The Tax Court in Bercy v. Commissioner, T.C. Memo. 2019-118 allowed the taxpayer’s (Bercy’s) bad debt deduction over the IRS’ objections. The case is notable because of an unusual argument made by the IRS. The taxpayer operated a lending business, but the IRS argued that the loan at issue was not part of that business because those loans were secured by personal property rather than by real property. The Tax Court rejected this unusual argument.
Background
Bercy operated a lending business through which he had made about $25 million in loans over the years. In 2007, Bercy loaned $100,000 to the operator a of a high-end furniture rental business, who was unrelated to Bercy. The borrower’s business suffered a downturn. Bercy and other lenders to the business concluded that a sale of the furniture assets held the best prospect for recovery on their loans.
In 2014, a buyer was finally found for the furniture assets of the defunct furniture business. The assets were sold to a party supply rental business. Bercy and the other creditors received shares of the promissory note the party supply company had transferred in exchange for the furniture. Bercy’s share of the principal amount was $38,600. Applying a discount to this promissory note based on a rationale documented by his accountant, Bercy valued this $38,600 of principal at $35,000 and reported an ordinary bad debt deduction of $65,000 on his 2014 tax return. The IRS disallowed the deduction and assessed $22,750 of tax.
Business bad debt and other deduction requirements
An ordinary deduction (as opposed to a less valuable capital loss) was available to Bercy only if the written off debt was a ‘business’ bad debt (within the meaning of section 166 of the Tax Code). To prove ‘business debt’ status, Bercy was required to show that he was engaged in a trade or business and that the debt was proximately related to his trade or business.
The IRS agreed that Bercy operated a lending business. The facts surrounding the loan’s origination indicated that it was proximately related to Bercy’s lending business. The IRS sought to label the loan at hand as a nonbusiness loan because it was secured by personal property, a fact distinguishing the loan from the bulk of Bercy’s lending activities, which mainly focused on loans secured by real property. The Tax Court rejected this novel argument. The fact that the loan to the furniture business was not secured by real property did not support the IRS’ claim of nonbusiness loan treatment.
Loss sustained
As a second ground for disallowing Bercy’s $65,000 deduction, the IRS argued that the loan did not become worthless in 2014. The IRS believed that Bercy could have pursued collection against the furniture business owner to collect more money. The court, however, found that Bercy exercised reasonable business judgement in deciding to pursue neither (1) collection action against the asset-poor business owner nor (2) action geared toward obtaining more than a pro rata share of the business sale proceeds based on the dollar amounts of each creditor’s debt. The court therefore agreed with Bercy that the loan became worthless in 2014.
IRS did not present an argument in this case based on section 1271(a) which potentially conflicts with the ordinary bad debt deduction rule of section 166(a). This potential conflict arises only in situations where the creditor receives a partial payment in connection with extinguishment of a debt. In this case, Bercy did receive something – a portion of the promissory note given by the party rental company to the borrower. Nonetheless, the IRS did not argue here that section 1271(a) should trump section 166(a) and yield capital loss treatment.
Amount of loss
The court reduced Bercy’s bad debt deduction from the $65,000 claimed amount to $61,400. The court agreed with the IRS that the discount rationale applied by Bercy’s accountant did not support Bercy’s claimed discount of Bercy’s $38,600 share of the party rental company’s promissory note to $35,000.
Conclusion
There are a couple of takeaways for taxpayers from reading the Bercy case. One takeaway, is that when the IRS picks a fight it can be unpredictable. In this case, the IRS approved going to court to support a $22,750 tax assessment – an assessment that IRS based on a novel theory with little, if any support. A second takeaway from this case is that taxpayers should, together with their tax advisors, carefully consider the various requirements for an ordinary bad debt deduction before claiming the deduction.
