The tax code allows you to claim a deduction for business debts that have become worthless. But qualifying for the deduction may be more complicated than you think.

In a recent case, the IRS denied more than $17 million in bad debt deductions on the grounds that the advances in question represented equity rather than debt, hitting the taxpayer with millions of dollars in taxes and penalties. The U.S. Tax Court, in Allen v. Commissioner, sided with the IRS.

When is the deduction available?

The bad debt deduction is valuable because you can use it to reduce ordinary income. But keep in mind that it’s available only for business bad debts. Nonbusiness bad debts (for example, from personal loans) generate capital losses, which can be used only to offset capital gains plus up to $3,000 in ordinary income.

Generally speaking, a bad debt deduction is available if 1) you hold a bona fide debt, 2) the debt instrument or documentation isn’t a security, and 3) the debt has become worthless — that is, there’s no reasonable expectation of payment. If a debt has become partially worthless, you may be able to deduct the portion of the debt that’s uncollectible, but only if you’ve charged it off for accounting purposes during the tax year.

Debt or equity?

In Allen, the IRS and Tax Court agreed that the taxpayer’s bad debt deduction failed to meet the first requirement listed above. That’s because the worthless “loans” in the case represented equity rather than bona fide debt.

The taxpayer managed a real estate enterprise made up of several companies that he owned or controlled. In the tax years under review, he caused certain entities within his enterprise to advance millions of dollars to various related entities. The taxpayer argued that the advances were intended as bona fide loans. But the IRS determined that his “business purpose was to infuse capital into recipient companies and then redistribute those funds to himself and his related business entities as equity.”

To determine whether the advances were debt or equity, the Tax Court analyzed 13 factors as set forth in a prior case:

  1. Names given to the certificates evidencing indebtedness,
  2. Presence or absence of a fixed maturity date,
  3. Source of principal payments,
  4. Right to enforce payment of principal and interest,
  5. Participation in management,
  6. Status of the contribution in relation to regular corporate creditors,
  7. Intent of the parties,
  8. Thin or adequate capitalization,
  9. Identity of interest between creditor and stockholder,
  10. Source of interest payments,
  11. Ability of the company to obtain loans from outside lending institutions,
  12. Extent to which the advance was used to acquire capital assets, and
  13. Failure of the debtor to repay on the due date or seek a postponement.

No single factor is controlling, and the factors aren’t necessarily weighted equally. Rather, the court considers each factor in the context of the specific facts and circumstances of the case.

Tax Court findings

In this case, the court found that seven of the factors (3, 4, 7, 8, 9, 10 and 11) favored equity, three (1, 2, and 5) favored debt and three (6, 12 and 13) were neutral. The court acknowledged that the purported loans were evidenced by promissory notes that identified fixed maturity dates, and that the taxpayer’s participation in management didn’t increase by virtue of the advances.

But several factors supported the conclusion that the advances were, in substance, equity infusions:

  • Repayment of the advances was dependent on the recipients’ sales.
  • Although the taxpayer had a contractual right to enforce payment, the recipients had no ability to repay the debts. So, in substance, there was no right to enforce payment.
  • There was no real expectation of payment, evidenced by a complete lack of interest payments and the fact that the taxpayer continued to make advances even after claiming bad debt deductions.
  • The recipients were thinly capitalized when they received the advances.
  • The interests of the purported lenders and borrowers were “significantly intertwined.”
  • The lack of interest payments indicated that the purported lenders were “not expecting substantial interest income and, instead, [were] more interested in future earnings.”
  • The recipients weren’t creditworthy at the time the advances were made and would have had trouble obtaining loans from outside lenders.

The Allen case is instructive for taxpayers hoping to ensure that advances (particularly to related parties) are treated as debt rather than equity. Executing appropriate loan documentation is important, but it’s not enough. It’s also critical that the borrower is creditworthy and sufficiently well capitalized to support a realistic expectation of repayment, and that the parties treat the transaction like a loan.

Want to avoid penalties? Show good faith

In Allen v. Commissioner (see main article), the U.S. Tax Court upheld the IRS’s imposition of significant underpayment penalties: 20% of the amount by which taxes were underpaid. Taxpayers can avoid these penalties by showing that they acted with reasonable cause and in good faith.

In determining the existence of reasonable cause and good faith, courts look at a taxpayer’s experience, education and sophistication, among other factors. They also place significant emphasis on the taxpayer’s efforts to assess the proper tax liability, including reasonable, good-faith reliance on professional advice. In Allen, there was no evidence that the taxpayer sought professional advice when he determined that the “loans” were worthless or took any other steps to assess the proper tax liability.

© 2024

Source: Allen v. Commissioner (T.C. Memo 2023-86).

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