The U.S. Tax court recently decided the case of Calloway v. Commissioner. The Court held that Calloway did not borrow money against his stock but instead sold his stock at the inception of the loan. This appears to be a case in which there was little empathy for this “ponzi scheme victim” who has been treated as if he “were in on it” from the start. We hope that this case containing many “bad facts” is not interpreted as denying taxpayers the ability to borrow on a non-recourse basis with a better set of facts.

Under the facts of the case, Calloway entered into a non-recourse loan with Derivium Capital LLC for approximately $93,600. Calloway pledged  Derivium 990 shares of IBM to secure the loan. At that time the shares were worth approximately $104,000. The loan had a term of 3 years, at an interest rate of 10% annually that was to be paid at the loan’s end and also was non-recourse. Calloway was told that any dividends received on the IBM shares during the life of the loan were going to be applied against the interest. The remainder of any interest due on the loan was payable at maturity. The loan could not be prepaid.

After three years, the amount due on the loan was approximately $124,400 and the IBM stock was worth approximately $83,000. Since Derivium’s only recourse against Calloway was against the stock, Calloway forfeited his stock to Derivium.

Some “bad facts” which probably tainted the Court’s opinion were the following:

1)     Calloway never reported any gain from the sale of his IBM stock. Clearly, the forfeiting of the stock to Derivium in satisfaction of the loan was a taxable disposition of the stock and should have been reported and taxed.

2)     Calloway never reported any dividend income on the stock during the life of the transaction. As the owner of the stock he should have recognized the dividend income and taken a corresponding interest paid deduction. Calloway received no 1099s during the life of the loan. Calloway did receive statements showing the shares in an account with both dividends credited and interest collected against that money.

3)     Derivium immediately sold the stock it received from Calloway and did not hedge its exposure to Calloway. Derivium entered into over a billion dollars worth of these transactions all in apparently the same fashion. Derivium was forced into bankruptcy when too many borrowers’ shares appreciated and the borrowers attempted to pay their loans and reclaim their pledged shares.

The Court found that Derivium’s immediate sale of the IBM stock was not consistent with the terms of the loan. As such, the Court ruled that no loan existed. Instead it found that Calloway sold the stock for its fair market value and simultaneously bought a 3 year call option on 990 shares of IBM.

Investor’s must be cognizant of the case despite its bad facts... We take some comfort from Judge Holmes who states that properly structured, non-recourse loans secured by stock should be respected for tax purposes. Some key factors would include the following. First, the lender should be restricted from selling the collateral. If sold, the lender should satisfy the borrower that it has made provisions that will allow it to be able to repurchase the stock. Second, the investor should receive 1099s and report the dividend income on the stock during the life of the loan. Finally, if the stock is forfeited and used to pay the loan, that should be treated as a taxable event with the sale price equaling the 90% received at inception plus the amount of any accrued and forgiven interest.