Executive summary: Allen v. Comm’r and the importance of properly documenting debt
The Tax Court has yet again denied a taxpayer’s bad debt deduction stemming from related party cash advances. The Allen Decision is another reminder of the need to properly document debt and cash advances. Failure to properly document purported debt may result in adverse treatment by the IRS. In recent years the IRS has shown it will apply particular scrutiny to related party cash advances. It is therefore critical that taxpayers understand the risks associated with undocumented cash advances and take steps to mitigate such risks as early as possible.
Tax Court once again denies related party bad debt deduction
Allen v. Comm’r—the facts
Allen v. Comm’r, T.C. Memo. 2023-86, addressed a taxpayer who owned several affiliated business entities and trusts engaged in residential real estate. The taxpayer would locate marketable and economically profitable land for residential real estate developments and then, via the business entities and trusts, manage, design and market the properties.
Beginning in the early 2000s, some of the taxpayer’s entities provided cash advances to other related entities. The cash advances, which ultimately totaled many millions of dollars, were memorialized in promissory notes that contained fixed maturity dates. However, the entities that received the advances did not complete loan applications for any of the loans they received, did not have earnings, and did not pay interest on any of the purported debts. Moreover, none of the purported creditor entities made any demands for repayment at the time of maturity, nor did they issue any notices of default.
Ultimately, the taxpayer (through his entities) claimed, under section 166, bad debt deductions in connection with the cash advances totaling more than $14M.
The Tax Court ruling
The Tax Court denied the bad debt deductions on the grounds that the cash advances were equity—and not debt—from the very beginning. The court highlighted the long-standing position of courts that tax deductions are a matter of legislative grace and that taxpayers therefore bear the burden of proving entitlement to a deduction. Moreover, the court noted, to successfully claim a tax deduction, a taxpayer must not only demonstrate that the claimed deductions are permitted pursuant to a statutory provision, but also must substantiate such claim by producing adequate records to determine the taxpayer’s correct tax liability.
Under section 166, a taxpayer is allowed a bad debt deduction for debt that becomes worthless within the taxable year, but only if the debt is bona fide debt. A debt is bona fide, the court explained, if at the time the funds were advanced the parties, in good faith, had an actual intent to create a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money. The determination of whether debt is bona fide debt, while case-specific, generally hinges on a set of debt versus equity factors often referred to as the Mixon factors, based on Estate of Mixon, 464 F.2d 394 (5th Cir. 1972). Various courts utilize various formulations of the Mixon factors; the Allen court utilized the formulation of the Fourth and the Eleventh Circuits. (We list a formulation of the Mixon factors in an article we authored previously regarding a similar Tax Court decision: Tax Court denies bad debt deduction holding advances were equity.)
Note that the Mixon factors are not all accorded equal weight. The Allen court noted that failure of a debtor to repay on the due date or seek a postponement is arguably the most significant factor in the debt-equity analysis. Other courts have noted that the factors of a fixed maturity date, interest payments, and the borrower’s ability to make principal and interest payments carry more weight than some of the other factors.
In its analysis, the Allen court found that seven of the thirteen factors favored equity, three favored debt, and three were neutral. The court therefore concluded that the cash advances did not constitute debt and the section 166 deductions were therefore not available.
Takeaway
Allen v. Comm’r yet again highlights the importance of properly documenting debt from the outset and respecting the terms of purported related party debt. This case is by no means unusual. For example, in Burke v. Comm’r, T.C. Memo 2018-18 (2018), and in Keeton v. Comm’r, T.C. Memo 2023-35 (2023) the Tax Court raised many of the same debt-equity issues raised in Allen. A taxpayer that wishes to treat related party cash advances as debt for tax purposes should therefore ensure that (i) the advances meet certain criteria, (ii) the advances are properly documented as debt and (iii) the terms of the debt agreements are respected by the parties.
As these cases illustrate, the IRS and courts apply heightened scrutiny to related party cash advances. It is therefore critical that taxpayers understand the risks associated with undocumented cash advances and take steps to mitigate such risks as early as possible.
