Tax Court holds extensively documented notes are not debt

Executive summary

As company structures continue to grow more complex and more transactions occur that are eliminated for financial statement purposes (i.e. consolidated financial statements for a global group), the recent Tax Court’s recent decision in Anaheim Arena Management LLC et al. v. Commissioner; No. 16724-19; T.C. Memo. 2025-68, is a warning to review their intercompany accounts and activity and look beyond internal financial reporting and documentation of intercompany advances and similar transactions.

In Anaheim Arena Management LLC et al. v. Commissioner; No. 16724-19; T.C. Memo. 2025-68, the Tax Court agreed with the IRS and disallowed a taxpayer’s claimed bad debt expense on related party debt. While the advances were extensively documented as debt, the court looked at the substance of the arrangements and concluded the advances were not debt.

With the new tax bill’s reversion¹ back to earnings before interest, taxes, depreciation and amortization for section 163(j) interest limitation purposes, the benefit of using debt rather than equity will likely increase. This case serves as a warning to taxpayers that merely documenting advances as debt does not establish a debt for tax purposes. Taxpayers should properly document and support the other characteristics of debt to ensure compliance and eligibility for both interest deductions and claiming a bad debt deduction, as was the issue in this case. The questionable status of related party advances has been around for a century, and the use of related party advances are only expanding due to the size and complexity of organizations in a global economy.

While this case deals with claiming a bad debt deduction, the status of related party advances as debt is critical to many tax determinations surrounding items such as ownership, deductibility of interest expense, dividend characterization and withholding taxes. Unlike other IRS wins where the taxpayer did not properly document advances as debt, in this case, Anaheim Arena Management LLC (AAM) meticulously documented the advances through notes. These notes specified terms such as interest rates and repayment schedules, in attempting to comply with proper classification of the advances. The court nonetheless ruled that the advances were not debt.

For RSM US articles on prior court decisions on this subject, see Tax Court denies bad debt deduction; advances were equity and not debt and Tax Court once again denies related party bad debt deduction.

AAM entered into a management agreement with the City of Anaheim, as well as promissory notes, authorizing AAM to advance operating expenses, which the City would repay from the net revenue with interest. In 2016, AAM concluded that the advances would not be repaid under the promissory notes and claimed a bad debt deduction in its 2015 tax year for approximately $51 million. The IRS audited AAM’s 2015 tax return, denied the bad debt deduction, and AAM petitioned the Tax Court, disputing the IRS’s determinations.

Main holding

• Bona fide debt: The court determined that the intercompany advances made by AAM were not bona fide debt. This classification is crucial because only bona fide debt qualifies for a bad debt deduction.
• Bad debt deduction: Since the advances were not considered bona fide debt, AAM was not entitled to claim a bad debt deduction for the amounts in question.
• Accuracy-related penalties: The court did not apply accuracy-related penalties in this case because the taxpayer relied on advice from its accountant.
• Partnership issue: This case involved a partnership, so section 385(c) did not apply to the situation. Section 385(c) pertains to the classification of certain interests in corporations as stock or indebtedness, which is not applicable to partnerships.

Case law factors for debt

The court discussed several factors to determine whether the advances constituted bona fide debt, including:

1. Intent of the parties: Whether there was a genuine intention to create a debtor-creditor relationship.
2. Documentation and formalities: The presence of formal loan agreements, promissory notes and repayment schedules.
3. Thin capitalization: Whether the company has sufficient capital to support the debt load.
4. Interest payments: Whether interest was charged and paid on the advances.
5. Repayment terms: The existence of a fixed repayment schedule.
6. Subordination to other debt: Whether the advances were subordinated to other debts.
7. Ability to repay: The borrower's ability to repay the advances from operating funds.
8. Ability to obtain third-party financing: Whether the borrower could obtain external financing.
9. Identity of interest: Whether the purported borrower is also an owner of the company.
10. Participation in management: Whether the lender is actively engaged in the management of the business.

After applying the factors to the facts of the case, the court held that the intercompany advances did not constitute debt for tax purposes.

^{[1] For a summary of the key tax provisions and reform in the “One Big Beautiful Bill Act,” see One Big Beautiful Bill Act | RSM US}