IRS cracks down on self-amortizing investments in conduit financing entities.

• Author: Josephs, Stuart R.

In Notice 97-21, the IRS noted that certain persons are engaging in multiple-party financing transactions designed to allow a person (the sponsor) to avoid tax on substantial amounts of income (or to shelter substantial amounts of other income), by using a conduit entity whose income tax treatment artificially allocates the conduit's income to participants not subject to Federal income tax.

Example: A corporate sponsor forms a real estate investment trust or a foreign corporation (the Company). The Company issues two classes of stock. The corporate sponsor holds substantially all of the Company's common stock. The other class (the fast-pay preferred stock) is held by persons not subject to Federal income tax (exempt participants). The fast-pay preferred stock has limited voting rights and provides for preferred "dividends" equal to 13% of the stock's issue price each year for 10 years.

The Company holds income-producing assets (such as one or more mortgage loans) that are the obligations of, or guaranteed by, the corporate sponsor or guaranteed by a Federal agency. At all times during the first 10 years after the fast-pay preferred stock is issued, the Company must invest in assets that will produce income and cash flows at least equal to 101% of the dividends payable on the fast-pay preferred. During the first 10 years, the Company also may make distributions on its common stock; however, it cannot distribute more than 105% of its income in any year. Accordingly, it is not permitted to make any distributions representing a meaningful return of initial investment to the common stock holders during the first 10 years.

In year 11 and thereafter, the fast-pay preferred stock provides for distributions each year of 1% of its original issue price. As a result, after the first 10 years, the fast-pay preferred stock's fair market value is substantially less than its cost to the exempt participants.

Beginning in year 11, the Company may be merged into another corporation without the exempt participants' approval, provided that they receive a formula payment equal to the present value of the annual 1% dividend payments on the fast-pay preferred stock (using a 10% discount rate). Otherwise, the fast-pay preferred stock cannot be called by the Company.

As illustrated by this example, the fast-pay preferred stock performs economically much like a 10-year, self-amortizing debt instrument. That is, the fast-pay preferred stock payments reflect, in part...