The Code is chock-full of provisions that will challenge the intellectual capacity, not to mention the patience, of most tax professionals. The complexity of these rules does not arise out of some sadistic intent on the part of Congress, the Treasury, or the IRS to torment taxpayers and their advisers;[i] rather, it is often a reaction to, and a direct function of, the complicated, multifaceted schemes that many of those very same taxpayers and advisers devise with the intent of reducing the taxpayer’s income tax liability.
Then there are those provisions of the Code that appear straightforward, at least until you try to apply them to a set of convoluted, and often poorly documented, transactions. Unfortunately, examples of such instances abound in the world of the closely held business, and especially in the case of transactions among[ii] related companies. The truth of this statement was illustrated by a recent decision[iii] of the U.S. Tax Court in which the principal issues in dispute arose from the transfer of funds among commonly owned business entities and the tax treatment of those transactions.
Among the issues addressed by the Court in its seventy-page opinion – the greatest part of which was dedicated to describing and unravelling the relevant facts (which will not be covered here) – were the following:
(1) Were transfers from a corporation to related companies bona fide loans, or should the transfers be treated as distributions by the corporation to the individual taxpayer-shareholder, such that the amount by which they exceeded the taxpayer’s adjusted basis in their stock should be treated as taxable capital gain?[iv]
(2) To the extent the funds transferred to the taxpayer and the related companies were bona fide loans, did the taxpayer receive taxable distributions when the loans were canceled and, if so, what was the amount of the distribution: the face value of the loan or something else?[v]
(3) To the extent loans existed, did the taxpayer have taxable cancellation of debt (COD) income, or was the taxpayer insolvent such that the discharge of indebtedness was not includable in the taxpayer’s gross income?[vi]
(4) Inextricably linked to the first three issues was the question of whether the taxpayer was entitled to a nonbusiness bad debt deduction[vii] for the canceled indebtedness?
Talk about a chain of dominoes.[viii]
The taxpayer in the above-referenced decision was in the business of purchasing assets that were used as security for nonperforming loans. The assets typically included a business entity and its associated real estate. The taxpayer would foreclose on the collateral, make improvements to the business and property, and then either operate the business or resell it.
Initially, the taxpayer borrowed money from third-party lenders to finance the purchase of the nonperforming loans. In a typical transaction, the taxpayer would set up two special purpose entities: one to own the foreclosed real estate and one to manage any business operations connected with the real estate; in this way, the risks from the business operations were isolated from the real estate.
At some point, the taxpayer decided to start transferring money between their affiliated companies to fund the taxpayer’s business ventures and recorded the transfers as loans. During the years in question, approximately $100 million of intercompany transfers were made which were characterized as loans. There were also some direct transfers to the taxpayer individually which were likewise recorded as loans.
Promissory notes were prepared and executed to reflect these transfers; they provided for interest at the short-term AFR.[ix] The accrued interest was tracked, and approximately $6 million of principal was repaid during the periods before the Court.
Bona Fide Loan?
The taxpayer’s businesses started to suffer beginning with the Great Recession. They lost money, the erstwhile loans could not be satisfied, and some loans were written off.[x]
The IRS audited the taxpayer’s income tax returns and determined that the intercompany transfers of funds were not bona fide loans. The Service issued notices of deficiency[xi] for the resulting income tax liabilities (plus interest and penalties), and the taxpayer petitioned the Tax Court.[xii]
As indicated above, the key issue in the case was whether a series of transfers from one of the taxpayer’s corporations to the taxpayer and/or his other controlled entities were bona fide loans or should be reclassified as taxable distributions.[xiii]
The taxpayer had consistently maintained that the transfers were loans, but the IRS disagreed.
According to the Court, the existence of a bona fide debt requires an intent to establish a debtor-creditor relationship when the transfers at issue are made. A bona fide debt, the Court continued, is a debt that arises from a debtor-creditor relationship based on “a valid and enforceable obligation to pay a fixed or determinable sum of money”; there must be “a real expectation of repayment and an intent on the part of the purported creditor to secure repayment.”
Whether an advance gives rise to a bona fide debt for tax purposes is determined from all the facts and circumstances. The Court explained that caselaw has established objective factors to consider when answering the question of whether a bona fide debtor-creditor relationship exists. Those factors include:
(1) whether the promise to repay is evidenced by a note or other instrument that indicates indebtedness,
(2) whether interest was charged or paid,
(3) whether a fixed schedule for repayment and a fixed maturity date were established,
(4) whether collateral was given to secure payment,
(5) whether repayments were made,
(6) what the source of any payments was,
(7) whether the borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan, and
(8) whether the parties conducted themselves as if the transaction was a loan.
Critical to the Court’s analysis was factor (7), above.
Can The “Loan” Be Repaid?
The Court observed that, early on during the years in question, the taxpayer no longer had a reasonable prospect of repaying the “loans” notwithstanding their argument that other factors supported the characterization of the transfers as loans.
For example, the taxpayer argued that loan treatment was supported by the accrual of interest and, in most cases, the taxpayer’s companies followed the formalities[xiv] of documenting the transfers as loans.
The taxpayer also maintained that the repayment was derailed only by the downturn in the economy that adversely affected the taxpayer’s real estate holdings and the profit potential of the taxpayer’s numerous transactions. Although the Court found this argument reasonable for the first year at issue, it lost its credibility afterward, the Court stated, when the taxpayer was fully “aware the economy was turning negative to” their businesses “but continued to have funds transferred” from their corporation “with less and less expectation of repayment.”
The taxpayer’s and his companies’ respect for loan formalities also waned as the economy made repayment all but impossible. Although the taxpayer’s companies followed a practice of careful accounting of loans, with some repayments, through the first year under exam, their respect for the loan characterization and repayments gradually disappeared after that first year.
Accordingly, the Court held that the intercompany transfers were not properly characterized as loans beginning with the second year under exam. This holding, in turn, affected the IRS’s position on whether the transfers were capital distributions or dividends and, alternatively, whether the taxpayer had COD income for the year the debts respected as such were canceled.
The Court held that the transfers beginning with the second year under exam were distributions to the taxpayer as a shareholder.
COD Income and Bad Debt Deduction
For the last year under audit, the taxpayer’s personal income tax return reported COD income, but excluded it from gross income based on the taxpayer’s alleged insolvency. The taxpayer also claimed a short-term capital loss deduction for bona fide debt which the taxpayer claimed became worthless within that taxable year.
The COD income was based largely on intercompany loans and was not calculated with enough precision to eliminate intercompany debt or to ensure that only the taxpayer’s personal debt was forgiven. Likewise, the capital loss deduction claimed by the taxpayer for the bad debt was calculated using the total of the recorded intercompany debts.
According to the taxpayer, because the debt was cancelled and was reported as COD income on the taxpayer’s return, “the other side of the same coin was a bad debt deduction” – it was a “zero sum” in that “without one you cannot have the other,” or so the taxpayer argued. For example, when the taxpayer’s lending entity was not able to collect the debts owed to it from various related entities, the amount of such debts was cancelled, creating a bad debt deduction for the taxpayer. Concurrently, when the debt owed to the lending entity was cancelled, the taxpayer “picked up the amount as cancellation of debt income.”
The Court rejected the taxpayer’s logic. The bad debt deduction, the Court stated, is not a function of alleged COD income; rather it arises from a debt owed to the taxpayer, not a debt owed by the taxpayer. The taxpayer’s “zero sum” argument, the Court continued, ignored the need to eliminate the debts between the taxpayer’s companies. These companies regularly passed funds between them. The taxpayer was unable to prove that the COD income on the business bad debts was properly calculated and that the debts were actually owed to or by the taxpayer. According to the Court, the taxpayer could not create a deduction by recording intercompany debt and then simply canceling it. To create a business bad debt, the Court stated, there had to be a debt owed to the taxpayer that was uncollectible. The taxpayer failed to establish such debt existed or was worthless. In any case, the Court added, its prior holding (above) transformed much of the alleged debt into distributions in earlier years, which had to be eliminated.
Tax Value of the Debt Distribution
Finally, the taxpayer argued that the distribution of the shareholder debt and other distributions caused by the forgiveness of shareholder debt, as found by the Court (above), should be valued at the fair market value of the debt rather than the face value of the debt.
Again, the Court rejected the taxpayer’s position. This argument, it stated, turned on the “characterization of the debt as property and not as a cash equivalent.” This argument was without legal support, the Court countered; the cancellation of shareholder debt “is considered the equivalent of a distribution of money in the face amount of the obligation.”
The key to determining the character of a payment between related parties as a loan or as something else ultimately turns on the economic reality of the payment.
If an outside lender would not have extended credit on the same terms and under similar circumstances as did the related entity, an inference may arise that the advance is not a bona fide loan.
On the other hand, if the transfer and surrounding circumstances give rise to a reasonable expectation, and an enforceable obligation, of repayment, then the relationship between the parties will resemble that of a creditor and debtor.
In that case, the form of the transaction should be consistent with, and support, its substance: a genuine loan transaction. Thus, there should be a written promise of repayment, a repayment schedule, interest, and security for the loan. However, as indicated above, merely following the formalities will not be enough in the absence of any substance.
The factors identified by the Court, above, provide helpful guidance for structuring and documenting a loan between related persons, including a business entity and any of its owners. If these factors are considered, the parties to the loan transaction will have objectively determinable proof of their intent, as reflected in the form and economic reality of the transaction.
Of course, the parties will also have to act consistently with what the transaction purports to be – they will have to act as any unrelated party would under the circumstances.
[i] Though I imagine many taxpayers view themselves as a tiny insect in the clutches of some malevolent child – which, from their perspective at least, represents the IRS – who is intent on removing first their wings, one by one, then their legs, one by one, until at last they are no longer capable of writhing. Sorry about that.
[ii] “Between” two parties; “among” at least three parties.
[iii] Kelly, v. Commissioner, T.C. Memo. 2021-76. https://www.thetaxadviser.com/content/dam/tta/summaries/2021-76-kelly.pdf .
[iv] Although not the case here, how many times have you encountered loans from a corporation to its shareholders in amounts that are proportionate to the shareholders’ respective equity interests? How about the case of a single shareholder of a corporation that has never made a dividend distribution but has a large entry on its balance sheet for loans to shareholder? I wish these were infrequent occurrences.
[v] Of course, there are many factors to be considered in determining the fair market value of a loan: the interest rate, the term of the loan, the frequency of interest and principal payments, whether the loan is secured or guaranteed (and by what or whom), the creditworthiness of the borrower, the economic health of the borrower, etc.
And when the loan is between related persons, always consider what unrelated parties would do under like circumstances.
[vi] IRC Sec. 108. COD is treated as ordinary income. I borrowed $X, had the benefit of its use, then was absolved from repaying it – I have realized an accretion in value and should be taxed thereon. The insolvency exception recognizes that the forgiveness has not improved my position, at least to the extent of my insolvency.
[vii] IRC Sec. 166. No easy feat where related persons are involved.
[viii] Not to be confused with the pseudo-pizza, Dominos. Don’t get me started. I’d be skinny if that were the only choice in town.
[ix] IRC Sec. 1274. Basically, the minimum rate required by the IRS. It is set monthly and is dependent upon the term of the loan, if any, and the frequency of payments.
[x] For obvious reasons, this is often an audit trigger when the loan is between related persons.
[xi] IRC Sec. 6212. The so-called “90-day letter.”
[xii] IRC Sec. 6213.
[xiii] IRC Sec. 301 and Sec. 1368.
[xiv] I will give them credit for that.