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What Was Intended?

Transactions between commonly controlled, closely held businesses are often conducted in an informal manner. This is unfortunate because, in the absence of documentation, it is sometimes difficult to discern the parties’ intent with respect to a transaction. This may be especially troublesome for the businesses and their owners where the transaction purports to create a debtor-creditor relationship.

Ostensible loans in the context of any group of closely held business can easily affect – in fact, may be intended to affect – the economic arrangement among the businesses and their owners. Such arrangements may even generate some unintended tax consequences.

The IRS and the courts have long recognized the potential inherent in any related party transaction for skewing the economic arrangement among the parties. That explains why such transactions are subject to rigid scrutiny, and why they are particularly susceptible to a finding that a transfer was intended as something other than a loan.

It is regrettable, considering the IRS’s position on related party “loans” has been known to tax advisers for decades, that many commonly- controlled businesses and their owners do not appreciate the importance of transacting with each other on terms that resemble their interactions with unrelated persons, as closely as is reasonably possible.[i]

A recent decision by the U.S. Tax Court[ii] – the latest in a line of seemingly countless others on this topic[iii] – provided an exhaustive analysis of the factors that the Court (and the IRS) will consider in determining whether a purported loan between related businesses should be respected as such.

A New Deal

Taxpayer was active in the residential real estate industry. To effectively manage his real estate enterprise, Taxpayer formed many different “independent” but affiliated companies, each of which was owned or controlled, directly or indirectly, by Taxpayer.[iv]

Taxpayer located land that he determined would be marketable and economically profitable for several residential real estate developments. He used the affiliated companies to manage, design, and market the properties, and to obtain financing for each development project.

Taxpayer’s development companies each entered into a marketing, sales, and administrative services agreement with Taxpayer’s separate development services company to provide services for their respective development projects. These agreements gave the development services company the rights to (1) use marketing companies to market and sell undeveloped lots in each of the development projects and (2) use Taxpayer’s administrative services company to provide administrative services for each of the development projects. The development services company’s fees were dependent on the gross proceeds from lot sales.

Purported Loan Transactions

During the period in question, three of Taxpayer’s affiliated companies[v] made what purported to be loans to many of the related entities mentioned above.

The companies that received these “advances” did not (1) complete loan applications for any of the loans they received; (2) have earnings; or (3) pay interest on any of the purported debts.

Despite receiving no interest payments, none of the lending companies made any demands for repayment or issued notices of default for any amounts.

Notice of Deficiency

Taxpayer prepared and filed his federal income tax return[vi] for the year in question. Taxpayer thereafter filed a claim for refund[vii] based upon the carryback of net operating loss deductions from the year in question.

Meanwhile, the IRS informed Taxpayer that his original tax return was being examined.

Ultimately, the IRS determined that Taxpayer had understated his income.

One of the S corporations controlled by Taxpayer filed its federal tax return[viii] for the year in question, on which it claimed bad debt deductions for the loans it purportedly made to many of Taxpayer’s affiliated entities.

All of these deductions flowed through the S corporation to the trusts[ix] that owned the S corporation, and then to Taxpayer’s individual tax return.[x]

In addition, one of the Taxpayer’s controlled partnerships filed its federal tax return[xi] on which it, too, claimed bad debt deductions for amounts purportedly advanced to other Taxpayer affiliates.

The IRS sent Taxpayer a notice of deficiency that disallowed the bad debt deductions claimed and increased his income tax liability for the year in question.[xii]

Taxpayer petitioned the Tax Court for relief.

The issue before the Court was whether the above-mentioned advances to the affiliated companies constituted debt for tax purposes.

The Court explained that tax deductions are a matter of legislative grace, and the taxpayer bears the burden of proving entitlement to any deduction claimed.[xiii] 

As relevant here, this burden required Taxpayer to demonstrate that the loss deductions claimed were allowable under the Code and to substantiate the loss by producing adequate records to enable the IRS to determine Taxpayer’s correct tax liability.[xiv]

Bad Debt

A taxpayer is allowed as a deduction any bona fide business debt which becomes worthless, in whole or in part, within a taxable year.[xv]  

Only a bona fide debt qualifies for this deduction.[xvi]

A business debt is “a debt created or acquired . . . in connection with a trade or business of the taxpayer” or “a debt the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.”[xvii]  

By contrast, a contribution to capital is not considered a “debt”; rather, it is considered equity.[xviii] 

A transfer of funds between affiliated companies is subject to special scrutiny; however, having an affiliate relationship alone does not necessarily mean the transfer lacks economic substance. 

Whether an advance of funds is, in substance, a bona fide business debt is a question of fact to be decided on the basis of all relevant facts and circumstances of each case. 

Thus, to properly claim a business bad debt deduction, the taxpayer must establish that they intended to create a debtor-creditor relationship and that a genuine debt existed. The taxpayer must then show that the debt became wholly or partially worthless during the taxable year. 

Because Taxpayer’s controlled entities advanced funds to affiliated entities, the Court examined the transfers with heightened scrutiny. 

Tests for Evaluating Debt Versus Equity

Taxpayer asserted that all of the advances made to the purported debtors were bona fide business debts. The IRS disagreed.

According to the Court, “We determine whether a purported debt is in substance and fact a debt for tax purposes from the facts and circumstances of each case, with the taxpayer bearing the burden of proof.” 

For a bona fide debt to exist, the Court explained, the parties to a transaction must have had an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced. 

According to the Court, an intent to establish a debtor-creditor relationship exists if the debtor intends to repay the loan and the creditor intends to enforce repayment. The expectation of repayment must not “depend solely on the success of the borrower’s venture”; for that matter, “[a]dvances made by an investor to a closely held or controlled corporation may properly be characterized, not as a bona fide loan, but as a capital contribution.” 

The Factors

The Court then identified at least 13 nonexclusive factors to consider in determining whether advances constitute debt or equity: (1) names given to the certificates evidencing the indebtedness; (2) presence or absence of a fixed maturity date; (3) source of payments; (4) right to enforce payment of principal and interest; (5) participation in management flowing as a result; (6) status of the contribution in relation to regular corporate creditors; (7) intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) ability of the corporation to obtain loans from outside lending institutions; (12) extent to which the advance was used to acquire capital assets; and (13) failure of the debtor to repay on the due date or seek a postponement.[xix]

For purposes of applying these factors to a specific situation, it is important to note that “these guidelines are not rigid rules mandating a particular conclusion when the court finds certain facts.” 

Moreover, no single factor is determinative. Rather, “[t]he substance of all of these multi-factor tests is identical,” and application of the factors is helpful but what is necessary is evaluating the factors selected by the Court to determine the taxpayer’s intent concerning a transaction. 

Names Given

As to the names on the certificates evidencing indebtedness, the Court stated that it accords greater weight to the economic substance of a transaction than to its form. That said, it considered the type of instrument evidencing the advance, with the issuance of a note being indicative of indebtedness. 

Taxpayer’s lending affiliates memorialized their advances by issuing to each recipient a “Future Advance Promissory Note,” “Second Note Modification Agreement,” “Assignment of Future Advance Promissory Note,” or “Promissory Note.” Taxpayer asserted that these instruments indicated bona fide indebtedness. The IRS disagreed because the advances were made among parties that were related to each other and controlled by Taxpayer.

The Court stated that, although evidence of formal debt instruments was indicative of a true debt, a genuine debtor-creditor relationship must be accompanied by “more than the existence of corporate paper encrusted with the appropriate nomenclature captions.” This was especially true in the context of related-party transactions. The Court added that because the lending entities advanced funds to affiliated entities, it would examine the transfers with special scrutiny.

Taxpayer asserted that the advances to the purported debtors were made to fulfill a valid business purpose and so the transfers should stand despite the parties being related to one another.

The IRS countered that the Court should disregard the notes because the purported debtors did not properly obtain the funds. To that point, the recipient entities’ organizing documents restricted the amount of debt that could be incurred and required board approval. The IRS stated that no board resolutions approving the increased debt obligations were entered into evidence.

The Court found these arguments compelling as they indicated a general lack of formalities in executing and fulfilling contractual obligations. The Court observed, however, that this factor only questioned whether formal lending documents were in place – they were. What’s more, the documents had a valid business purpose.

Thus, this factor weighed in favor of debt.

Maturity Date

The Court next considered the presence or absence of a fixed maturity date. Generally, an advance issued with a fixed maturity date is indicative of an obligation to repay, a characteristic that supports a bona fide debt. Conversely, the absence of a fixed maturity date indicates that repayment depends on the borrower’s success, which signifies that the advance is likely equity. Similarly, an advance made with a fixed maturity date that has been postponed for prolonged periods suggests that “the nominal lender does not intend to require repayment and that the transfers are equity.” 

Each note that was issued by Taxpayer’s business entities identified a fixed maturity date between five to nine years after the date of issuance. The maturity dates were applied to original promissory notes and to modified[xx] promissory notes.

This factor, the Court stated, weighed in favor of characterizing the advances as bona fide debt.

Source of Payments

Repayment of an investment based solely on the expectation of corporate earnings or the success of the borrower’s business, the Court observed, was more likely to be characterized as a capital contribution rather than a bona fide debt. 

Taxpayer conceded that each of his development companies agreed to pay the lender companies a percentage of the gross sale price for each lot sold from the real estate development projects.[xxi]

Because repayment of the loans was dependent on lot sales, the Court found that this factor supported characterizing the advances as equity.

Right to Enforce Payment

An advance with a definite obligation to repay a fixed or determinable sum of money provides some indicia of a bona fide debt.  This factor, however, is not an exception to the substance over form doctrine. One must examine “economic reality” for determining whether an advance of funds constitutes a bona fide debt.  And the fact that the lender has an enforceable right to payment but “t[akes] none of the customary steps . . . [to] assure repayment” supports the conclusion that the advances constitute equity. 

The parties conceded that, in form, Taxpayer’s affiliated lenders had an enforceable right to payment. The IRS, however, argued that in substance this was an equity infusion, and the Court agreed.

Although the lenders had the legal right to enforce payment, they never made written demand[xxii] on the purported debtors and never collected interest from any of them. Additionally, the notes did not create realistic creditor safeguards – they did not have a sinking fund from which payments might be made, and the notes were unsecured. 

The Court noted that the purported debtors had little or negative income. They relied solely on projected cashflow to repay the “loans” at issue. Still, knowing this reality and never having received payments of interest or principal, Taxpayer’s lending companies extended the maturity dates on the loans.

The Court acknowledged that the lenders had a contractual right to enforce the payments. And it was clear they advanced funds to affiliated entities. However, the economic reality of the situation was that the advance recipients had no ability to repay the debts.

Therefore, although there was an enforceable right in form, there was not one in substance. This factor weighed in favor of equity.

Participation in Management

If as a result of an advance the lender receives an increase in the business’s management, the advance indicates an equitable contribution rather than a debt.  The parties acknowledged that Taxpayer either wholly or partially owned or managed each of the purported debtors by some direct or indirect interest.

Because Taxpayer already controlled (either directly or indirectly) the purported debtors before the advances were made, there could be no increase by virtue of the advances. This factor, the Court stated, weighed in favor of debt.

Status vis-à-vis Regular Corporate Creditors

An advance made to a purported debtor that expressly or implicitly becomes subordinate or inferior to the claims of other creditors may be characterized as equity rather than debt. Nevertheless, subordination does not necessarily indicate equity when an advance is given priority over the claims of shareholders. 

The parties agreed that none of the lenders subordinated their priority of payment on the general advances made to the purported debtors. But two development companies took on secured debt from unrelated persons to fund capital acquisitions. This secured debt took greater priority over the unsecured advances by the affiliated lenders.

The other purported debtors did not have secured debt. And the record did not provide any persuasive evidence on the order of priority of the debts of the lenders versus those of other creditors, if there were any. In such a case, the Court looked to whether the purported creditor received a share of the proceeds from a sale for which the advance was made.

The lenders in this case were entitled to a percentage of the purported debtors’ sales. Thus, they would have had priority over other creditors with that entitlement.

On the basis of these conflicting points, the Court found that this factor weighed “neutral towards the analysis.”

Intent of the Parties

The intent of the parties to create a bona fide debt had to be examined objectively, the Court stated.  “We must look beyond the parties’ self-serving declarations and, instead, analyze whether they had a reasonable expectation of repayment, whether their intentions comported with the economic reality of the debtor-creditor relationship, and how they treated the relevant documents and agreements.” 

Taxpayer contended that he intended at all times for the funds advanced to be bona fide loans. The IRS disagreed and asserted that Taxpayer’s business purpose was to infuse capital into recipient companies and then redistribute those funds to himself and his related business entities as equity.

The Court conceded that objective facts in the record suggested that the purported loans complied with the formal indicia of bona fide debt: each advance was documented by a promissory note or future advance promissory note and required interest to be paid on a stated maturity date. Additionally, each advance was recorded on unaudited balance sheets, amortization schedules, general ledgers, and federal income tax returns as either a “loan,” “loan receivable,” or “commission receivable.”

Moreover, each purported debtor reported cancellation of indebtedness income on their federal income tax returns,[xxiii] and two of the affiliated lenders received repayments of principal.

The IRS countered that other objective facts suggested the parties did not intend for the advances to be bona fide debts. For example, although some of the purported debtors made principal payments, there was no consistency across the group. Several of the companies made only nominal principal repayments. Others did not make any principal payments. This failure, the IRS asserted was consistent with the purported debtors’ financial status – they had no ability to repay the advances – and their relation to the lender-companies.

The Court rejected Taxpayer’s contentions, stating that formalities (promissory notes and bookkeeping entries) should be given minimal consideration in related-party transactions.[xxiv] 

On the basis of the foregoing, according to the Court, it was apparent that the advances were documented to appear to be bona fide debts. The facts, however, indicated that there was no real expectation of repayment. This was evidenced by the complete lack of interest payments and inconsistent repayment of the principal.

Moreover, some of the purported debtor companies continued to receive advances even after Taxpayer had claimed the bad debt deductions at issue.

All of these facts were amplified by the fact that all of the parties – lenders and borrowers– were related entities created by Taxpayer.

Taking all of that into account, the Court concluded that the true intention was to create equity positions in the recipient companies, which weighed in favor of equity.

Thin or Adequate Capitalization

An advance made to a purported debtor that has thin capitalization is “very strong evidence of a capital contribution,” and not bona fide debt. For this factor, the Court examined whether the purported debtors’ initial debt-to-equity ratios were high and whether they realized it might increase.[xxv] 

To determine whether a purported debtor was thinly capitalized, the Court considered the fair market value of the debtor’s liabilities and assets, including its intangible assets, to ascertain its debt-to-equity ratio. Although “there is no magic debt-equity ratio which is appropriate for all corporations in all circumstances,”  the Court recalled that one Circuit Court had previously suggested that a debt-to-equity ratio in excess of 5 to 1 was considered “high” and may result in finding inadequate capitalization. 

The IRS argued that 12 of the 15 purported debtors’ debt-to-equity ratios exceeded the 5 to 1 benchmark and 6 of them had a “negative equity” position when they received the funds. The IRS also cited Taxpayer’s testimony, where he indicated that this result was obtained intentionally – his goal was to limit liability, and he did that by creating many different legal entities which held few assets that judgment creditors could go after.

Taxpayer argued that the purported debtors were well capitalized, claiming that the above debt-to-equity ratios were inaccurate because they do not take into account the companies’ significant intangible assets and their expectation of near-term growth in the real estate industry. His argument relied significantly on intangible assets such as Taxpayer’s (1) business reputation; (2) “exclusive sales and administrative contracts for resort residential developments”; (3) a “well-trained workforce”; (4) a valuable client database; (5) development plans; and (6) the ability to quickly “pre-sell . . . high-value development real estate . . . that [was] expected to generate sufficient cashflow.”

The Court responded that “intangible assets such as those claimed for [Taxpayer] have no place in assessing debt-equity ratio unless it can be shown by convincing evidence that the intangible asset has a direct and primary relationship to the well-being of the corporation.”  It added that “it seems clear . . . that the assets sought to be valued must be something more than management skills and normal business contacts,” which “are expected of management in the direction of any corporation.” 

Moreover, while the sales contracts, client database, and development plans would have a “direct and primary relationship to the well-being” of the purported debtors, the Court found that no evidence of such “off-balance-sheet assets” had been provided and, therefore, could be included in any debt-to-equity analysis.

For that reason, the Court found that the purported debtors were thinly capitalized when they received the advances, a fact that favored equity.[xxvi]

Identity of Interest

An advance made by a creditor who is also a stockholder is examined with closer scrutiny.  An inference of equity rather than debt arises when the amount advanced by the stockholder aligns pro rata with the stockholder’s ownership interest.  In contrast, “[a] sharply disproportionate ratio between a stockholder’s percentage interest in stock and debt is, however, strongly indicative that the debt is bona fide.” 

Taxpayer argued that there was no identity of interests because none of the lending entities ever held an ownership interest in any of the purported debtors.

The IRC countered that may be, but Taxpayer or a member of his family owned 14 of the 15 recipient companies by way of the trusts mentioned above. This constructive identity of interests was sufficient to make this factor weigh in favor of equity, because the interests between the borrower and lender were “significantly intertwined,” such that the creditors would not enforce payment, a factor which favored equity. 

The Court agreed that the trusts were set up for the benefit of Taxpayer and his family, that the trusts wholly owned the lenders in question and also wholly owned most of the purported borrowers. Therefore, Taxpayer was on both sides of the purported lending transactions, albeit indirectly. Consequently, the Court found that tis factor favored equity.

Source of Interest Payments

“[A] true lender is concerned with interest,” and an advance made with an interest rate suggests an intent to create a bona fide debt.  Generally, unless the purported debtor provides a reasonable explanation for the lack of interest payments, the absence of interest payments indicates that the purported creditor is not expecting interest income and, instead, is more interested in future earnings, a characteristic of equity. 

The parties agreed that no interest payments were made by any of the purported debtors. Taxpayer asserted that this factor nonetheless supported a debt finding because (1) each advance was issued with accruing interest due at maturity, (2) Taxpayer expected the interest to be paid, and (3) he had a reasonable business explanation for the lack of enforcement: It allowed for “vital cashflow flexibility.”

The Court was not convinced. Although the advances may have intentionally been structured with the objective of allowing the purported debtors increased cashflow, it was not apparent that they were “seriously expecting any substantial interest income” since none was ever collected.  Instead, it appeared that the future earnings of the purported debtors were of utmost importance. This factor weighed in favor of equity.

Ability to Obtain Loans from Outside Lenders

Debt characterization is supported when the advance at issue could have been obtained with substantially similar terms from an unrelated outside lending institution.[xxvii] 

Taxpayer argued that the purported debtors could have obtained similar terms from private lenders when the loans were made because they had significant assets and projected revenue.

The IRS argued that the terms of the purported loans were not commercially acceptable and that unrelated lenders would not have issued loans with similar terms without personal guaranties, collateral, or higher interest rates. The IRS also asserted that the economic reality of the purported debtors’ financial status – i.e., their being undercapitalized and insolvent – would have inhibited an outside lender from issuing similarly termed advances to the purported debtors.[xxviii]

In addition, Taxpayer’s expert witness conceded that most of the purported debtors had credit ratings of below CCC, meaning they were credit risks when the advances were made. Since the purported lenders had full access to the debtors’ financials, they must have disregarded these risks, indicating that the advances were not true debts. 

The Court found it very difficult to believe an unaffiliated lender would have advanced funds to the purported borrowers on similar terms. Thus, this factor favored equity.

Used to Acquire Capital Assets

The Court explained that an advance of funds used to meet the cost of daily operational needs, rather than to purchase capital assets, is indicative of bona fide indebtedness.  Conversely, it continued, “[u]se of an advance by an ongoing business to expand its operations, e.g., by acquiring an existing business,” suggested an equitable contribution. 

While the Court agreed with Taxpayer that some of the advances were used to meet the costs of daily operations, it also acknowledged that others were used to purchase capital assets, such as real property. Thus, this factor was neutral at best.

Failure to Repay or Seek Postponement

A debtor’s failure to repay on the due date, or to seek a postponement, the Court stated, was arguably the most significant factor in the debt-equity analysis. 

In the present case, each of the purported loans included a due date at least four years after the year in question, and the purported debtors were not obligated to make repayments before such maturity date. Because Taxpayer and his affiliated lenders had already written the debts off as worthless, the purported debtors technically did not fail to repay the advances by the due date. For that reason, Taxpayer argue that this factor weighed in favor of debt.[xxix]

The Court responded held that it was “premature to rely on this factor as tending to demonstrate either the equity or the debtlike features of the advance agreements” where the debts had not yet matured. 

Accordingly, this factor was neutral.

Court’s Conclusion

Of the 13 factors described above, 7 favored equity, 3 favored debt, and 3 were neutral. After weighing the above factors in the context of the specific facts and circumstances – not merely counting them off – the Court concluded that the advances in question did not constitute debt and, therefore, were not deductible as bad debt expenses.

No surprises here but plenty of lessons and cautionary advice that should be heeded by the owners of closely held businesses, especially those who too often treat legally separate entities as one big wallet. These folks ignore the economic reality of their arrangements and, consequently, experience unfavorable tax outcomes.

The key, as always, is to consider what unrelated persons would do under the circumstances and to act consistently with what the transaction purports to be.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Indeed, many such businesses “report” such transactions as “other assets” or “other liabilities” on the balance sheet schedules filed with their tax returns. Notwithstanding that these lines ask that an explanatory statement be attached to the return, it is rare to find one that is informative.

[ii] Allen v. Commissioner, T.C. Memo 2023-86 (July 11, 2023).

[iii] I have heard it said that repetition is the mother of all learning. I have also been told that the definition of insanity is doing the same thing over and over and expecting different results.

[iv] These companies were owned by various trusts created by Taxpayer. He served as trustee of some of these trusts.  In some cases, the trusts wholly owned or controlled various management corporations, limited partnerships, or LLCs of which Taxpayer was the president or manager.

At all relevant times, the primary beneficiaries of these trusts were Taxpayer, his spouse, and/or his issue.

[v] One of which, a partnership for tax purposes, was formed to make loans to businesses involved in the residential real estate industry.

[vi] On Form 1040, U.S. Individual Income Tax Return

[vii] On Form 1045, Application for Tentative Refund.

[viii] On Form 1120S, U.S. Income Tax Return for an S Corporation.

[ix] Although not identified as such in the opinion, the trusts must have been grantor trusts as to Taxpayer. IRC Sec. 671.   

[x] IRC Sec. 1366.

[xi] On Form 1065, U.S. Return of Partnership Income.

[xii] The notice of deficiency also determined he was liable for accuracy-related penalties for substantial understatements of income tax under IRC Sec. 6662(a). 

[xiii] Generally, the IRS’s determinations set forth in a notice of deficiency are presumed correct and the taxpayer bears the burden of proving otherwise. Tax Court Rule 142(a).

[xiv] IRC Sec. 6001.

[xv] IRC Sec. 166(a); Reg. Sec. 1.166(a)-1.

This deduction does not, however, apply to a nonbusiness debt held by a taxpayer other than a corporation; instead, the taxpayer is allowed a short-term capital loss deduction for the taxable year in which the debt becomes worthless. IRC Sec. 166(d)(1), 1211(b); Reg. Sec. 1.166-5(a)(2).

[xvi] IRC Sec. 166; Reg. Sec. 1.166-1(c).

[xvii] IRC Sec. 166(d)(2). It was undisputed that Taxpayer ’s companies were engaged in a trade or business.

[xviii] Reg. Sec. 1.166-1(c).

[xix] Other factors that are often considered by the courts are the following: schedule of payments; the presence or absence of a fixed rate of interest and interest payments; the adequacy or inadequacy of capitalization; the identity of interest between the creditor and the stockholder;  the security, if any, for the advances; the extent to which the advances were subordinated to the claims of outside creditors; the extent to which the advances were used to acquire capital assets; and the presence or absence of a sinking fund to provide repayments. 

[xx] The modifications were made to increase the likelihood of repayment, or so the Taxpayer contended.

[xxi] Taxpayer confirmed that repayment of the purported loans was dependent on lot sales, which he identified as “cash flow or revenue.”  Still, Taxpayer argued that this factor weighed in his favor because repayment was not “legally contingent” on the purported debtor’s success.

[xxii] The Court stated that any formal demand for payment was not determinative to the Court’s analysis where the purported lender and creditor were commonly controlled.

[xxiii] IRC Sec. 61(a)(12) and Sec. 108(a).

[xxiv] The better position is that such factors represent conforming to mere form, not substance. However, where other factors point toward debt status, the presence of such formalities may be determinative. Ask yourself, what would be done in an arm’s length transaction?

[xxv] The Court also considered whether substantial portions of the advances were used to purchase capital assets or cover expenses needed to commence operations. 

[xxvi] The Court also observed that a larger portion of the advances went to the purchase of capital assets than they did to commence operations. 

[xxvii] “[T]he touchstone of economic reality is whether an outside lender would have made the payments in the same form and on the same terms.”

[xxviii] This would have been especially true for any lender, like Taxpayer, who had full access to the purported debtors’ financials at the time of the advances.

[xxix] I have to admit, Taxpayer came up with some creative arguments.