of basis from assets not committed to the partnership or other entity for partners with less than a 5 percent interest, on the grounds that it is unlikely that the creditors are looking to partner assets because of the difficulties of collection. Application of the proposal to consolidated returns would end the negative basis in excess loss ac- counts on the grounds that the negative basis means that basis has been overrecovered. Taxpayers pay- ing tax at statutory rates of less than 30 percent (ignoring the deductions at issue) would not be subject to the rules because sheltering is a more modest problem in low tax brackets.

The rule would reduce cancellation of indebtedness income cases. Cancellation of indebtedness income arises, in general, not because there is an economic gain at the time of the cancellation, but because the debt-financed deductions have gone too far and need to be reversed into income.

The proposed remedy goes to the heart of the leveraged tax shelters that Congress has repeatedly tried to curtail. The ‘‘at-risk’’ remedy of section 465 is focused primarily on the inflated liabilities that occur inevitably when a seller sells property for a liability to the seller that cannot be enforced except by reseizure of the property. The proposed remedy attacks the tax sheltering that arises from bona fide cash borrowing from unrelated creditors as well as the inflated liabilities from two-party nonrecourse debt. The ‘‘passive activity’’ remedy of section 469 prevents outsiders from getting access to shelters, while allowing the negative-tax subsidies from the mismatch of debt and rapid write-offs to those who materially participate in the activity. The proposed remedy would stop sheltering even for the insiders who materially participate in the debt-financed shelter. The remedy would go to the heart of the tax shelters, that is, the fundamental inconsistency between tax treatment of investment that is more generous than allowed in a pure income tax, and treatment of debt that is consistent only with a pure income tax.

1. Partnership negative capital accounts. A part- ner’s capital account is the partner’s share of partnership equity, when assets are stated at their tax-accounting adjusted basis. The balance sheet lists the assets of the partnership on the debit (left hand) side, and the claims on those assets on the credit (right hand) side. Under double-entry ac- counting, the debits and credits must equal each other: Claims must exactly cover all the assets, but nothing more. On the credit or claims side, debt is listed first and is paid first. Whatever remains is by definition partnership equity. A partner’s capital account is a single partner’s share of partnership equity.

Assume for example a simple partnership ABC with three equal partners, which has $1,000 in cash, $1,000 in land, and $500 in equipment. The cash arose from partnership income, not yet distributed.

The partnership owes the bank $700 on the mort- gage that arose to buy the land. The partnership equity is thus $1,800:

Each partner has a one-third interest in the partnership so that each partner has a claim against the partnership for one-third of total partnership equity, and one-third of $1,800 is $600.

Under the tax accounting that defines partner- ship capital accounts, the assets of the partnership are stated at the partnership’s adjusted basis for its assets. Under double-entry bookkeeping, partner- ship equity must therefore equal the total adjusted basis of partnership assets reduced by its liabilities. A positive capital account means the partner’s share of adjusted basis exceeds the partner’s share of liabilities. Partner capital accounts would represent the amount the partner would get if the partnership liquidated by selling all of its assets at exactly their adjusted basis and distributing the cash. It is under- stood that it is highly unlikely that the sale price of partnership assets will exactly equal adjusted basis: Going concerns, for example, tend to have future income that will make the partnership’s value higher than its adjusted basis in all assets. The partner’s capital account, however, will not, and by definition, cannot reflect any values of assets or the partnership as a whole that is different from the tax adjusted basis.

For example, assume the land held by partner- ship ABC is now worth $40,000, and the partnership will have a steady perpetual income of $10,000 a year, so that at a 10 percent discount rate, the partnership is worth $100,000 as a whole. Assume that the partnership is about to receive $60,000 earnings in cash and that the equipment is really worth $2,000, but its basis has been reduced to $500 by incentive depreciation that allowed deduction of costs that had not yet expired. None of those facts are relevant to the calculation of the adjusted basis of partnership assets and hence necessarily have no impact on partnership equity or any partner’s capi- tal accounts. Capital accounts are not about valua- tion, but about balancing the books.

Capital account is a bit of misnomer because an important part of a partner’s capital account will typically be the partner’s share of the year’s income or receivables that have not yet been distributed. Partner capital accounts include all booked but undistributed income. The capital account is based on the balance sheet, however, and reflects income only because the asset entry from the income is included on the balance sheet. Capital account, moreover, does not now imply anything about a partner’s share of partnership income from investment of capital. A partner with a capital account equal to 1 percent of partnership capital might be entitled to 99.9 percent of the cash from investment of partnership capital. A partner’s capital account is a capital account just because it is a balance sheet account, rather than part of the income statement.

A negative capital account means that the liabilities of the partnership asset exceed the adjusted basis of the partnership assets. Assume, for ex- ample, partnership DEF borrowed $100 to develop a valuable software product. The costs of the soft- ware would be expensed,[1] would have zero basis, and would be stated at zero on the assets or debit side of a tax accounting balance sheet. Assume DEF also purchased a building by the typical constant periodic payment mortgage. For a 30-year constant payment mortgage, the debt declines very slowly in early years, at a rate slower than pro rata straight- line reduction of the debt. For tax, by contrast, a residential building is depreciated straight-line over 27½ years.[2] After 10 years, a building purchased with $100 debt bearing 5 percent interest will have $63.64 basis, but $81.01 outstanding mortgage.[3]

DEF partnership has both the software development and the 10-year-old apartment building:

Partnership DEF has negative partnership equity of $117, which is the excess of its debt over the adjusted basis of its assets. The negative partner- ship equity is a forced conclusion because balance sheets must have debits equal to credits, and liabilities exceed adjusted basis of the partnership’s as- sets. Each one-third partner would have a negative capital account of one-third of $117, or $39.

If a positive capital account represents a claim by partners against the partnership on liquidation, the negative capital account in some sense represents a claim by the partnership against partners. If DEF is a general partnership, the partners might each be called on to pay $39 on liquidation with a sale equal to adjusted basis to pay off the creditors. If the partnership is a limited partnership or limitedliability company taxed as a partnership, the partners cannot be called on to contribute to the partnership, and it will be the creditors who lose the $117 total negative equity. Or at least the creditors must await future income that has not yet been booked or rely on values not reflected in the adjusted basis of the assets.

In truth, negative capital accounts commonly have no meaningful economic impact. Negative capital accounts are not interest bearing, so under time value of money principles, the $117 obligation does not have a present value of $117. Allocation of partnership income from capital has nothing to do with the relative value of partner capital accounts, and partners with negative capital accounts can continue to receive a share of cash from capital investments of the partnership. Negative capital accounts are respected if the partner is obligated to pay tax when the obligation of the negative capital account disappears, but the tax can be at capital gains rates of 15 percent and can be a long way away. No one negotiating the deal who is not the tax lawyer pays much attention to them. Negative capital accounts, like positive capital accounts, have nothing to do with valuation: They are about balancing the balance sheet.

Creditors, however, tend to protect themselves, and they do not willingly go into positions in which the assets of the debtor are insufficient to cover the liability. Even in a general partnership in which the creditor can chase partners for the $117, it is often hard work to find dispersed partners. It is the self-protection of creditors that led us to the conclusion that a debtor has no economic gain by borrowing: The obligation to repay the debt with adequate interest is enforced by creditors and prevents the cash in hand by borrowing from being considered economic gain. So too, the self-protection by creditors implies a plausible reason for the negative capital accounts: The assets have a value as collateral or will generate future income sufficient to cover the $117 deficit, but the adjusted basis of DEF’s assets is $117 below the value of the assets.

Partnership DEF has plausibly been allowed to expense investments that have not been lost and to depreciate property at a rate faster than economic decline. In any event, negative capital accounts do not usually represent $117 the partners expect to pay into the partnership, nor any insecurity about the payment of the partnership debts. Negative capital accounts simply identify that the partner’s share of adjusted basis of partnership assets is lower than his share of partnership level debt, as required by double-entry bookkeeping.

While the term ‘‘negative capital account,’’ in ordinary usage, applies to a partnership account, there is no impediment to applying the same concepts when there is a single owner, whether an individual or a corporation. A corporation can have an adjusted basis in its assets that is smaller than its outstanding liabilities. Individual investors do not ordinarily keep balance sheets, but in concept, an individual can have liabilities that exceed adjusted basis in assets. If the liability is nonrecourse liability, the negative capital account means simply that the assets that the creditor can reach to satisfy the liability have an adjusted basis of less than the debt outstanding.

2. Excess loss accounts. The corporate consolidated return regulations create a ‘‘negative basis’’ account for subsidiary stock called the excess loss account (ELA).[4] The ELA negative basis arises because losses deducted by the consolidated group exceed the parent corporation’s basis in the subsidiary stock. Losses in excess of basis happen because the subsidiary pays for deductible or depreciable costs with subsidiary debt, and the deductions occur before the debt is repaid.[5]

The negative basis ELA becomes additional gain when the subsidiary stock is sold or becomes worthless. For example, if a parent corporation invested $10 in a new subsidiary within the consolidated group, the subsidiary borrowed $40, and lost $45, the losses would be deductible on the consolidated tax return, and the $45 losses would reduce the parent’s basis in the subsidiary from $10 to negative $35. If the subsidiary stock were sold to a buyer which is not a member of the consolidated group for $2, the parent would have a $37 gain.[6]

The $37 gain is not by reason of receipt of $37 or economic gain at the time, but rather because $35 of the loss was not paid for. For tax to reflect the total transaction, the $35 losses must be reversed into income at least by the termination of the ownership of the subsidiary. The $35 gain, for instance, is recognized if the subsidiary ceases to be a member of the consolidated group, for instance if 20 percent of the stock of the subsidiary becomes owned by employees or other holders outside the group.

An ELA is different from a negative capital account only because debt of a partnership ordinarily passes through to partners and becomes part of their basis. Debt of the subsidiary is not part of a parent corporation’s basis. Without that difference, an ELA negative basis is synonymous with negative partnership equity and negative capital accounts. If the subsidiary described above had been an equally owned partnership of two corporations, for ex- ample, the partnership would have had a negative partnership equity of $35. The proposal, by disallowing deductions that would reduce basis below debt, also would prevent negative basis ELAs when applied to corporations.

The ELA system is avoidable, however, because the negative basis is purged and disappears if the subsidiary merges or liquidates into the parent. In the event of tax-free liquidation or merger, the parent takes over the basis the subsidiary had in its assets as its own, and the parent’s basis of subsidiary stock disappears without any recognition of the $35 negative basis.[7] The negative basis that disappears in a liquidation or merger still represents basis allowances that exceed the taxpayers’ cost, but the excess losses are never recovered. The proposal would prevent deductions that lead to the negative basis ELA in the first place.

3. Other shelter remedies. Congress has attempted to limit the negative tax from leveraged shelters in several ways since 1976. Two important overrides that suspend shelter deductions arising from debt- financed investments are the ‘‘at risk’’ rules of section 465, and the ‘‘passive activity’’ rules of section 469. The at-risk rules of section 465 restrict the deduction of losses from an investment to the amount for which the taxpayer is at risk regarding the property. Depreciation deductions are computed from basis that includes nonrecourse liability which is not at-risk, but deductions are suspended once basis from at-risk sources is fully recovered, until the taxpayer increases amounts at risk by paying off the debt or receiving more income from the transaction.

The abuses that were the target of the at-risk rules were the deductions arising from inflated two-party nonrecourse liability owed to the seller who provided both the debt and the property.[8] The at-risk rules do not limit depreciation from debt for which the taxpayer was personally liable, debt adequately secured by unrelated property, and qualified nonrecourse liability borrowed from an unrelated party, on the ground that those liabilities are unlikely to be inflated.

For this proposal, by contrast, no borrowing, whether or not at risk or vulnerable to inflation, would increase the ceiling for deductions because borrowing would not increase the capital account above the negative range.

The passive activity loss limitations of section 469 were adopted as a part of the 1986 Tax Reform Act to limit tax shelters so that the act could cut maximum tax rates for the richest taxpayers and also not change the distribution of the burden of taxes.[9] The limitations are based on a skeptical assessment that deductions created by ordinary tax accounting from a basis that includes debt does not represent true losses. Under the passive activity rules, losses from an activity in which the taxpayer does not materially participate are suspended and may not shelter income from salary, portfolio in- vestments, and regular business, until the taxpayer terminates the activity. At termination, debts need to be paid, so that the losses surviving to that time will represent real losses of cash rather than deductions from creditor money or promises to pay. Material participation is defined to require time equal to a quarter of a year of full-time work during the tax year. The material participation rules allow insiders who do spend the requisite time to get access to shelter deductions and protect the insiders from outsider competition.

Both the at-risk rules and the passive activity limitations are best understood as limiting artificial accounting losses that arise from the mismatch of debt and generous deduction of investment, as explained below. The proposal here bears a resemblance to both the at-risk rules and the passive activity loss provisions in that it allows deductions to be computed from a basis that includes debt, but then suspends the deductions so as to prevent artificial losses. The proposal attacks not just two- party nonrecourse debt likely to be inflated, but also

T able 1. Equivalence of Exempt Yield and Expensing