Editor: Mark G. Cook, CPA, MBA
Expenses & Deductions
Whether a taxpayer can claim a business bad debt or a nonbusiness bad debt is particularly important and can lead to a different result on the tax return. Under Sec. 166, a bona fide business bad debt may be deducted during the year in which it becomes worthless. By contrast, a nonbusiness bad debt is not deductible and is treated as a short-term capital loss. In a recent case, Haury, T.C. Memo. 2012-215, the Tax Court held that a loss is a nonbusiness bad debt where a taxpayer’s dominant motive is to protect his investment in a corporation, even if the taxpayer is an employee.
Haury was an engineer who developed software and licensed it to NuParadigm Government Systems Inc. (NPGS) and NPS Systems Inc. (NPS), two information system companies for which he provided technical advice and strategic direction. During 2007, he was the CEO and owned 48.3% of NPGS and was the president, secretary, and sole board member of NPS, of which he owned 49.2%.
In late 2006, NPGS and NPS were involved in a subcontract agreement in trying to assist in the development of a national alert warning system software, and the companies incurred approximately $4 million of development costs. In 2007, to improve cash flow, Haury transferred $434,933 to the companies from his IRA and executed interest-bearing promissory notes that required the companies to repay Haury on demand. To loan the money to the companies, Haury withdrew from his IRA the amounts of $120,000, $168,000, $100,000, and $46,933 on Feb. 15, April 9, May 14, and July 6, respectively. On April 30, 2007, the IRA trustees received and deposited into Haury’s account a $120,000 check from NPGS.
Subsequently, a private investor loaned $500,000 to NPGS but conditioned it on Haury’s agreement to subordinate his repayment rights. This note provided for monthly interest payments and was payable in full on demand.
In December 2007, the deal fell through, and Haury demanded that the companies repay the funds transferred from his IRA. NPGS and NPS refused his demands and insisted that the companies could not repay. After 2007, Haury received no form of compensation from the companies.
In February 2010, the IRS prepared a substitute for return relating to Haury’s 2007 tax year and on May 10, 2010, sent him a statutory notice of deficiency. The IRS determined that Haury had a tax liability relating to wage income of $149,216; a $434,964 early withdrawal from an IRA; and penalties for failure to file a tax return, timely pay tax, and pay estimated income tax.
In August 2010, Haury filed his 2007 return, reporting a bad debt deduction of $413,000, ordinary wage compensation of $149,000, and a retirement distribution of $434,964.
The Tax Court analyzed two primary issues raised by Haury. First, Haury claimed that although he had received distributions of $434,964 from his IRA, the $120,000 deposited back into the account was a rollover contribution that was not includible in gross income. Amounts distributed from an IRA are includible in gross income unless an exception applies under Sec. 408(d)(1). Per Sec. 408(d)(3), the amount is nontaxable if “the entire amount received . . . is paid into an individual retirement account . . . for the benefit of such individual not later than the 60th day after the day on which he receives the payment or distribution.” However, the court ruled that since the distribution was paid into the IRA more than 60 days after the date of the distribution, it did not qualify as a rollover and was, thus, fully taxable. In addition, since the taxpayer was less than 59½ years of age, he was subject to a 10% additional tax under Sec. 72(t)(1).
Last, and more important, the Tax Court considered Haury’s argument that the $413,000 claimed on Schedule C was deductible as a bad debt related to the taxpayer’s trade or business. Under Regs. Sec. 1.166-1, a deduction is considered a bad debt if the debt is considered worthless in whole or in part during the year and it is a bona fide debt. Under Regs. Sec. 1.166-1(c), a bona fide debt is a debt that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. Based on the facts of the case, the court agreed that there was a bona fide debt in place and that the debt was worthless during the year. However, the court did not agree that the debt was a business debt, focusing its analysis on whether the taxpayer’s investment in and management of the companies constituted a trade or business.
Citing Whipple , 373 U.S. 193 (1963), the court stated that investing one’s money and managing one’s investment do not amount to a trade or business. In Whipple , the taxpayer owned 80% of the stock in a corporation, and he was also the CEO. He made a number of loans to the corporation to try to keep it in business, but it went bankrupt. When he filed his return, he deducted the loss as a business bad debt under Sec. 166. The IRS argued, and both the Tax Court and Supreme Court agreed, that the loans were not made as part of the taxpayer’s business and therefore were nonbusiness bad debt.
In Haury’s case, The Tax Court found that the dominant motivation for making the loans was not his trade or business as an employee of the companies and the protection of his salary. As evidence, the court pointed to the fact Haury had not taken a salary since 2007. The Tax Court, noting that Haury had designed the software used by the companies and invested significant time and money to ensure the companies’ success, instead found that protection of his investment interests in the companies was the dominant motivation. As a result, the Tax Court found that his loans were nonbusiness debt that was not deductible in 2007. Accordingly, the court upheld the IRS’s deficiency assessment based on the substitute return.
Mark Cook is a partner at SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or email@example.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.