United States

Tax Court treats related party loans as equity

Denies claimed bad debt deductions

TAX ALERT  | 

An S corporation owned by the taxpayer in Sensenig v. Commissioner, T.C. Memo 2017-1, had advanced money to various businesses it owned an equity stake in. It claimed bad debt deductions with respect to some of these loans. The S corporation’s conduct did not resemble the conduct of a lender, so the IRS disallowed the bad debt deductions, treating the related party loans as equity. The Tax Court agreed with the IRS. The case serves as a reminder that taxpayers who advance money to related companies should consider creditworthiness and attend to debt documentation.    

Background

The S corporation, Conestoga Log Cabins Leasing, Inc. (CLCL), provided high-risk capital to various companies, seeking favorable returns. CLCL’s owner, Mr. Sensenig, owned a significant equity interest in each investee company.  

CLCL made various advances to the investee companies, which it recorded on its books as loans (the Loans). CLCL did not enter into debt agreements with the investee companies and did not conduct any business process to evaluate their creditworthiness.

CLCL did not demand repayment of the loans, claim that they were in default, or take any collection activity.

CLCL claimed bad debt deductions totaling over $10 million with respect to some of the Loans that it had made to three of the investee companies. Because CLCL was an S corporation, Mr. Sensenig’s individual income tax return reflected these deductions. CLCL subsequently advanced additional Loans to these three companies. The IRS disallowed the bad debt deductions.  

Tax Court agreed with the IRS

The Tax Court agreed with the IRS. To support the claimed bad debt deductions, CLCL needed to show that: (1) the Loans were properly treated as debt for federal income tax purposes, and (2) that they became worthless during the taxable year. The Tax Court held that neither of these elements were present.

Case law generally governs the determination of whether a loan is treated for debt or equity for federal income tax purposes. In certain circumstances, regulations under section 385 also apply, but those regulations were inapplicable in this case.

The case law requires examination of the facts and circumstances and weighing of multiple relevant factors. The facts in this case did not support debt treatment for the Loans. There was little or no documentation of the loans, the lender did not make any assessment of the borrowers’ creditworthiness, the lender and the borrower were related parties, the lender advanced funds where an unrelated creditor would not, and the lender continued advances even after bad debt deductions were claimed. All of these facts support treating the Loans as equity for tax purposes, and the Tax Court held the Loans were treated as equity.

The court also held that even if the loans were treated as debt, the taxpayer had not demonstrated their worthlessness. One fact that appeared to contradict the claim of worthlessness was CLCL’s continued Loan advances to the same companies after the bad debt deduction were claimed.

In addition to denying the bad debt deductions, the Tax Court found that Mr. Sensenig was liable for the accuracy-related penalty. The accuracy-related penalty amount generally is 20 percent of the relevant amount of understated tax.

Conclusion

The Sensenig case provides a reminder to related party lenders to consider creditworthiness and attend to debt documentation if the intent is to treat the loan as debt for tax purposes.

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