Unstated Interest and Market Discount in 'Borna v. Commissioner'

A recent Tax Court memorandum decision addresses the entrepreneurial and financial activities of a California realtor and businessman who formed, among other businesses, a venture in China called Zhuo Zhou Borna Plaza Real Estate Development, Ltd. (Zhuo Zhou Development) to profit from the building spree prior to the 2008 Summer Olympic Games in China. Borna v Commissioner, T.C. Memo 2017-73. It is a splendid story involving real estate finance, the exchange of more than 100 third-party notes between Mr. Eddie Borna (the petitioner) and Mr. Nigel Barrow (an investor in Zhuo Zhou Development), the diversion of funds for personal use, apparent mendacity, and some findings about unstated interest and market discount that are something of a mystery. 

Originally, the petitioner conceived of the idea for Zhuo Zhou Development and owned all of the enterprise, but needing additional financial resources he joined forces with Mr. Barrow. Together, they structured a plan under which the petitioner would acquire third-party notes that Mr. Barrow owned (the Barrow notes) in exchange for noninterest bearing notes issued by the petitioner (the Borna notes). The parties intended that Mr. Borna would use future payments on the Barrow notes to fund Zhuo Zhou Development. 

The petitioner ultimately acquired about 100 Barrow notes under an agreement memorialized in 2003. The Barrow notes generally had seven-year terms, provided for monthly payments, and mostly had stated interest rates of 8.9% through 10.9%. Payments on the Barrow notes were to be applied first to any interest due, and then to principal. The petitioner was obligated to pay Mr. Barrow the principal amounts of the Barrow notes two years after the due dates of those notes (i.e., generally during 2015), and was obliged to account for all principal payments made during 2015 on the last day of 2015. Each Borna note was secured by a stated percentage of the petitioner’s interest in Zhuo Zhou Development. In lieu of making the required principal payments to Mr. Barrow during 2015, the petitioner could, at his discretion, assign his interests in Zhuo Zhou Development to Mr. Barrow. 

After examination of the petitioner’s 2004, 2005, and 2006 returns, the IRS asserted deficiencies, and the matter came before the Tax Court as an unreported income case. Most of the factual findings in this proceeding revolve around the IRS’s efforts to ferret out unreported income via a revenue agent’s bank deposits analysis and are unobjectionable, if not commendable. 

That said, the decision also includes several curious, if not inscrutable, assertions about market discount. In particular, the IRS advanced, and the court adopted, market discount calculations that attributed an aggregate of $622,551 of market discount income to Eddie Borna with no meaningful explanation of which specific notes the market discount was attributable to, why it was so attributable, and why the IRS’s numbers were correct. The Tax Court sustained the IRS’s calculations, partly (perhaps mostly) because petitioner’s counsel did not assert error in the proffered calculations. Unfortunately, the reasoning behind the court’s acceptance of the IRS’s proffered calculations is hazy at best, and arguably largely absent.

Prior to addressing market discount, the court correctly observed that the Borna notes lacked stated interest and, for this reason, had unstated interest under §483 and Reg. §1.483-2. However, after making this assertion the court did not carry the ball forward and analyze the implications of §483 for Eddie Borna. Instead, for no apparent reason the §483 trail went cold at this point, and the court suddenly and abruptly jumped to a discussion of market discount income. Why the train jumped off the tracks at this point is both odd and a mystery.

The court referred to a basis rule under which the amount of a promissory note issued to acquire nonpublicly traded property (e.g., each Borna note issued to acquire each Barrow note) is the stated principal amount of the note, reduced by any unstated interest. Because the court found that the Borna notes had unstated interest under §483, the court may have believed that Eddie Borna’s basis in each Barrow note was equal to the corresponding Borna note’s face amount, less unstated interest. If this interpretation of what the court was trying to say is correct, it appears that the court attributed market discount income to Eddie Borna because the face value of the Barrow notes exceeded his basis in those notes. However, the decision is not clear on this point, and the decision also seems to suggest a finding of market discount on the Borna notes

Attributing market discount to the petitioner in regards to the Borna notes would be, at best, very difficult to understand. While it is clear that Eddie Borna issued the Borna notes in exchange for property, and thus acted as a debtor vis-à-vis Nigel Barrow, there is nothing in the record suggesting that Mr. Borna ever purchased or otherwise acquired the Borna notes, and in the absence of some acquisition by Eddie Borna, it is pellucidly clear that no market discount could arise for the him as issuer of the Borna notes. Stated differently, it is very hard to imagine how the petitioner could have accrued market discount income in relation to his own notes under the facts presented. 

If the court meant to attribute market discount to Mr. Borna in regards to his acquisition of the Barrow notes, it would have been good if the court had verbalized some explicit finding to this effect. Unfortunately, the court did not. For example, the court could have stated that the Barrow notes qualified as market discount bonds under §1278(a)(1), that these notes had market discount under §1278(a)(2), and that the rules of §1276 imputed disposition gain representing market discount as ordinary income to Eddie Borna. The decision does not say any of this, and moreover does not provide any discussion of (or even reference to) the market discount rules of §1276 or §1278. Moreover, as noted the decision seems to attribute market discount to Eddie Borna in regards to the Borna notes, which would be abject legal nonsense.

It may also be that the court intended to treat the exchange of the Barrow notes for the Borna notes as an interest-free loan (or series of loans) under §7872. This line of reasoning would lead to a finding of interest income for Nigel Barrow, not for Eddie Borna. That said, under a §7872 approach a hypothetical payment would also be imputed to Eddie Borna, and in theory this hypothetical payment could constitute some sort of income to Mr. Borna under Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), and progeny. That said, neither the IRS nor the Tax Court asserted, or even suggested, a §7872 line of reasoning, and thus this approach to the conundrum that is Borna v. Commissioner is purely speculative.

In brief, the court’s assertions of §483 unstated interest and §1276 market discount income in Borna are incomplete and sketchy, and something of a mystery.