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Derivium Loan Update: IRS Targets Derivium
IRS has targeted taxpayers who have engaged in loan transactions through Derivium Capital by sending them Preliminary Notices, in late January, 2007, stating that the Derivium loan transaction may be a "tax avoidance" device.
In essence, IRS claims the Derivium loan transaction is really a taxable sale of securities at the time taxpayers received the proceeds, rather than a bona fide loan. IRS has an audit project underway in Sacramento, California, involving Derivium-type loans.
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In general, Derivium arranged loans for 90% of the value of a stock for an initial 3-year period at a compounded interest rate of approximately 10%. The loan is non-recourse, which means that at the end of the loan term, if the borrower cannot repay both principal and interest, the lender forecloses on the stock in full payment for the loan. The borrower has the option of rolling over the loan at maturity for an additional fee.
Note: Derivium has filed for bankruptcy and its client list has become public, thereby providing IRS with a road map of taxpayers who engaged in the loan transactions. Derivium is no longer in business.
IRS challenges the transaction and maintains a sale occurred in the initial year of the transaction on the following grounds:
1. The taxpayer was obligated to transfer the stock to Derivium, but repayment was optional because the purported loan was non-recourse to the taxpayer. 2. Taxpayers eliminated the risk of loss. 3. Principal payments are prohibited during the entire term of the transaction. 4. Legal title to the stock was transferred to Derivium. 5. The stock was treated as belonging to Derivium. 6. Derivium sold the stock to fund the transaction.When the loan matures and if the borrower does not repay it, the lender forecloses on the security (the stock) and the borrower has a taxable event at that time. The stock is treated as sold for the full amount of principal and interest outstanding. Thus, the borrower has a gain equal to the difference between the sales price (the full amount outstanding on the loan) and the borrower's basis in the security. The gain will usually meet long-term capital gain requirements under federal law and be taxed at 15%.
IRS's position is questionable on several fronts:
After representing at least a dozen taxpayers concerning Derivium loan transactions, it turns out that accepting the IRS position, in many instances, results in either a small increase or decrease in tax.
Thus far, I have not seen the situation where it was economically justifiable to challenge IRS's position, because of how the interest calculations work. Taxpayers who incurred capital losses in the years after they entered into the transaction may find themselves with unused capital loss carryforwards.
Also, as part of any settlement, penalties should be waived since there is no justification for penalties under these circumstances, especially when the transaction was clearly structured to be a loan and IRS has not published any warnings or guidance regarding these transactions.
Based on the present state of the law, the loans arranged by Derivium Capital should be considered bona fide loans and not the sale of securities. However, once a taxpayer understands how to analyze the transaction and how to crunch the numbers, filing an amended return to report the transaction in the year of sale may be the least costly alternative. For some taxpayers, they may wind up owing less tax under the IRS's theory.
Those who have received a Preliminary Notice from IRS regarding Derivium-type loans need to consult with an experienced tax professional and thoroughly understand the ramifications of amending their returns to report the transaction as a sale, as advocated by IRS.