You just couldn't play it smart, could you?
All you had to do was box, but no,
not you, you hardhead.
Funny thing is, there ain't gonna be
any boxing championships this year.
As I mentioned in my initial post on Fidelity International Currency Advisor, there is much material in the saga of Richard Egan's doomed tax shelters. I will wrap up my EMC trilogy with an observation on the greatest irony of the case. The Egan's had two partnerships one designed to shelter capital gain and the other ordinary income. I explained the capital gain scheme, but not the ordinary income one. Basically you get a free basis step-up by entering into offsetting option contracts and have an accountant handle one leg of the transaction and a tax attorney the other half. The debit goes on the left and the credit goes ... What credit ? The ordinary income refinement requires a foreign partner to be allocated gains and then be bought out. (Of course the buy-out cannot be prearranged wink, wink). This deal was done in 2000, a long time ago to some, but well after the 704(b) regulations were issued. Sadly the case does not explain the theory that deemed there to be substantial economic effect to the allocating of 160 million of gains to someone who was shortly bought out for around $325,000. That's not where I see the irony, though.
After a whirlwind tour of the Big Apple's accounting emproia where these brilliant maneuvers were presented Richard Egan, according to one of his advisers, told his son Michael, who headed his family office, that he wished his advisers would help make him money rather than save it. The advisor was told that she may have misheard and that "Dick" knows how to make money, but may not know how to save it. This presumably was how the advisers would distinguish themselves. One of the earliest events recorded in the case is something that James Reiss, CFO of Carruth Management (Egan's family office) wrote to attorney Stephanie Denby:
On April 25, 2000, Reiss wrote to Denby that Michael Egan was “anticipating unloading his father's EMC shares at $140” per share, and asked if she had a “good lead on a transaction and insurance.” The “transaction” he had in mind was one that would avoid taxes.
By the fall of 2000, the price of EMC exceeded $100 per share and had it kept appreciating at a similar rate $140 would have been achieved before long. The effort involved in selecting just the right tax shelter and making sure it was properly documented took time. Once all that energy was expended there was a desire to make sure the paid-for basis was properly used. Sadly the market did not cooperate with the plan.
At the beginning of September 2000, EMC stock was trading at $98.00 per share. Thereafter, the share price of EMC steadily declined, with the exception of a small increase in January 2001. By the end of November 2001, EMC stock was trading at $16.79 per share.
The Fidelity High Tech transaction had created a purported “basis” of $ 160 million. As the price of EMC stock began to decline, however, it became apparent to Michael Egan and others that the stock could not be sold for a sufficient gain to take advantage of that entire “basis.” In addition, the Egans did not want to show a loss on the sale of the stock. Accordingly, in 2001 the Egans added additional low-basis stock to the High Tech Fund—a practice that was referred to as “stuffing.” As Haber advised Pat Shea, the Egans could “stuff [High Tech] with more stock to get our per share basis lower [--] that will allow us to sell shares tax free.”
At least as early as May 2001, Michael Egan was being provided with spreadsheets prepared by Carolyn Fiddy that set forth the fair market value of the stock held in High Tech. The spreadsheets showed how much additional stock would need to be contributed to bring the value of the portfolio up to the amount of the $160 million purported basis,
In late 2001, employees at Carruth performed further calculations in order to determine how much additional stock needed to be contributed to Fidelity High Tech in order to take advantage of the purported $160 million basis. In addition to EMC stock, Michael Egan authorized contribution of other low-basis stock owned by the Egans to Fidelity High Tech to take advantage of the “stepped-up” basis (or, as Shea put it, to “absorb” that basis).
On December 19, 2001, Carolyn Fiddy reported to Reiss that “the final “stuffing” for Fidelity High Tech Advisor A has been organized.” . The same day, Shea reported to Reiss that “the “stuffing” of Helios I [High Tech] took place today.” On December 20, Fiddy reported to Haber that “additional contributions of low basis stock” had been made to High Tech.
On December 20, 2001, Pat Shea reported to Haber that “we have “stuffed” this fund with several other assets including more EMC stock.”
The beauty of the transaction was that it would have a "low reporting profile" since it was "merely" eliminating gains rather than creating a loss. Ultimately the transaction would be showing a loss as there was not enough fair market value of EMC stock contributed to take advantage of the basis.
In the end the capital gains tax had to be paid and apparently a 40% gross valuation overstatement penalty. Not to metnion all the fees which were estimated to be around 20% of the "tax savings". The really interesting question, though, is how much was lost due to stock being sold at less favorable prices than might have been obtained without the complications of the shelter planning ?
The Egans were not the only people afflicted by the belief that EMC stock could only go up. And of course EMC was part of the larger tech bubble. Just for perspective we can reflect on what might have happened to many of the EMC rankers. The belief that tax laws are rigged in favor of the ultra wealthy is really a delusion. Mr. Egan had to get somebody to find a friendly Irishman to pick up 160,000,000 dollars in currency gain and then be bought out to shelter his non-qualified option ordinary income. A regular EMC employee would have qualified options. So if such an employee exercised an option to buy at say $20 when the stock was at $90 all he or she had to do was hold onto the stock for a year in order to get capital gains treatment on the $70 plus of course the additional amount that the EMC stock would go up by in the course of the year. Of course there was that nasty alternative minimum tax so maybe there would be $15 or so to pay in April, which might have been about what the stock finally sold for. So as they stretched to turn a 40% tax into a 20 % tax, they ended up with, in effect, a 100% tax. They ended up with AMT credit carryovers and AMT capital loss carryovers, many of which have been used by now, but it was really painful in 2001.
The usual prize of the privilege of naming a topic for a future goes for identifying the quotation leading the post. In order to get full credit you have to name the historic event that corresponds to the tech bubble in the analogy that I am creating.