BART’s Tax Shelters

Remember when BART helped a few giant multi-national corporations establish lucrative tax shelters?

You probably don’t. It hasn’t been written about much in the press. The type of deal BART agreed to has gotten some attention, but even so, most people are unfamiliar with the scheme and how it works. BART’s tax shelter deals almost cost the transit agency $40 million in 2009 when the financial sector was melting down. One of the agreements withered and BART lost $5.5 million. Few people know this.

So what sketchy tax shelters am I talking about? They’re called lease-in, lease-out, or LILO agreements. BART calls them lease, leaseback agreements in their financial reports.

In a LILO deal a public transit agency like BART leases its trains or train operating equipment to a private corporation for some extended period of time. The corporation immediately turns around and leases the property back to BART. The terms of the lease are incredibly complicated and circuitous. I wont go into details here. It’s the kind of creative accounting and contract law that vast financial disasters are made from, and it’s mind-numbing in detail.

Why would BART ever do this you ask?

The most immediate answer is because it provided up front cash payments to BART which the agency then capitalized over a period of future years. This had the effect of easing BART’s budgetary strains, and providing BART with more borrowing capacity. It was the closest thing to free money the agency had ever been offered besides its cut of the regional sales tax, and it could be gotten without political pain, without appealing to voters for a bigger trim of retail sales. And BART wouldn’t need to confront the big real estate corporations in San Francisco and Oakland that have benefitted so much from the system. Million of dollars could be generated out of a shuffle of paperwork and a fictitious transfer of capital through a circular lease agreement.

Of course there’s no such thing as free money. The money that BART obtained from the deals was cut from the profits that BART’s private financial partners were making through the LILO agreements. These profits came not out of any productive investment activities or new efficiencies, for the LILO deal didn’t meaningfully transfer or redeploy ownership of BART’s assets, nor did it redeploy the lease payments into any other economic activity. Rather, the profits were harvested from federal tax deductions claimed by the private corporations leasing and then subleasing BART’s trains and equipment. It was, in the words of Senator Charles Grassley, “a good old fashioned tax fraud.”

Of course BART would never characterize it that way. Nor will the financial corporations that have been the instigators of these deals.

It all began in the 1970s when some clever bankers and lawyers devised a tax sham that essentially transfers an unclaimed tax deduction from a public, non-profit agency to a private corporation. The public agency cannot claim the deduction because it doesn’t pay federal income tax. It has no taxable income to offset with a deduction. But once the capital assets and debt are transfered to a private party with large taxable earnings then the possibility of a massive tax cut becomes realizable.

Here’s how it works: the private corporation takes out loans from banks or hedge funds and either purchases or leases the assets of a public agency. The public agency turns right around and leases the assets back. The lease and the sublease are more or less designed to cancel one another out over the term of the agreement so that neither party actually profits off the other. The private corporation claims a tax deduction on the debt it incurs when borrowing funds to buy or lease the public agency’s assets. In addition, the corporation can claim depreciation deductions as the value of the assets decline.

1. Transit system and investors agree to lease and sublease. 2A. Transit system places portion of investor’s “head lease” with a Payment Undertaker who will pay out the transit system’s lease obligations. 2B. Transit system uses left over cash for whatever purposes it wants. This is the “free” money that LILOs generate for public agencies. 4. Private investors obtain tax breaks on debt and/or depreciation of the assets they virtually own. 5A and 5B. When the lease’s terms are up and the lease and sublease payments net out, the deal expires and the assets return to the transit agency.

These deductions are the central purpose of the LILO deal and they allow big banks to reduce their federal tax burdens by billions of dollars each year. For helping the private corporations and banks profit off of these tax loopholes the public agency gets a small cut in the form of cold hard cash. It’s all essentially a transfer from federal taxpayers to private corporations with a small portion flowing to local public agencies that facilitate the deals.

It’s hard to blame transit agencies for setting up these tax shelters after decades of tax cuts in federal and state assistance. Faced with declining real revenues relative to their needs transit agencies across the US have entered into LILO deals. In the Bay Area the list of transit agencies that have completed LILO deals includes AC Transit, MUNI, SAMTRANS, Santa Clara Valley Transportation Authority, and San Jose’s RTA. The Bay Area region’s transit agencies have allowed giant corporations and banks to claimed billions in tax deductions over the last two decades.

BART has done multiple sale-in, lease-out, and lease-in, lease out deals. In 1995 BART sold 25 of its train cars to a Swedish subsidiary of General Electric called GE Credit Finans AB for the price of $50.38 million. This was a sale-in, lease-out (SILO) deal, a predecessor to the LILO tax shelter strategy that is similar in form and substance in that there’s not economic rationale to it besides dodging taxes. In the 2002 deal BART immediately leased the cars back from GE at a price of $48.36 million. The $2 million difference in what GE paid and what BART paid was cash in BART’s pocket. That deal appears to have worked out more or less as it was planned. BART gained $2 million and GE gained some lucrative tax break by deducting a portion of the $50.38 million from its tax bill, either as debt used to finance the initial purchase, or perhaps by depreciating the assets until the deal expired in 2011. Federal taxpayers had to make up for whatever GE didn’t pay over these years by cutting programs, or going further into debt. Deals like these are part of the bigger web of tax shams that allows GE to basically not pay federal taxes anymore.

It was BART’s 2002 LILO deal that blew up in the agency’s face. That year BART leased its rail traffic control equipment to private investors under a 40-year agreement valued at $206 million. BART was to be paid $23 million for setting up the tax shelter for several corporations. The 2002 LILO deal was especially complicated. BART agreed to deposit most of the lease payment made to it by the private investors with a “payment undertaker,” a third pary who would invest the funds and pay BART’s sublease to the investors until 2018. If, however, the payment undertaker’s credit rating dropped below a certain level the private investors would have the right to cancel the sublease and demand huge termination penalties from BART.

What could go wrong?

In 2008 credit markets froze and the financial system crashed. Credit downgrades struck most banks, insurance companies, and corporations. BART’s payment undertaker AIG was downgraded and BART faced a possible $20 million termination fee unless it could replace AIG with a AAA-rated party. That might have proven possible a year prior, but few financial companies were retaining the vaunted AAA grade. What’s more is that the banks and corporations on the other side of BART’s LILO deal wanted to force BART to pay the termination fees so they could call the deal quits and book a big profit.

Why did they want to close out the otherwise lucrative tax loopholes? Because the IRS was catching up to them. SILO, LILO and similar deals have been the target of IRS investigations since they originated. The IRS considers most of them mere shams and has attempted to outright ban them on several occasions. Fearing that the taxman was closing in, the firms on the other side of the LILO deals with dozens of major transit agencies nationwide sought to force the public to pay the big termination fees. The fees would be straight up profits, taxed yes, but not subject to the possible clawback sought by the IRS.

To counter this threat transit agencies like BART banded together and got legislation introduced in the U.S. House and Senate that would have taxed any termination fees at 100 percent. Other lobbying maneuvers made the termination demands of the banks very unpopular, and most transit agencies were able to successfully renegotiate the deals.

In September of 2009 BART ended up terminating a portion of the 2002 LILO deal with a company called Key Equipment Finance, Inc. Wrapping up this part of the 2002 LILO agreement cost BART $5.5 million. The agency was able to salvage the rest of the deal, it appears, saving local taxpayers millions more. But saving the deal meant that federal taxpayers are still being stiffed out of millions in income taxes offset by the deductions claimed on the private end of the LILO deal.

And yes, BART workers might strike beginning at 12:00am, Monday. The workers have been characterized as “greedy,” and “paid too much” by the major newspapers and TV networks. Meanwhile the tax shelters that earned wealthy investors millions over the last two decades by using BART, and putting BART at great risk, have gone mostly unanalyzed.