The use of the reverse Morris Trust to avoid paying taxes is apparently quite legal but, in my view, not a loophole that the tax law needs to support. Like most loopholes, it benefits very few with no discernable social value.

However, in this case I don’t think there would’ve been a taxable gain. I suspect that what the use of the reverse Morris Trust did for Verizon is avoid the necessity of taking a write-down. If the assets in the Northern New England States were sold for cash, it’s doubtful whether they would have bought the nominal price Verizon achieved with the sale. I’ve heard plenty of stories (although from sources who don’t want to be identified) of Verizon not being interested in a more straight forward sale.

By leaving the FairPoint stock in the hands of Verizon holders rather than keeping it in Verizon, Verizon is insulated from future write-offs of the value of these assets. Their only remaining exposure, should the deal be approved, is whatever FairPoint debt they end up holding.

However, the comparison to the sub-prime market/ Enron is unfair. If anything, the Morris Trust maneuver is the opposite of what they did (and, I’m sure, plenty of others are still doing).

The objective of the Enron limited partnerships, and the sub-prime securitizations used by New Century et al., are to create the form of an asset sale while avoiding the substance. The Morris Trust transaction creates the substance of a sale while maintaining the form, for tax purposes of a spin-off.

To explain: Sub-prime lenders would sell the loans to third parties, while retaining responsibility for collecting and maintaining an obligation to cover bad debt. They then reported gains on the sale based on “expected” defaults over the life of the loans. (When defaults go up, massive losses come due that the company is not prepared for.) Enron pretended to sell assets to third parties that were actually partnerships controlled by Enron’s CFO. Again, this was done to create the appearance of a profit even though the company was often still on the hook for any losses incurred or, in a few case, to buy back the assets at a guaranteed price.

The common element is that both strategies create income (which, I believe is generally taxable) even though the company retains an economic risk in the assets.

The Morris Trust enables the company to sell the assets in substance, while creating the form of a spin-off, and therefore avoiding triggering taxable gains for either the company or its shareholders. For Verizon, the assets sold to Fairpoint are gone. It has no economic interest in them going forward, and debt holders have no recourse to Verizon should Fairpoint default. Economically, it is a real disposition of the assets, no different than if Fairpoint had borrowed $1.7B itself. paid the cash and some shares to Verizon for the assets, and then Verizon used the cash to reduce its own debt.

This appears complicated because the tax rules require complication to meet the form required to avoid triggering capital gains. The substance is fairly straightforward.