Understanding the Risks of Transfer-Of-Title Stock Loans: IRS Rules Nonrecourse Stock Loans As Sales

Definition of Transfer-of-Title Nonrecourse Securities Loans. A nonrecourse, transfer-of-title securities-based loan (ToT) means exactly what it says: You, the title holder (owner) of your stocks or other securities are required to transfer complete ownership of your securities to a third party before you receive your loan proceeds. The loan is “nonrecourse” so that you may, in theory, simply walk away from your loan repayment obligations and owe nothing more if you default.

Sounds good no doubt. Maybe too good. And it is: A nonrecourse, transfer-of-title securities loan requires that the securities’ title be transferred to the lender in advance because in virtually every case they must sell some or all of the securities in order to obtain the cash needed to fund your loan. They do so because they have insufficient independent financial resources of their own. Without selling your shares pracitcally the minute they arrive, the could not stay in business.

History and background. The truth is that for many years these “ToT” loans occupied a gray area as far as the IRS was concerned. Many CPAs and attorneys have criticized the IRS for this lapse, when it was very simple and possible to classify such loans as sales early on. In fact, they didn’t do so until many brokers and lenders had established businesses that centered on this structure. Many borrowers understandably assumed that these loans therefore were non-taxable.

That doesn’t mean the lenders were without fault. One company, Derivium, touted their loans openly as free of capital gains and other taxes until their collapse in 2004. All nonrecourse loan programs were provided with insufficient capital resources.

When the recession hit in 2008, the nonrecourse lending industry was hit just like every other sector of the economy but certain stocks soared — for example, energy stocks — as fears of disturbances in Iraq and Iran took hold at the pump. For nonrecourse lenders with clients who used oil stocks, this was a nightmare. Suddenly clients sought to repay their loans and regain their now much-more-valuable stocks. The resource-poor nonrecourse lenders found that they now had to go back into the market to buy back enough stocks to return them to their clients following repayment, but the amount of repayment cash received was far too little to buy enough of the now-higher-priced stocks. In some cases stocks were as much as 3-5 times the original price, creating huge shortfalls. Lenders delayed return. Clients balked or threatened legal action. In such a vulnerable position, lenders who had more than one such situation found themselves unable to continue; even those with only one “in the money” stock loan found themselves unable to stay afloat.

The SEC and the IRS soon moved in. The IRS, despite having not established any clear legal policy or ruling on nonrecourse stock loans, notified the borrowers that they considered any such “loan” offered at 90% LTV to be taxable not just in default, but at loan inception, for capital gains, since the lenders were selling the stocks to fund the loans immediately. The IRS received the names and contact information from the lenders as part of their settlements with the lenders, then compelled the borrowers to refile their taxes if the borrowers did not declare the loans as sales originally — in other words, exactly as if they had simply placed a sell order. Penalties and accrued interest from the date of loan closing date meant that some clients had significant new tax liabilities.

Still, there was no final, official tax court ruling or tax policy ruling by the IRS on the tax status of transfer-of-title stock loan style securities finance.

But in July of 2010 that all changed: A federal tax court finally ended any doubt over the matter and said that loans in which the client must transfer title and where the lender sells shares are outright sales of securities for tax purposes, and taxable the moment the title transfers to the lender on the assumption that a full sale will occur the moment such transfer takes place.

Some analysts have referred to this ruling as marking the “end of the nonrecourse stock loan” and as of November, 2011, that would appear to be the case. From several such lending and brokering operations to almost none today, the bottom has literally dropped out of the nonrecourse ToT stock loan market. Today, any securities owner seeking to obtain such a loan is in effect almost certainly engaging in a taxable sale activity in the eyes of the Internal Revenue Service and tax penalties are certain if capital gains taxes would have otherwise been due had a conventional sale occurred. Any attempt to declare a transfer-of-title stock loan as a true loan is no longer possible.

That’s because the U.S. Internal Revenue Service today has targeted these “walk-away” loan programs. It now considers all of these types of transfer-of-title, nonrecourse stock loan arrangements, regardless of loan-to-value, to be fully taxable sales at loan inception and nothing else and, moreover, are stepping up enforcement action against them by dismantling and penalizing each nonrecourse ToT lending firm and the brokers who refer clients to them, one by one.

A wise securities owner contemplating financing against his/her securities will remember that regardless of what a nonrecourse lender may say, the key issue is the transfer of the title of the securities into the lender’s complete authority, ownership, and control, followed by the sale of those securities that follows. Those are the two elements that run afoul of the law in today’s financial world. Rather than walking into one of these loan structures unquestioning, intelligent borrowers are advised to avoid any form of securities finance where title is lost and the lender is an unlicensed, unregulated party with no audited public financial statements to provide a clear indication of the lender’s fiscal health to prospective clients.

End of the “walkway.” Nonrecourse stock loans were built on the concept that most borrowers would walk away from their loan obligation if the cost of repayment did not make it economically worthwhile to avoid default. Defaulting and owing nothing was attractive to clients as well, as they saw this as a win-win. Removing the tax benefit unequivocally has ended the value of the nonrecourse provision, and thereby killed the program altogether.

Still confused? Don’t be. Here’s the nonrecourse stock loan process, recapped:

Your stocks are transferred to the (usually unlicensed) nonrecourse stock loan lender; the lender then immediately sells some or all of them (with your permission via the loan contract where you give him the right to “hypothecate, sell, or sell short”).

The ToT lender then sends back a portion to you, the borrower, as your “loan” at specific interest rates. You as borrower pay the interest and cannot pay back part of the principal – after all, the lender seeks to encourage you to walk away so he will not be at risk of having to go back into the market to buy back shares to return to you at loan maturity. So if the loan defaults and the lender is relieved of any further obligation to return your shares, he can lock in his profit – usually the difference between the loan cash he gave to you and the money he received from the sale of the securities.

At this point, most lender’s breathe a sigh of relief, since there is no longer any threat of having those shares rise in value. (In fact, ironically, when a lender has to go into the market to purchase a large quantity of shares to return to the client, his activity can actually send the market a “buy” signal that forces the price to head upwards – making his purchases even more expensive!) It’s not a scenario the lender seeks. When the client exercises the nonrecourse “walkaway” provision, his lending business can continue.

Dependence on misleading brokers: The ToT lender prefers to have broker-agents in the field bringing in new clients as a buffer should problems arise, so he offers relatively high referral fees to them. He can afford to do so, since he has received from 20-25% of the sale value of the client’s securities as his own. This results in attractive referral fees, sometimes as high as 5% or more, to brokers in the field, which fuels the lender’s business.

Once attracted to the ToT program, the ToT lender then only has to sell the broker on the security of their program. The most unscrupulous of these “lenders” provide false supporting documentation, misleading statements, false representations of financial resources, fake testimonials, and/or untrue statements to their brokers about safety, hedging, or other security measures – anything to keep brokers in the dark referring new clients. Non-disclosure of facts germane to the accurate representation of the loan program are in the lender’s direct interest, since a steady stream of new clients is fundamental to the continuation of the business.

By manipulating their brokers away from questioning their ToT model and onto selling the loan program openly to their trusting clients, they avoid direct contact with clients until they are already to close the loans. (For example, some of the ToTs get Better Business Bureau tags showing “A+” ratings knowing that prospective borrowers will be unaware that the Better Business Bureau is often notoriously lax and an easy rating to obtain simply by paying a $500/yr fee. Those borrowers will also be unaware of the extreme difficulty of lodging a complaint with the BBB, in which the complainant must publicly identify and verify themselves first.

In so doing, the ToT lenders have created a buffer that allows them to blame the brokers they misled if there should be any problems with any client and with the collapse of the nonrecourse stock loan business in 2009, many brokers — as the public face of loan programs – unfairly took the brunt of criticism. Many well-meaning and perfectly honest individuals and companies with marketing organizations, mortgage companies, financial advisory firms etc. were dragged down and accused of insufficient due diligence when they were actually victimized by lenders intent on revealing on those facts most likely to continue to bring in new client borrowers.

SBA Loans and the New Small Business Bill

Near the end of September 2010, President Barack Obama signed a Small Business Bill into effect. The new bill set aside $30 billion for small business lending. The law also includes $12 billion in tax breaks for small companies. This bill was signed into effect as a response to the 9.6 unemployment dissent in America. President Obama and the administration signed the bill to demonstrate an effort to decrease the unemployment levels in the United States. President Obama hopes that the loan will create as many as 500,000 new jobs within the next couple of years.

Small Business Jobs Act 2010 Changes

The Small Business Jobs Act includes the Recovery Act Loans Extension that provides $14 billion in lending support. Small Business Administration (SBA) Recovery loans will be extended under the law with a 90% guarantee and reduced fees. At the time that the bill was signed, 1,400 small businesses were waiting for funding. Since the signing of the Recovery Act, 70,000 Recovery loans have been supported. Over $680 million dollars have created $30 billion in lending support.

The bill supports higher loan limits, and the maximum loan sizes increased in the pre-established loan programs. The new bill also increases the 7(a) and 504 loan limits from $2 million to $5 million. Manufacturers may receive up to $5.5 million. The 7(a) loan program is one of the most flexible loan programs offered for start ups and existing small businesses. Most of these loans are gained through commercial lending institutions. The 7(a) loan program includes an Export Loan program and a Rural Lender Advantage program. Some businesses will be able to refinance and incorporate their commercial real estate mortgages into the 504 loan program. However, this only applies to owner occupied units.

Microloan limits increased from $35,000 to $50,000. These loans are designed to help entrepreneurs with large start-up companies and small businesses owners in underserved communities. The new bill also increases small business eligibility for SBA loans. They make this possible by increasing the “alternate size standard” to small businesses with less than $15 million in net worth. This also applies to those businesses with less than $5 million in average net income. The law also increases the amount of Small Business Administration (SBA) Express loans from $350,000 to $1 million. Working Capital and Commercial Real Estate Refinancing received temporary enhancements to assist small business owners.

Tax Cuts

The tax cuts include the following:

- More Deductions for Start Ups
- Deductions for Cell Phones provided by the Employer
- Self Employed Health Insurance Deductions
- Penalty limitations for small business tax reporting errors
- Accelerated or Bonus Depreciation
- Provisions for up to Five Years of Net Operating Losses
- Up to $500,000 for Small Business Expenses: The Highest Expense Ever

Fees Associated with the SBA Loans

Fees are assessed to offset the costs of the SBA loan to the taxpayer. Lenders are charged a guaranty fee and servicing fee for each approved loan loan. The fees are a percentage of the amount loaned to the borrower. The lender may charge the guaranty fee upfront. However, the borrower is not responsible for the lender’s annual fee.

ARC Loans

ARC Loans are small business loans that do not carry any associated fees. In the past, the fees for loans were between 1% and 3.5% of the total cost of the loan. ARC loans offer 100% guaranty from the SBA to the lender. No fees are required to be paid to SBA. Many of these loans are provided over a six month period. The repayment of the principal of the loan may be deferred for 12 months after the final disbursement of the loan. Repayment may last as long as five years. The best candidates for this type of loan are companies that have been profitable in the past, but are currently struggling. These companies may have begun to miss payments recently because of financial hardship. These funds may be used to make payroll, buy inventory or improve core operations.

7(a) Loans

Lenders will be charged an annual fee of 0.55 percent of the guaranteed portion of 7(a) loan. The fee will only be assessed to the balance of the loan and not the entire loan amount.

504 Loans

Borrowers will pay an annual fee of 0.749 percent on the outstanding balance of the 504 loan. This amount increased from 0.389 percent. Loan interest rates may not exceed 4.75% and may be as little as 2.25% when negotiated through a bank.

How Long is the SBA Loan Process?

Since the Small Business Administration is a guarantor and not a lender, the amount of time required to approve the loan will vary. The Small Business Administration attempts to reach its decision within seven to 21 business days from the receipt of the application. To accelerate the process, applicants should have several components of their application in place.

The length of time it takes for the SBA to respond to the application depends on the loan program your business elects to apply to. A business plan with financial statements is required for all loan programs. Earnings projections and collateral offerings must be established. In general, the SBA microloan is the least time consuming application and will be approved the fastest. The maximum loan amount was increased to $50,000. The funds cannot be used to buy property or pay debt.

Top Five SBA Loan Lenders

The banks have sorted SBA lending by region. Some of the most prominent banks involved in lending are the following:

Wells Fargo Bank

Wells Fargo managed a No. 1 ranking between October 1, 2009 and September 30, 2010 for the Small Business Administration 7(a) loan. The bank issued 91 SBA loans with a total value of $31.9 million. The bank was the second leader in terms of ARC loans. The bank issued 23 loans for a combined value $710,100.

JPMorgan Chase Bank

Chase Bank issued 33 ARC loans with a total value of $935,100. They ranked No. 1 in this category of loans issued.

Mortgage Capital Development Corporation

This particular bank issued the most 504 SBA loans. Businesses may use these loans for real estate purchases, property constructions and upgrades.

TMC Development

This bank issued 71 SBA loans for a combined value of $54.1 million. Nearly, 56 of these loans were 504 loans. The loans had a total combined value of $48.9 million.

Capital Access Group

Capital Access Group issued 51, 504 loans for combined value of $37 million.

Rates of Top Five SBA Loan Lenders

Wells Fargo

Typically, 3.5% of the SBA amount is due at the time of the loan. However, the fee may be financed. An origination fee may include bank fees. A fixed or variable interest rate will be negotiated by the bank for the Wells Fargo portion of the loan.

Chase Bank

A guaranty fee of 1% to 3.5% of the guaranteed amount must be paid by the lenders. The lender must also pay the annual fees of 0.25%. The lender may pass the guaranty fees onto the lender, but not the annual fees.

Mortgage Capital Development Corporation

This bank charges 0.389% of the balance of the loan for fees.

TMC Development

Most 504 loan programs will pay up to 90%. Therefore, most borrowers only have to make a 10% down payment. This bank offers a 4.39% interest rate to those seeking a loan. The fees are typically 1% or less.

The E-Z Guide To Student Loans (Stafford Loans)

Student Loans are a bit overwhelming at first. Especially when you’ve just graduated high school and you have so much other stuff on your plate.

I remember when I graduated high school, the only thing I wanted to know was “What will it take for me to get a college degree”. Whatever it was, I was prepared to do it. So I applied for financial assistance using FAFSA (the letters stand for Free Application for Federal Assistance in case you were wondering). Then once I actually got to college, I was ushered into a room and made to sign all this paperwork with the underlining idea being: Unless you’re going to pay your tuition cash or through some scholarship fund, you need to sign these student loan documents. I ended up signing and practically forgot about my student loans until I graduated. Then I got the bill…. OH BOY!

I believe everyone should know something about student loans before signing your life away… I mean the loan documents. Not to say that student loans are BAD per say, just that an informed person is more prepared to deal with something than someone who doesn’t know their hands from their feet.

So let’s get into it!

What kind of Student Loans are there?

The first one we’ll discuss is: The Direct Stafford Loan

The money being borrowed from this loan comes directly from your good ol’ Uncle Sam. Yes, Uncle Sam cares about you too! Direct Stafford Loans are “low-interest loans for eligible students to help cover the cost of higher education at a four-year college or university, community college, or trade, career, or technical school.” I’m sure you’re asking what the requirement is to receive the Direct Stafford Loan and as with all complicated questions, the answer is, IT DEPENDS.

There’s two types of Stafford Student Loans

There’s the Subsidized Stafford Loan and then there’s the Unsubsidized Stafford Loan.

With the Subsidized Stafford Loan, you are not charged interest as long as you’re enrolled into school at least half-time and during grace periods and deferment periods. The Federal Government actually pays the interest for you while you’re still in school. So the loan value is actually the same amount you really borrowed. Sounds great right? Well there’s a catch. The catch is that this loan is dependent on the financial needs of the student. This loan isn’t available to everyone, its availability actually dependent on what tax bracket you and your parents fall into. Another catch is that your school actually determines how much you can barrow.

The second type of Stafford Loan is Unsubsidized Stafford Loan. This type of loan is geared toward those who are qualified for Subsidized Stafford Loans, but need a little more money to pay their tuition as well as those that aren’t qualified for Subsidized Stafford Loans but still need money to pay their tuition. Just about every household is eligible for Unsubsidized Stafford Loans.

How is that possible? Well for Unsubsidized Stafford Loans interest begins accumulating from the first time money is paid out. So the very first semester that your Unsubsidized Stafford Loan is applied to is also the beginning of interest accumulation on your loan. What that also means is the longer you decide to stay in college, the more interest will accumulate on your loan.

What a great way to motivate you to complete your degree in 4 years right? Well, not really, but it’s definitely worth keeping in mind. However, as a word of advice, you should try paying at least your accumulated interest while your still in school to avoid blowing up your loan even further. By doing so, you could get the same benefit that Subsidized Stafford Loans give by only being responsible for the amount of your loan by the time you graduate. If you decide not to pay anything towards your loan while still in school, you’ll end up with a hefty bill by the time you graduate since your accumulated interest ends up accumulating its own interest as well.

Another important point about Unsubsidized Stafford Loans is that, like Subsidized Stafford Loans, your school decides on the amount you receive. The Unsubsidized Stafford Loan isn’t quite the blank check you wished for, but it does help take care of those semesters at more expensive schools.

How much money can you barrow with the Stafford Student Loan?

Well as I mentioned above, ultimately your school decides that, but they also have to work within the limits set by the loan. The maximum amounts your school could allow you to barrow are listed below:

Dependent Undergraduate Student (except students whose parents are unable to obtain PLUS Loans)

First Year: $5,500- No more than $3,500 of this amount may be in subsidized loans.

Second Year: $6,500- No more than $4,500 of this amount may be in subsidized loans.

Third Year: $7,500- No more than $5,500 of this amount may be in subsidized loans.

Maximum Total Debt from Stafford Loans When You Graduate* (aggregate loan limits): $31,000-No more than $23,000 of this amount may be in subsidized loans.

Independent Undergraduate Student (and dependent students whose parents are unable to obtain PLUS Loans)

First Year: $9,500-No more than $3,500 of this amount may be in subsidized loans.

Second Year: $10,500-No more than $4,500 of this amount may be in subsidized loans.

Third Year: $12,500-No more than $5,500 of this amount may be in subsidized loans.

Maximum Total Debt from Stafford Loans When You Graduate* (aggregate loan limits): $57,500-No more than $23,000 of this amount may be in subsidized loans.

Graduate and Professional Degree Student

First, Second, and Third Years: $20,500-No more than $8,500 of this amount may be in subsidized loans.

Maximum Total Debt from Stafford Loans When You Graduate* (aggregate loan limits): $138,500-No more than $65,500 of this amount may be in subsidized loans. The graduate debt limit includes Stafford Loans received for undergraduate study.

* You can spend more than 4 years in college but the maximum total amount you barrow from the Stafford Loan cannot exceed the limit above.