The Tax Court held that a taxpayer who made high-interest loans to friends and acquaintances was not entitled to any bad debt deduction in 2008 for a loan that arguably went belly up in 2008, because he did not prove that it was a business loan or that the loan was wholly worthless in that year.
Fred Cooper was a full-time employee of USANA Health Sciences Inc. (USANA), serving as the company's president. He owned an eclectic mix of business interests, including rental properties, a car wash, a search engine optimization company, a pheasant farm, and a drug manufacturing company. In addition, Cooper over the years sporadically made loans to friends and acquaintances referred to him by two of his friends. He lent money on a short-term basis and charged high interest rates (up to a 40% annualized rate).
Cooper made 12 loans to 11 borrowers from 2005 to 2010, but he had promissory notes for only five of those loans. Cooper knew five of the borrowers before making the loans, and his friends introduced the other six borrowers to him. Cooper did almost none of the due diligence that would be customary in a lending business and did not conduct credit checks, verify collateral, or collect information through any loan applications before extending the funds. Cooper claimed that he made loans to individuals based on their character and whether he thought they had the ability and the willingness to pay him back.
Cooper also kept virtually no contemporaneous records of his loan activities. Despite his lack of due diligence and recordkeeping, he asserted that he devoted between 150 and 200 hours in 2006 to his lending activities and between 120 and 150 hours each year from 2007 forward.
One of the 12 loans was to Richard Wolper, who was the president of Wolper Construction, which performed infrastructure, sewer, water, road, and pipeline construction. Cooper made the loan to Wolper in 2005, and Wolper repaid the loan with interest in six months.
In March 2006, Cooper made a loan to Wolper Construction, which, according to the promissory note for the loan, was for $750,000 and came due in six months. The promissory note included a collateral guaranty in the form of a deed of trust on real property owned by Wolper Construction; however, no lien was recorded, and Wolper testified at trial that he did not believe any deed of trust was ever created. In October 2006, Cooper extended the loan for an additional six months, and Cooper and Wolper signed a successor promissory note for $925,000, which reflected the unpaid principal of $750,000 plus the interest due.
When the second loan came due, Wolper Construction did not pay. In June 2008, with the loan still unpaid, Wolper Construction filed for bankruptcy. Cooper did not file a claim for the loan with the Bankruptcy Court, and twice in the first half of 2009 he represented to third parties in personal net-worth statements that the loan had a value in excess of $1 million. However, the Wolper Construction bankruptcy proceedings closed in August 2013 with Cooper receiving nothing for the loan.
Cooper did not report the loan as a bad debt in the amount of $750,000 on his original return but included it as a business bad debt deduction in an amended return he filed in 2010. Cooper's accountant claimed that Wolper Construction had been sent a Form 1099-C, Cancellation of Debt, for the loan, but the accountant had no proof of mailing, and the IRS had no record of receiving the form.
The IRS refused to process the amended return and opened an audit of Cooper's 2008 and 2009 returns. As a result of the audit, the IRS issued a notice of deficiency in which it did not allow the bad debt deduction. Cooper petitioned the Tax Court, alleging that the IRS had erred in disallowing the $750,000 bad debt deduction for the Wolper Construction loan.
Sec. 166 and the Bad Debt Deduction Rules
Sec. 166 allows taxpayers to deduct any debt that becomes worthless within the tax year. To be entitled to a deduction, the taxpayer must show a bona fide debt based on a debtor-creditor relationship. However, the statute provides for different treatment for business and nonbusiness bad debts. Business debts are debts created or acquired in connection with a trade or business of the taxpayer or debt that is incurred in the taxpayer's trade or business; all other debts are nonbusiness debts. Taxpayers must treat nonbusiness bad debts as losses from the sale or exchange of a short-term capital asset and can deduct the debt only for the year in which the debt becomes wholly worthless. However, business debts are ordinary losses that can offset ordinary income. Whether a debt is a business or nonbusiness debt is a question of fact.
The Tax Court's Opinion
The Tax Court held that the Wolper Construction loan was not a business bad debt and was not deductible in 2008 as a nonbusiness bad debt. The court found that it was not a business bad debt because Cooper was not in the lending business. It concluded the loss was not deductible as a nonbusiness bad debt in 2008 because Cooper had failed to prove that the loan was wholly worthless in that year.
Not in the business of lending: The Tax Court stated that based on its precedent, the "right to deduct bad debts as business losses is applicable only to the exceptional situations in which the taxpayer's activities in making loans have been regarded as so extensive and continuous as to elevate that activity to the status of a separate business." After analyzing the facts and circumstances of Cooper's lending activities, the court gave five reasons for concluding that Cooper was not in the business of lending:
First, Cooper had made only 12 loans over a six-year period, and lending was not a significant activity for him in terms of the time actually devoted to the activity or as a percentage of his total activities, including his work for USANA. Second, he made loans only to friends and acquaintances. Third, Cooper did not follow the typical business formalities of the lending industry. Fourth, Cooper did not publicly hold himself out as being in the lending business and did not advertise for or otherwise actively seek out new lending clients. Fifth, Cooper did not keep adequate contemporaneous business records and had created what records he was able to produce at trial after the fact.
Worthlessness of loan in 2008: Having found that Cooper was not in the business of lending, and that therefore the Wolper Construction loan was not a business loan, the Tax Court looked to see if Cooper was entitled to take a nonbusiness bad debt deduction in 2008. For him to do so, under the express language of Sec. 166, the loan must have been wholly worthless in 2008. The court stated that for a debt to be wholly worthless, the "last vestige of value" of the debt must be gone, and the taxpayer asserting that it is worthless must prove it by objective facts. While a bankruptcy filing by a debtor can be an indicator of a debt's worthlessness, it is not dispositive, and sometimes a debt is worthless before a bankruptcy settlement is reached and other times only when a settlement is reached.
The Tax Court found that Cooper had not proved that the loan was wholly worthless and that his actions belied his claim that it was. The court noted that Cooper had not treated the loan as worthless in 2009, listing it as an asset on two net-worth statements and failing to report the loan as a bad debt to Wolper Construction or the IRS on a Form 1099-C. In addition, he did not report the loan as a bad debt on his original 2008 income tax return that he filed in October 2009, and he only first treated the loan as worthless in 2010 on his amended return for 2008. The only objective proof of worthlessness that Cooper could point to was Wolper Construction's 2008 bankruptcy filing, but, consistent with Tax Court precedent, the court concluded that the filing did not establish with reasonable certainty that the debt was wholly worthless.
The facts related in the Tax Court's opinion would seem to indicate that by the end of 2008, in reality, there was little or no hope that Wolper Construction was ever going to repay Cooper and that with a minimal amount of thought and effort, Cooper could have created the necessary contemporaneous evidence to successfully support the claim that the debt was worthless in 2008. If a CPA has any inkling that a client is making loans that the client may eventually want to claim as bad debts, the CPA should review the rules for bad debt deductions with the client, stressing that the IRS and the courts will not simply take a taxpayer's word for it that a loan was worthless in a particular year.
Cooper, T.C. Memo. 2015-191