The war of the MIPS.

• Author: Zinn, Michele R.
• Position: Taxation of monthly income preferred shares

In May 1998, the Enron Corporation fried a Tax Court petition contesting the IRS's disallowance of a deduction for interest payments on a monthly income preferred shares (MIPS) transaction. MIPS is a financial product designed to give the overall effect of equity-like treatment for regulatory, rating agency and financial accounting purposes, while providing an interest deduction for tax purposes. However, the Service's position in the Enron deficiency notice apparently did not win IRS National Office support; on Nov. 16, 1998, the Service released Letter Ruling (TAM) 9910046, supporting the taxpayer's treatment of a MIPS transaction. On Dec. 24, 1998, the IRS dropped its challenge to Enron's interest deductions arising from the MIPS securities.

MIPS Transactions

In a typical MIPS arrangement, a parent forms a transparent, wholly owned limited liability company (LLC) or similar passthrough entity. The LLC issues MIPS, which are preferred interests in the LLC, to the public for cash. The LLC then lends the cash from the MIPS sale to the parent, thus creating a related-party loan. The loan and the MIPS generally have identical terms and typically contain a combination of equity and debt features. Equity features include a very long maturity, deep subordination and a holiday of up to five years on the interest payments. Debt features include acceleration of principal payment on default and the right to repayment of the entire principal amount.

Regulators and rating agencies consider the overall effect of a transaction; these agencies conclude that the parent group issued an equity-like instrument. For tax purposes, however, a taxpayer characterizes the transaction in accordance with its form--a sale of a minority interest in an LLC and a related-party debt between the parent and the LLC. The parent takes a deduction for the periodic interest payments made to the LLC on a related-party loan. The LLC makes periodic preferred equity payments to the MIPS holders with the cash it receives from the parent's interest payment. The aggregate amount of preferred equity payments made by the LLC to the MIPS holders normally equals the aggregate interest paid by the parent to the LLC. When the related-party loan from the LLC to the parent matures, the MIPS are redeemed, generally for cash.

MIPS have been a major source of aggravation for the IRS; since MIPS and similar hybrid securities were first approved as equity for balance sheet purposes, taxpayers...