In Owens, T.C. Memo. 2017-157, the Tax Court held that an individual was entitled to a bad debt deduction for loans he made to a business that subsequently went bankrupt because (1) the individual was involved in the business of lending money during the years at issue; (2) the loans were bona fidedebt (despite at times being made to keep the struggling business afloat); and (3) the debt became worthless in the year claimed, even though the borrower did not file for bankruptcy until the following year.
Owens's lending business: William Owens was the majority shareholder of Owens Financial Group Inc. (OFG), a commercial lending company started by his father, and had served as OFG's president for 20 years. OFG gets much of its business by referrals, and it and Owens enjoyed a good reputation in the industry. Based on Owens's estimates, during his time at OFG, the company made about $2.5 billion in loans (about $225 million of which it had to foreclose on). In addition to his lending through OFG, since at least 1986, Owens had made a number of loans from his personal assets, often through his personal trust. He would typically lend from his personal funds as an investment in borrowers that were too risky for OFG, but for whom he had a trust and belief in their business model. Owens provided documentation showing 89 loans that he made between 1999 and 2013. OFG's staff handled the correspondence, documentation, and legal issues relating to Owens's personal loans the same as it did for those made directly through OFG.
Initial loans to borrower: David Lohrey ran a hotel laundry business in the San Francisco Bay Area. In 2003, after some difficulties Lohrey experienced, he sought funding at a bank, which considered the business too risky but referred Lohrey to OFG.
Owens reviewed Lohrey's business and its assets and determined (based in part on an appraisal) that they were worth $20 million. He determined OFG could lend Lohrey $7.5 million and agreed to personally lend to Lohrey an additional $2.75 million. Owens's personal loan was in a junior position to OFG's but included a right to participate in income above a certain threshold as additional compensation. When Lohrey initially faced cash flow shortages and fell behind on payments, Owens gave him additional time. However, in late 2005, Owens entered into an operating agreement making Owens's trust a member of Lohrey's business with a 30% share of profit, 99% share of loss, and 30% of capital.
Additional loans, bankruptcy, bad debts: Lohrey subsequently sought more funds to expand his business. He was in negotiations with a manager of 16 hospitals to take over their laundry services. Owens continued to believe in Lohrey's business but was unable to provide the funding, and so he referred Lohrey to another company, Vestin Mortgage, for the additional funding. Vestin agreed to loan the money but on the condition that Owens subordinate his loans to Vestin, which Owens agreed to do.
Lohrey won the hospital contract, but his business continued to lose money. After experiencing further difficulties in 2008, Lohrey, for reasons outside his control, abruptly ended the business. At the time, Owens had outstanding a total of $16 million in loans to Lohrey, who subsequently filed for bankruptcy in early 2009. In connection with the bankruptcy case, Owens filed a "proof of claim" — a statement asserting that Owens had a right to receive a potential payout from the bankruptcy estate.
In the bankruptcy, Owens recovered none of the money he had lent to Lohrey. On the advice of his CPA, Owens claimed a bad debt deduction under Sec. 166 for 2008.
The court explained that Sec. 166 allows an ordinary deduction for bad debt expense when a taxpayer meets three conditions with respect to a debt. Specifically, the debt:
1. Must have been created or acquired in the taxpayer's trade or business;
2. Must be bona fide debt between the taxpayer and the debtor; and
3. Must have become worthless in the year in which the taxpayer claimed a bad debt deduction.
The court held that Owens met all three requirements and was entitled to a bad debt deduction for 2008.
Trade or business: Whether someone is involved in the trade or business of money lending is a question of fact, and courts over the years have identified a number of relevant facts and circumstances (e.g., number of loans made, period over which they are made, records kept, and time and effort spent).
The court noted that, based on the record from 1999 through 2013, Owens made at least 66 loans to various borrowers, in total exceeding $24 million. The court observed that it and other courts have held making fewer loans of a smaller aggregate amount to qualify as operating a lending trade or business. While the government pointed out that Owens did not personally keep records on the loans but rather OFG kept the records, the court considered this factor to weigh on the side of the practice's being a trade or business.
The court did not find it problematic that Owens did not prove how much time he spent on the personal loans. It acknowledged that entrepreneurs often do not track their time, and it assumed, based on the amount of the loans, that Owens spent sufficient time on them. Similarly, the court did not count against Owens that he did not advertise the availability of his personal loans, because he had a strong reputation as a lender and attracted borrowers through referrals and repeat business.
In its final argument on the issue, the government contended that a reasonable lender would not have continued lending money to Lohrey as the business continued to struggle with debt and cash flow issues. But the court concluded that under Owens's strategy it was a reasonable business decision at the time (although it turned out to be flawed based on hindsight) to try to keep the business afloat so that he could recoup his loans.
Accordingly, the court determined that Owens lent money continuously and regularly in the operation of a trade or business during the years at issue.
Bona fide debt: With respect to the bona fide debt condition, the court found that the Ninth Circuit — to which an appeal would lie — has identified 11 factors in a debt vs. equity analysis, with no single factor controlling. The court considered each factor, ultimately concluding the debt was bona fide.
The court found several favorable factors, including that (1) each loan was evidenced by a promissory note; (2) the loans had maturity dates (even though Owens subsequently decided not to enforce them); (3) there was a legal right to enforce repayment, and repayment was not legally contingent on the business's success; (4) the evidence showed that Owens and Lohrey intended for the advances to OFG to be loans; and (5) Lohrey was able to obtain loans from third parties during the years at issue. Notably, the court did not look unfavorably upon the fact that Owens continued to loan money even though the borrower was experiencing financial difficulty. The court specifically declined to treat later advances as equity, even though they were not secured, because they were meant to protect previous debt investments. One negative factor was that Owens subordinated his advances to Vestin, but the court found that this factor was not determinative.
When debt is worthless: As with the other conditions, a number of factors may be considered in determining when a debt becomes worthless. Owens concluded the debt was worthless in 2008, the year in which Lohrey's business abruptly ended. The government contended that the debt did not become worthless until 2009, when Lohrey filed for bankruptcy. The court considered Owens's belief that the debt became worthless in 2008 to be reasonable. Lohrey had also told Owens in 2008 that he would be filing for bankruptcy. With his debt subordinated to Vestin, Owens knew he would recover nothing (and he, in fact, did not recover anything).
The government contended that Owens's filing of a proof of claim in the bankruptcy showed that he expected at least some recovery. The court acknowledged that this factor weighed in favor of Owens's believing that he had hopes for some recovery, but it did not consider this single factor controlling in light of the broader facts and circumstances.
Although only a memorandum decision, Owens is notable for several taxpayer-favorable holdings. In particular, the court's treatment of later advances as debt rather than equity when made to protect earlier debt investments is helpful in concluding that loans made to distressed borrowers can constitute debt. The Tax Court's discussion of whether Owens was in a trade or business was generally in line with its other decisions, although its discussion related to OFG's handling of the documentation and servicing of the loans is useful to show that one can still qualify as having a trade or business even without strict separation from other ventures. Finally, the court's conclusion about the year of worthlessness could be helpful for taxpayers looking to claim a bad debt deduction when the borrower has yet to file for bankruptcy.
Michael Dell is a partner at Ernst & Young LLP in Washington.
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