Taxpayer failed to substantiate advances represented debt
The United States Tax Court recently held that an individual taxpayer’s advances to his friend’s struggling scuba-diving corporation were equity investments, not bona fide debt. [Burke v. Commissioner, T.C. Memo 2018-18 (Feb. 21, 2018)].
The taxpayer at issue did not obtain formal loan documentation upon making loans to the corporation beginning in 1995. Instead, the taxpayer’s first advance was in exchange for a 50 percent interest in the business, and later advances were provided in exchange for an additional 10 percent ownership interest. Taxpayer continued to advance funds even as the business deteriorated, and did not obtain formal loan documentation for any of the advances until 2010.
After multi-million dollar advances, taxpayer obtained outside financing from third party lenders. When the business ultimately failed, taxpayer alleged that each advance to the business was a loan and tried to deduct the losses. The Commissioner argued that the taxpayer was attempting to disguise an equity investment as debt and disallowed the loss. The Court agreed.
Formal loan documentation, such as a bond, a debenture, or a note, tends to show that an advance is a bona fide debt. Taxpayer did not obtain formal loan documents for any of these payments until 2010, and even then, the Court did not find taxpayer’s argument that post-January 2010 promissory notes were evidence of bona fide indebtedness persuasive. The Court found those promissory notes were simply ad hoc tax planning and were not instructive in determining taxpayer’s intent at the time it made the advances. The advances also lacked the usual incidents of a loan, especially a maturity date and a stated interest rate. In contrast, when the business obtained loans from other lenders over the years, it signed formal written documents and paid the lenders back. This factor highlighted the business’ inconsistent treatment with loans from unrelated lenders and supported the Court’s characterization of the advances as equity.
The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of a debt obligation. Taxpayer’s alleged loans had no fixed maturity date, rather each time taxpayer advanced funds, it did so without setting a time for repayment. At the time of trial taxpayer had not received a single repayment of any advance or interest and did not expect to receive payment until the business was profitable.
Taxpayer argued that before the notes, the business’ financial statements recorded its advances as loans, but provided no authority that this would give him a right to enforce repayment. The Court explained, “even if we view the 2010 promissory notes as having created an enforceable right to repayment, failure to take customary steps to ensure repayment is an indication of equity…[taxpayer] never asked for repayment, and we find that [taxpayer] never intended to enforce the notes: As part of [taxpayer’s] tax planning, [taxpayer] sold one and relied on the possible sale of [the business] to pay the other. This factor weighs in favor of finding the advances to be equity.”
A bona fide debt is one that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Treas. Reg. Sec. 1.166-1(c). Whether a purported loan is a bona fide debt is determined by the facts and circumstances of each case. Because this case would be appealable to the Ninth Circuit, the court followed that jurisdiction’s precedent for guidance. In A.R. Lantz Co. v. United States, 424 F.2d 1330 (9th Cir. 1970), the Ninth Circuit provided eleven nonexclusive factors to determine whether an advance of funds gives rise to bona fide debt as opposed to an equity investment. There, the court cautioned against overemphasizing any one of the following factors:
- The names given to the certificates evidencing the indebtedness,
- the presence or absence of a maturity date,
- the source of the payments,
- the right to enforce the payment of principal and interest,
- participation in management,
- a status equal to or inferior to that of regular corporate creditors,
- the intent of the parties,
- “thin” or adequate capitalization,
- identity of interest between creditor and stockholder,
- payment of interest only out of “dividend” money, or
- the ability of the corporation to obtain loans from outside lending institutions.
The Tax Court found that nearly all of these factors weighed in favor of characterizing taxpayer’s advances as equity, specifically noting that “the inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties.” A.R. Lantz Co., 424 F.2d at 1333. Taxpayer never received or demanded payments of interest or principal from the business, and did not expect to be paid until the business was profitable. At the time of making the advances, taxpayer was also unsure whether the business was recording them as loans in its books. While the business’ financial statements do show that they included taxpayer’s advances in their total debt, no one else from the business testified on taxpayer’s behalf. Thus, the Tax Court gave the business’ treatment of the advances on its balance sheet little weight.
In summary, this case is a good example of the negative consequences that can follow implementation of a tax planning strategy without the proper planning. When establishing business advances or loans, it is critical to consider the various debt/equity factors and attempt to establish as many debt characteristics as possible, understanding that creation of a debt instrument with stated principal, interest and maturity date is not necessarily sufficient to establish the instrument as a debt. Consult with your tax advisor when exploring such a transaction.