Sale versus loan: a current development in tax ownership?

• Author: Borghino, Jeff

The characterization of a transaction as a sale has significant tax implications, and there is an abundance of case law and IRS guidance that interprets if and when a sale occurs in numerous contexts. One recent case, Calloway, 135 T.C. No. 3 (2010), rules on if and when a taxpayer sold his stock upon entering into an agreement, which purported to be a nonrecourse loan. While the result of the case may appear acceptable due to the facts and circumstances, the rationales in reaching the result significantly differed among the court's judges. This item summarizes the facts and holding in Calloway and the differences among the judges' opinions.

The Facts of Calloway

In this case, Calloway purchased 990 common shares of IBM while employed at IBM. The shares appreciated in value after Calloway acquired them. In early August 2001, Calloway entered into an agreement with Derivium Capital LLC, which provided that Derivium would lend an amount of cash to Calloway that was equal to 90% of the market value of the shares (the loan). The terms provided that the loan accrued interest equal to 10.5% (which compounded annually), was nonrecourse, and had a three-year maturity term.

On August 16, 2001, Calloway transferred the shares to Derivium as collateral for the loan and agreed that Derivium had the right to sell some or all of the shares without providing notice to him. Calloway did not have to maintain margin requirements other than transferring the shares. Dividends that Derivium received from the shares would be applied against the interest due from Calloway.

On August 17, 2001, Derivium sold the shares on the open market and subsequently transferred the loan to Calloway based on the amount that it received from the sale (i.e., 90% of the market value of the shares). Thus, the amount of the loan was not determined until after Derivium sold the shares. Calloway could not prepay the loan, and Derivium could not require Calloway to repay the loan prior to maturity.

Upon the end of the loan's three-year maturity term, Calloway had the option to:

* Pay cash equal to the outstanding principal and interest related to the loan and receive the shares;

* Extend the term of the loan in exchange for a fee that would be equal to a percentage of the balance due; or

* Surrender the shares with no additional obligation.

On July 27, 2004, immediately prior to the loan's maturity, Calloway stated that he relinquished his right to the shares in satisfaction of the loan and never made any payments of principal or interest on the loan.

The primary issue in Calloway was whether the loan constituted a sale of the shares in 2001 or a nonrecourse debt that Calloway owed to Derivium. If the loan constituted a nonrecourse debt, Calloway would have had dividends from the shares after he transferred the shares to Derivium and gain from relinquishing the shares in retirement of the loan in 2004. However, Calloway failed to report such dividends and gain on his tax returns.

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