It appears Trump gave his creditors shares of his failing businesses to avoid taxes on hundreds of millions of dollars they granted him in debt relief, a practice that has since been explicitly outlawed, the Times explained.
In short, “He made it up,” said legal scholar Edward Kleinbard of the University of Southern California.
Some had missed Trump's maneuver, Kleinbard said, because they did not think that it would have been allowed at the time.
“The reason nobody thought of it is that nobody thought that it existed,” Kleinbard said. “The real surprise here is that he apparently got away with it.”
Trump declined to comment for the Times's story.
In a letter published by the Times, lawyers warned the New York businessman that his strategy would be legally risky. He was audited by the Internal Revenue Service, which has not commented on the result of its investigation.
The details of Trump's reported maneuver are somewhat complicated, but the essential idea is fairly straightforward. The documents reviewed by the Times suggest Trump worked around a couple of basic principles of U.S. taxation.
The maneuver began when Trump's businesses borrowed money from banks to purchase the Plaza Hotel in New York and his casinos in Atlantic City. Neither Trump nor his businesses owed taxes on the cash infusion because the tax code doesn't consider debt to be taxable income.
For instance, when someone takes out a mortgage, the money is not counted as income, even though the bank has just given the borrower hundreds of thousands of dollars. Mortgages do not actually make borrowers better off, because the borrowers are expected to return the money eventually.
“We don’t tax proceeds on borrowing, because you’ve also assumed a liability,” said Steven M. Rosenthal, an attorney at the Tax Policy Center. “Your net position hasn’t changed.”
If the bank forgives the loan, however, then the amount that is forgiven does count as income under federal law. A canceled debt is equivalent to a gift from the bank, and it is subject to income taxes.
That is what happened to Trump. When the casino and hotel investments failed catastrophically, Trump's businesses declared bankruptcy, and his creditors were forced to forgive much of the debt.
“He borrowed other people's money and spent it in spectacular fashion,” Rosenthal said.
From the point of view of Trump's income, it all came out in the wash. He had lost a lot of money, but he had also persuaded the banks to write down what he owed them — a gift that largely wiped out his losses.
Trump then claimed on tax returns that he had lost the money, but he did not acknowledge the income in the form of canceled debts. He likely did not have to pay taxes on that money — which totaled at least $425 million, Rosenthal estimates based on his review of the documents obtained by the Times.
To avoid taxes on the income from his canceled debts, Trump used what experts described as a dubious legal argument, according to the account provided by the Times.
First, in exchange for writing down his debts, he gave the creditors shares of the partnerships through which he controlled the failing hotel and casinos. Then he essentially argued that the lenders had not done him a favor at all, because they had simply exchanged one asset for another.
The asset the banks gave up was real money Trump owed them. What they got, on the other hand, were shares in failing properties. Trump claimed that he and his borrowers were square.
Kleinbard and his colleagues developed an early version of the maneuver, sometimes called a “stock-for-debt swap,” more than three decades ago when he worked for Salomon Brothers. He recalled using it to engineer roughly 75 deals for the firm's corporate clients in about a year-and-a half. Business was good until 1984, when Congress mostly shut down the practice. It was, Kleinbard admitted, clearly an abuse of the system.
Trump also would have been able to count his substantial losses against any future income, as well, Rosenthal said, possibly sparing him from the need to pay federal income tax again for years. Under the tax code, taxpayers can count their losses against future income because they aren't really better off until they're back in the black. By swapping stock for debt, Trump would have been able to claim he was still in the red.
The documents obtained by the Times that Rosenthal reviewed list at least $425 million in forgiven debts. Trump did not acknowledge that these cancellations effectively wiped out about half of his $916 million loss, Rosenthal said. As for the rest of that red ink, Trump might have used a similar maneuver with regard to loans that were not listed in the documents, or he might have used some other legal strategy to claim that he really was still in the hole.
In a recent debate with Democratic presidential nominee Hillary Clinton, the Republican candidate was asked about whether he pays federal income tax.
"Did you use that $916 million loss to avoid paying personal federal income taxes for years?" moderator Anderson Cooper asked him.
"Of course I do," Trump replied. "Of course I do, and so do all of her donors, or most of her donors."
Kleinbard said that he would have enjoyed bringing Trump to court on behalf of the authorities in order to force him to pay up. “I would have been certain that I would have won,” Kleinbard said.
Lawyers for Willkie Farr & Gallagher, the firm Trump retained to provide an opinion on the strategy, wrote that if the authorities took Trump to court, his odds of winning would be no better than a coin flip.
“We are unable to provide legal assurance that the probabilities are more likely than not that such positions will be upheld if litigated,” they wrote, according to the letter published by the Times.