The Tax Court held that a note contributed to a partnership by an individual in exchange for an interest in the partnership was a bona fide debt and the partnership was entitled to a worthless debt deduction in the year the note became worthless.
Background
Joseph Spinosa is a Louisiana real estate developer who over the years had developed numerous large residential, office, and retail projects. In the mid-2000s, he organized two companies, Perkins Rowe Associates LLC and Perkins Rowe Associates II LLC (collectively Perkins Rowe) to develop two adjacent 20-acre properties (the Perkins Rowe property) for mixed residential, retail, and office use.
In 2006, Perkins Rowe was attempting to obtain a construction loan from Keybank for the Perkins Rowe property development. However, it had already begun work on the development, so Perkins Rowe needed a bridge loan to pay construction costs until it was able to obtain the construction loan. Spinosa solicited a bridge loan from football coach Nick Saban, whom Spinosa knew from Saban's time as head coach at Louisiana State University. Saban, who is now the head football coach for the University of Alabama, at that time was head coach of the NFL's Miami Dolphins.
Saban agreed to make a bridge loan of $2 million, and the Perkins Rowe entities jointly executed a promissory note to Saban for $2 million with a maturity date of April 10, 2007. Shortly after the note was executed, Perkins Rowe obtained a loan commitment of $170 million from a consortium of lenders led by Keybank. When the loan closed, Perkins Rowe obtained a draw of $12.2 million on the loan. Spinosa had originally intended to pay back Saban from this loan disbursement, but due to delays and cost overruns that had already cropped up on the development, he decided not to use money from the first disbursement to pay Saban.
With the Perkins Rowe property development continuing to experience difficulties, in April 2007, Spinosa asked Saban to extend the repayment period for his loan. Saban agreed, and he and Perkins Rowe executed a new note on May 29, 2007 (the 2007 note), for the accrued principal and interest on the old note with a maturity date of June 1, 2008.
Over the next year, the Perkins Rowe property development ran into more problems, resulting in cost overruns and the need for more capital. In late 2007, Spinosa attempted to obtain a further $15 million loan from Keybank, but ultimately he was forced to obtain the money by selling an interest in another project to a real estate investment trust. In 2008, Spinosa and Keybank also discussed refinancing the original $170 million construction loan and increasing the principal amount to $215 million, but Keybank did not approve the refinancing.
As the maturity date for the 2007 note approached, Saban, who was aware of the Perkins Rowe property development's problems, asked Spinosa about a plan for repaying the loan. Because the construction on the development was not completed, Spinosa did not want to pay off the 2007 note on the maturity date. Therefore, Spinosa presented Saban five options to "satisfy the debt currently due from Perkins Rowe." Four of these options involved Spinosa's transferring ownership interests in other ongoing or proposed projects, and the fifth involved renegotiating the note with a reduction in interest and a delay in repayment. Of these options, Saban chose to take an ownership interest in 2590 Associates LLC, which owned a piece of property in Baton Rouge on which Spinosa planned to build a residential community.
2590 Associates was owned 90% by a trust for the benefit of Spinosa's children and 10% by a limited liability company (LLC) that Spinosa controlled. There was no business relationship between Perkins Rowe and 2590 Associates, but both were managed by Spinosa and had some common ownership. To avoid it being known that he was investing in the project, because he perceived there was negative sentiment toward him in Baton Rouge for having taken the head coaching job at Alabama in 2007 after leaving the Miami Dolphins, Saban invested in 2590 Associates through TLS Investments LLC, which was owned by Saban and his wife, Terry.
Perkins Rowe executed a new promissory note (the 2008 note) to Saban for the principal and accrued interest on the 2007 note ($2.9 million) dated Dec. 2, 2008, and payable on Aug. 19, 2010. The note stated "it was given in substitution" for the 2007 note. Saban endorsed the note over to TLS Investments as a capital contribution, and TLS Investments transferred the note to 2590 Associates. In return, 2590 Associates admitted TLS Investments as a member with a 15% allocation of profit, gain, and loss.
Despite Spinosa's efforts to solve the problems with the Perkins Rowe property development, it continued to falter. From November 2008 on, Perkins Rowe failed to make its interest payments on its construction loan, and although principal repayment on the loan was not due until August 2009, Keybank and the other lenders sued in July 2009 to foreclose on the Perkins Rowe property. While the case was proceeding, Spinosa made constant efforts to somehow resolve the financing problems so that foreclosure could be avoided and Perkins Rowe could complete the development, but to no avail. In August 2011, a district court held that Keybank and the other lenders could foreclose on the property although final judgment in the case was not entered until 2012.
2590 Associates did not receive any payments on the 2008 note that Saban had contributed to the LLC. On its 2011 partnership return, 2590 Associates claimed a worthless debt deduction of $2.9 million for the note. The IRS issued a notice of final partnership administrative adjustment to 2590 Associates, disallowing the deduction. The IRS stated that, "Since the partnership did not establish that the cash transfer was a bona fide loan, the amount has been determined to be a contribution to capital." 2590 Associates challenged the IRS's determination in Tax Court.
The Tax Court's decision
The Tax Court held that the 2008 note was a bona fide debt between 2590 Associates and Perkins Rowe. Therefore, 2590 Associates was entitled to take a worthless debt deduction for the 2008 note in 2011, the year in which the note became worthless.
Sec. 166(a) generally allows taxpayers to deduct "any debt which becomes worthless within the taxable year." The Tax Court has held that for a Sec. 166 worthless business debt deduction, taxpayers must show: (1) the deducted amount represents a bona fide debt; (2) the debt became worthless during the year; and (3) the debt was incurred in connection with a trade or business (Sensenig, T.C. Memo. 2017-1). The IRS disputed whether the 2008 note was bona fide debt and whether it became worthless in 2011.
Bona fide debt: While it conceded that the loan by Saban to Perkins Rowe that was incorporated in the 2006, 2007, and 2008 notes was a bona fide debt, the IRS argued that the contribution of the 2008 note to 2590 Associates did not create a bona fide debt between 2590 Associates and Perkins Rowe. Instead, Perkins Rowe satisfied the Saban loan by transferring an interest in 2590 Associates to Saban. Moreover, there was no other transfer of funds between 2590 Associates and Perkins Rowe that could create a debt between the entities.
The Tax Court disagreed, finding that Saban's transfer of the 2008 note to 2590 Associates did not negate the debt's legitimacy. The court found that while Perkins Rowe had missed two interest payments at the time of the transfer, the company was not insolvent, and otherwise, the circumstances at the time indicated that the loan potentially might be repaid. According to the court, the transfer of the note did not satisfy the debt and instead only allowed Perkins Rowe to delay the debt's repayment until the extended due date in the third note. Furthermore, Perkins Rowe did not own 2590 Associates, so it could not have offered Saban an interest in 2590 Associates to satisfy his loan.
The IRS also argued that the debt was not valid because 2590 Associates did not intend to collect on it. The Tax Court, citing Spinosa's testimony on this point, determined that had Perkins Rowe become economically viable, 2590 Associates would have collected on the debt.
The IRS further claimed that the debt's legitimacy was compromised because the companies shared common management and some common ownership. The Tax Court was not convinced that this affected the debt's legitimacy because Spinosa had in the past intermingled the funds of his various real estate projects owned through different entities and had even done so when the Perkins Rowe property development needed capital in 2007, by injecting into the development $15 million raised in a separate real estate deal.
The Tax Court also analyzed the debt under the 13 factors used to determine if a debt is bona fide set out by the Fifth Circuit (to which an appeal of the case would lie) in Estate of Mixon, 464 F.2d 394 (5th Cir. 1972). Of these factors, the court found that nine weighed in favor of the existence of a bona fide debt, two were neutral, and two weighed against (the note's subordination to secured creditors and Perkins Rowe's failure to repay the debt and accrued interest). Thus, under the Fifth Circuit's 13 factors, the Tax Court found that the debt between the entities was bona fide.
Year of deduction: As a fallback position from its bona fide debt argument, the IRS contended that the 2008 note did not become worthless in 2011, the year 2590 Associates deducted it, but instead in either 2009, the year the Perkins Rowe foreclosure case began, or 2012, the year of the final judgment in the case. The Tax Court held that the 2008 note became worthless in 2011, so 2590 Associates had properly deducted it in that year.
The court rejected 2009 as the year the debt became worthless because in that year, although Perkins Rowe was experiencing financial difficulties, Spinosa was still negotiating with lenders over the construction loan and there was a reasonable expectation at the end of 2009 that foreclosure could be avoided, allowing the debt to be repaid.
In contrast, in 2011, in the court's view, no viable means of refinancing the development remained, Spinosa's negotiations with Keybank to avoid foreclosure had broken down, and Perkins Rowe had essentially lost the foreclosure case. Therefore, it was reasonable to abandon hope of recovery on the 2008 note by the end of 2011, although final judgment in the foreclosure case was not entered until 2012.
Reflections
As the court noted, with Perkins Rowe less than seven months from a foreclosure lawsuit, Saban may have "received a windfall by exchanging his debt for an equity interest in 2590 Associates," as he was able to exchange a debt that might very well not be repaid for an investment in development property. However, the IRS did not argue that the 2008 note should have been discounted and did not dispute 2590 Associates' adjusted basis in the note. The IRS took an all-or-nothing approach by arguing solely that the note was not bona fide debt, and since it could not have it all, it got nothing.
2590 Associates, LLC, T.C. Memo. 2019-3
