Cash advances fail to meet bona fide debt criteria

By James A. Beavers, CPA, CGMA, J.D., LL.M.

The Tax Court held that a renowned scientist was not entitled to a bad debt deduction for advances he made to his unsuccessful health technology company because the advances were equity contributions to the company rather than debt.

Background

William Rutter is a world-renowned scientist in the field of biotechnology. He received a Bachelor of Science degree from Harvard College, a Master of Science degree from the University of Utah, and a Ph.D. in biochemistry from the University of Illinois. He completed postdoctoral work at several universities, including the University of Wisconsin and the Nobel Institute in Sweden.

Rutter began his illustrious academic career in 1955 as a professor of biochemistry at the University of Illinois and eventually ended up at the University of California, San Francisco (UCSF), serving there from 1969 to 1982 as a professor and chair of the biochemistry and biophysics department. He has published 400 scientific papers, holds more than 25 patents, and has received numerous awards and accolades for his accomplishments in the biotechnology field.

Shortly before leaving UCSF, Rutter formed Chiron Corp., one of the first publicly held biotechnology companies. Under his leadership Chiron made major contributions in the areas of vaccines and infectious diseases. Ciba-Geigy, a major European pharmaceutical concern, bought 49% of Chiron's stock, and the company's successor, Novartis, purchased the remaining 51% from Rutter in 2006.

Rutter did not limit himself to Chiron but invested in other businesses, including purchasing a company called Healthvantage Inc. in 1999, which was later renamed iMetrikus. In 2002, Rutter incorporated iMetrikus International, and iMetrikus became its wholly owned subsidiary. (The two companies are referred to collectively herein as IM.) IM was a "telehealth" company that developed technology systems to enable remote monitoring of patients' health.

Although Rutter was IM's driving force, he owned no common stock in the company. IM had about 70 common shareholders, including key employees and some of Rutter's kin, but common stock was only a small portion of its capital structure. From the time Rutter incorporated IM through December 2009, IM's primary funding source was cash advances he made to the company.

Rutter advanced large sums of cash to IM: Between September 2000 and February 2002, he made 39 cash advances to IM totaling approximately $10.6 million. For each of these advances, IM executed an interest-bearing promissory note and actually made interest payments on the notes.

Between February 2002 and May 2005, Rutter advanced to IM another $22 million but only $3.4 million of these advances was covered by promissory notes; he received no promissory notes or other evidence of indebtedness for the rest of the advances, which IM recorded as loans on its books. The loans accrued interest, but, after February 2002, IM paid no interest on any of this purported indebtedness.

In May 2005, IM converted the approximately $43.4 million Rutter had advanced to IM to preferred stock, giving him preferred stock with a face value of $43.4 million, after which roughly 78% of IM's capital structure consisted of Rutter's preferred stock. Rutter, however, was not through throwing good money after bad.

Between May 2005 and December 2009, he made additional cash advances to IM totaling $43.04 million, which were the sole source of the company's funding during this period. As before, IM executed no promissory notes for these advances, furnished no collateral, and recorded the advances on its books as loans accruing interest, but never paid any interest on the debt. As of Dec. 31, 2009, the balance of Rutter's open-account advances to IM, including accrued interest, was approximately $47.5 million and, coupled with his $43.4 million of preferred stock, constituted roughly 92% of IM's capital structure.

At this point, IM's business plan was to create pilot programs for telehealth products and services by seeking partnerships with pharmaceutical companies, health care providers, and technology companies. However, IM had trouble finding partners. Things looked up in 2009 when IM entered into discussions with Google, but in March 2010, Google decided not to enter into a partnership with IM, marking the beginning of the end for IM. Rutter continued advancing cash to IM to the tune of another $37.5 million, but the company discontinued operations in 2013.

Rutter's bad debt deduction and the IRS's response

By the fall of 2009, Rutter had come to the conclusion that at least some of the money he had advanced to IM was not coming back, and he began investigating the possibility of writing off some or all of the advances. He and his advisers decided to write down the debt from IM by $8.55 million, and the advisers created the necessary documentation to implement the write-down.

Rutter timely filed a 2009 federal income tax return, which included on a Schedule C, Profit of Loss From Business, an $8.55 million business bad debt loss reflecting the write-down of his advances to IM. Rutter claimed this loss in full as a deduction against ordinary income. According to him, this loss corresponded to advances he had made during 2005 and 2006 after the conversion of his previous advances to preferred stock and included no accrued interest.

The IRS selected Rutter's 2009 return for examination and disallowed the business bad debt deduction in full. It also made various computational adjustments and determined an accuracy-related penalty. The IRS issued Rutter a timely notice of deficiency, and Rutter petitioned the Tax Court to challenge the IRS's determination.

The Tax Court's decision

The Tax Court held that Rutter was not entitled to a bad debt deduction for his cash advances to IM. The court found, based on an 11-factor test developed by the Ninth Circuit, that the advances were not debt but instead were equity contributions to the company.

Sec. 166(a)(1) allows as a deduction any bona fide debt that becomes worthless within the tax year. A bona fide debt is a debt that arises from "a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money" (Kean, 91 T.C. 575 (1988)), and a gift or contribution to capital is not considered a "debt" for purposes of Sec. 166. Whether a purported loan is a bona fide debt for tax purposes is determined from the facts and circumstances of each case.

Advances made by an investor to a closely held or controlled corporation may properly be characterized not as a bona fide loan, but as a capital contribution. In general, advances made to an insolvent debtor are not debts for tax purposes but are characterized as capital contributions or gifts. For an advance to constitute a bona fide loan, the purported creditor must expect that the debtor will repay the debt.

Because the case would be appealable to the Ninth Circuit, the Tax Court looked to that circuit's precedent for guidance on the debt versus equity question. It found that the Ninth Circuit has identified 11 nonexclusive factors to determine whether an advance of funds gives rise to bona fide debt as opposed to an equity investment: (1) the labels on the documents evidencing the alleged indebtedness; (2) the presence or absence of a maturity date; (3) the source of payment; (4) the right of the alleged lender to enforce payment; (5) whether the alleged lender participates in management of the alleged borrower; (6) whether the alleged lender's status is equal to or inferior to that of regular corporate creditors; (7) the intent of the parties; (8) the adequacy of the alleged borrower's capitalization; (9) if the advances are made by shareholders, whether the advances are made ratably to their shareholdings; (10) whether interest is paid out of "dividend money"; and (11) the alleged borrower's ability to obtain loans from outside lenders. The Tax Court applied each of these factors to the facts in Rutter's case.

The Tax Court found that the first seven factors and the 11th factor favored an equity characterization for the advances; the ninth and 10th factors either slightly favored it or were neutral; and only one factor—the eighth—favored debt characterization, and that only slightly. Thus, evaluating the factors as a whole, it found that the advances were equity investments and not debt.

Of the factors favoring equity characterization, the court pointed to three as strongly supporting this characterization—the source of payments, the right to enforce payment of principal and interest, and the payment of interest. Regarding the source of payments, the court noted that at all times IM's "expenses vastly exceeded its revenue" so any repayment of the advances would likely come from further cash infusions from Rutter, which did not support characterizing the advances as debt.

On the right to enforce payment of principal and interest, the court observed that there was no written evidence of indebtedness fixing a repayment obligation, and the advances were not secured by collateral. Moreover, even if Rutter had a right to enforce repayment, it was nugatory because it was his cash infusions that were keeping IM afloat. Thus, any repayment of the advances would have only required a larger advance in the month after the repayment. On the payment of interest, the court simply stated that this strongly supported equity characterization because IM had not paid any interest at all on the advances from 2002 to 2009.

The only factor the court found that could favor Rutter was inadequate capitalization. The court noted that between 2005 and 2009, IM did have capitalization in the form of Rutter's preferred stock almost equal to the amount of the advances Rutter made during that period. Nonetheless, since Rutter, who was making the advances, held all the preferred stock, the equity cushion the preferred stock afforded would be of little value. Therefore, the court stated that this factor at best weighed only slightly in Rutter's favor.

Reflections

If Rutter had not made it over the debt/equity hurdle, in order to take a bad debt deduction, the advances would have had to have been business debts, and the debts would have had to have become worthless in 2009. Although the court, based on its debt/equity determination, did not need to analyze these two issues, it did for the sake of completeness. The court found that the advances would not have been business debts because Rutter made them as an investor, not as a person in a trade or business of lending money. The court further found that Rutter had failed to prove that any portion of his advances to IM became worthless in 2009.

Practitioners should note that the debt/equity test is one of substance over form. Therefore, even if a taxpayer advances funds to a corporation and formally executes notes for the advances and properly pays interest on the notes, the IRS and the courts may still determine that the advances are contributions to equity based on the overall facts and circumstances.

Rutter, T.C. Memo. 2017-174

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