Tax Court rejects bad debt deductions

Editor: Mark Heroux, J.D.

The taxpayer in Allen, T.C. Memo. 2023-86, claimed bad debt deductions of over $17 million with respect to advances between companies the taxpayer controlled. The IRS denied the bad debt deductions, arguing that the advances represented equity, not debt. The Tax Court agreed and upheld the IRS’s assessment of tax and penalties.

In a nutshell, the Allen case provides reminders of these tax principles:

• Lack of sufficient capitalization and creditworthiness, coupled with inattention to payments, are factors that make equity treatment of related-party loans more likely. Equity treatment renders bad debt deductions unavailable.
• Where factors favor equity treatment, properly executed legal documentation of the loans generally does not suffice to support debt treatment or a bad debt deduction.
• Failure to obtain professional tax advice with respect to a substantial tax deduction increases the risk that tax penalties will apply.

Bad debt deductions in general

There are three essential requirements for a taxpayer to successfully claim a bad debt deduction under Sec. 166. First, the taxpayer must hold a bona fide debt (Regs. Sec. 1.166-1(c)). Second, the debt instrument must not be a security within the meaning of Sec. 165(g)(2)(C) (Sec. 166(e)). Third, the debt must have become worthless (see generally Regs. Sec. 1.166-2).

A fourth requirement applies where a partial bad debt deduction (partial worthlessness) is claimed: The taxpayer must record a charge-off with respect to the debt instrument during or prior to the tax year for which it claims the deduction (see generally Sec. 166(a)(2) and Regs. Sec. 1.166-3). Noncorporate taxpayers must meet an additional requirement for claiming an ordinary bad debt deduction, as opposed to a less valuable capital loss: The ordinary deduction typically is available only if the worthless debt was not a nonbusiness debt within the meaning of Sec. 166(d).

The taxpayer’s bad debt deductions were denied in Allen because the court concluded the first requirement was not met: The purported loans in question were not treated as debt for federal income tax purposes.

Advances treated as equity

In Allen, the taxpayer, William G. Allen, was president and an employee of Waterfront Development Services Inc. (WDS) and sole manager of its disregarded entity, Waterfront Development Services I LLC (WDS I). Humbolt Investments LLC was owned by the Allen Family Investment Trust and GST Trust. GST Trust in addition owned Waterfront Communities, an S corporation of which Allen was also the president.

In the early 2000s, WDS, WDS I, and Humbolt made millions of dollars in advances to Waterfront Communities and over 20 other related entities, trusts, and individuals involved in Allen’s extensive real estate enterprise.

The IRS disallowed more than $14.5 million of bad debt deductions WDS claimed on its return for 2009 and all of the more than $3.4 million in bad debt deductions Humbolt claimed on its 2009 return. The IRS also examined Allen’s 2009 individual return and denied more than $28 million in net operating loss deductions carried back to 2004 through 2006 that arose from the bad debt deductions. In addition, the IRS imposed Sec. 6662 accuracy-related penalties against Allen, who petitioned the Tax Court for a redetermination.

The Tax Court determined that the loans should be treated as equity for tax purposes by applying the 13 factors outlined in Estate of Mixon, 464 F.2d 394 (5th Cir. 1972). These factors are: (1) the names given to the certificates evidencing the indebtedness; (2) presence or absence of a fixed maturity date; (3) source of payments; (4) right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) status of the contribution in relation to regular corporate creditors; (7) intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) ability of the corporation to obtain loans from outside lending institutions; (12) extent to which the advance was used to acquire capital assets; and (13) failure of the debtor to repay on the due date or seek a postponement.

In Allen, the written loan documentation contained fixed maturity dates, stated interest, and rights to enforce payment. The Tax Court concluded that this documentation favored debt treatment of the advances and was not counteracted by the subsequent extension of the maturity dates.

The IRS’s assertion of equity characterization, however, was supported by facts indicating that the creditor companies did not exercise their rights to payment. Few interest or principal payments were made.

When addressing the payments made, the court did not address whether the payment ordering rules of Regs. Secs. 1.446-2(e) and 1.1275-2(a) should be considered relevant. Under those regulations, payments denominated by the parties to a debt as principal payments may be treated as interest for tax purposes.

The court concluded that the facts did not support the taxpayer’s contention that the advances were intended as debt. One reason for this conclusion was that advances characterized as loans continued to be made even after the bad debt deductions were claimed. Additionally, repayments of the loans to most of the recipients were effectively contingent on the borrowers’ successful future sales of real property lots. The court concluded that this contingency supported equity treatment, even though the taxpayer pointed out that the debt terms called for noncontingent payments.

The court concluded that the borrowers were thinly capitalized, with the taxpayer’s evidence not sufficient to support his contention that intangible assets and business relationships rendered the borrowers’ capitalization levels adequate. The IRS argued that the borrowers could not have obtained equivalent loans from an unrelated lender, and the court agreed. The court stated that the recipients of the advances lacked the ability to repay these related-party debts.

While noting that an equity vs. bona fide debt determination is based on all the facts and circumstances and that factors such as those of the Mixon test are merely helpful in a court’s consideration rather than dispositive to its decision, the court found that, of the 13 Mixon factors, seven favored equity treatment (3, 4, 7, 8, 9, 10, and 11); three favored debt (1, 2, and 5); and three were neutral (6, 12, and 13). Weighing the factors, the court found that the advances did not constitute debt, and thus Allen was not entitled to his claimed bad debt deductions under Sec. 166.

Penalties

The IRS proposed a penalty equal to 20% of the relevant underpaid taxes, the substantial-understatement penalty of Sec. 6662. There is an exception to this penalty’s applicability for taxpayers who have acted with reasonable cause and in good faith (Sec. 6664(c)). One way taxpayers may qualify for this exception is by reasonably relying on professional tax advice (see Regs. Sec. 1.6664-4(c)).

The Tax Court concluded that the taxpayer did not qualify for the exception and upheld the IRS’s penalty assessment. The court noted that Allen did not seek professional tax advice regarding the bad debt deduction claims and in fact stated, “There is no evidence that Mr. Allen took any steps to assess the proper tax liability.”

Taxpayers’ conduct and expectations scrutinized

Overall, the Tax Court’s opinion in Allen emphasizes the parties’ conduct with respect to payments and contractual rights, along with a realistic view of the repayment expectations. This emphasis demonstrates that, while documenting loans with binding legal agreements is helpful in achieving debt treatment for tax purposes, the documentation step is not by itself sufficient support.

The court’s approval of the proposed penalty serves to point out the potential importance of professional tax advice, particularly where deductions totaling millions of dollars are considered.

Editor Notes

Mark Heroux, J.D., is a tax principal in the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Heroux at mark.heroux@bakertilly.com.

Contributors are members of or associated with Baker Tilley US, LLP.