(I was going to post about this in P&E when it struck me that I ought to have at least a rudimentary understanding of the issue.)
Apparently Donald Trump has reported a $50 million loan that may not actually exist. One reason why this could have been done is something called “debt parking” – a tax avoidance scheme.
How does debt parking work? I understand that when a loan is forgiven the amount forgiven is reportable as income. How does faking another loan make it so you don’t have to pay tax on that income?
The basic idea is that if you’re a debtor and get a partial forgiveness of a loan (because, for instance, your creditor wants money sooner than you contractually have to repay, and you agree with the creditor to make a payment in return for a forgiveness of an amount that’s greater than what you repaid), then the difference between what you pay and the reduction of the debt will be a taxable profit. To avoid this, you could try to structure the transaction as one whereby the debt isn’t partially forgiven, but rather sold by your old creditor to another company you control and transferred to that - you “park” the debt with the other company, and now owe the debt to that one. This is not necessarily illegal, but can be tax avoidance if you have no intention to actually repay the debt to the other company you control.
My (admittedly sketchy) understanding of tax law is that typically(1) something that is taxable income to one party is a tax deduction to the other. If the loan forgiveness is structured so that it’s not taxable to the borrower, does that mean the creditor can’t take a deduction?
I’m far from a tax expert too, but I don’t think this is even typically true. If I use my salary to buy groceries, then that will be revenue, and hence taxable income, for the seller of the groceries (who can, of course, count the costs of producing the groceries against that income for tax purposes). But I don’t get a deduction for the groceries; I buy them from my after-tax salary. If every piece of taxable income were a deduction for someone else, then wouldn’t the aggregate taxable in once across the economy, and hence the tax revenue for the government, be zero?
I think the issue here is the difference between personal and business income taxes. Businesses pay taxes on their profits, which means that any reasonable expense occurred can be “written off”, i.e. subtracted from revenue for the purpose of determining tax liability. Individuals, on the other hand, pay tax on all their income, which can only be reduced by a set amount, plus a few special categories of expense like mortgage interest payments and charity.
In this case, a business probably could take a tax write off on a forgiven loan, although I am not an export either, so don’t quote me on that.
This arrangement isn’t how “debt parking” is typically used in the United States (it generally refers to a totally different type of scheme), but it does seem to common use in Canadian tax law, which took steps to prevent it in the 90s, and I assume what it’s describing could be done in the United States in some fashion.
As I understand it, the original Creditor will sell the debt to the debtor-affiliated company for a significant discount. It can then take the loss as a business loss. The affiliated company doesn’t take any action to recover on the debt (it gets “parked”), but it remains valid, so it hasn’t been forgiven (which would create a taxable event for the debtor).
So, to use a simplified example: Acme Bank loans Debtor $50,000. Acme then sells the debt to Friendly Corp for $25,000. Acme “lost” $25k on the transaction, and can record it accordingly. But, Debtor now owes Friendly Corp. the $50k, so nothing has been forgiven (and there’s no taxable event). Friendly Corp. “parks” the debt (takes no action to recover), so – in effect – Debtor has had $25k forgiven without incurring the related income tax.
It also sounds like illegal tax avoidance. I suspect the IRS would agree with me, but they may not have ever put it to the legal test. (I tried googling to see if it’s illegal, but it turns out that the term “debt parking” also refers to a collection agency putting a debt on a consumer’s credit report without notifying them, so that’s what all the matches referred to.)
I don’t know if it’s illegal. I suspect it becomes a very factually intensive test regarding intent – whether it actually qualified as debt forgiveness.
Buying and selling debt is common enough and I don’t think there’s any real obligation to actively collect on a debt you hold.
(Relatedly, there are programs in the United States with respect to medical debt where the debt is purchased and the forgiven and that is viewed as a non-taxable gift to the debtor. I assume that’s different because there no connection between the debtor and the entity that forgives the debt).