Related Party Loans
If you’ve been around closely held businesses long enough, you know that a transfer of money between a business and its owner, or between two related businesses, is sometimes characterized by the parties as a loan (“related party loans”).
However, in order for such a transaction to be respected as a bona fide loan for purposes of the income tax, it will not suffice for the related putative borrower and lender to merely label the transfer of value between them as an obligation to be repaid.[i]
The parties’ stated intention must also be manifested in their actions. For example, in the case of a related party loan between two businesses, the purported indebtedness should: be properly authorized by each business; not violate any financial covenants to which either business is a party; be evidenced by a written agreement that sets forth a maturity date, an appropriate rate of interest, and a schedule for the payment thereof; identify the collateral securing the debt; spell out the lender’s rights on default by the borrower; be reported as debt by the parties for tax and other purposes.[ii]
In addition, the related parties must act consistently with the terms of the loan agreement. This may be the most difficult challenge, say, for a lender that is faced with a defaulting borrower to which the lender is related. Specifically, will the lender exercise its remedies under the agreement, and the law, to protect its investment in the borrower?[iii] Or will the lender effectively “waive” its enforcement rights, thereby casting doubt on the bona fide nature of the purported loan?[iv]
Does It Matter?
An ostensible related party loan may affect – in fact, may be intended to affect – the economic arrangement between the parties to the transaction by allowing them to “manipulate” the tax consequences.[v]
The IRS and the courts have long recognized this truth, which explains why related party loans are subject to great scrutiny and are susceptible to a finding that: (i) the transfer of funds was intended from the outset as something other than a loan or, (ii) having started out as a true loan, the relationship between the parties evolved into something else.
When taxing authorities refuse to respect a related party “loan” as such, the recharacterization of the transaction may generate some unexpected income tax consequences.[vi]
A recent decision by the Ninth Circuit considered a history of purported loans between closely held business entities in which individual Taxpayer owned a substantial interest. The issue before the Court was whether the transfers of funds between the entities were bona fide loans and, if they were, was the Lender entity entitled to bad debt deductions upon the cancelation of such loans.[vii]
Taxpayer’s Business
Taxpayer owned Lender, which was flush with cash.
Taxpayer organized the Borrower entity for the purpose of investing in various business ventures, for which Lender would provide the initial capital.
Over the course of several years, Lender transferred millions of dollars to Borrower, in exchange for which Borrower issued interest-bearing notes. Lender recorded these transfers as loans on its books.
Borrower invested these loan proceeds – together with substantial amounts borrowed from unrelated lenders – in several different businesses.
Write-Offs
Unfortunately for Taxpayer, the businesses in which Borrower invested did not do well. Consequently, Taxpayer had difficulty paying creditors, especially with the onset of the 2008 financial crisis.
Despite the fact that Taxpayer’s businesses were struggling and did not provide a reasonable prospect of repaying the loans from Lender, Taxpayer continued advancing funds from Lender to Borrower.
To avoid declaring bankruptcy, and to continue servicing the loans from the unrelated creditors, Taxpayer reduced the debt owed between the related companies, including Borrower’s obligations to Lender. In some cases, the debt was written off; in others, it was distributed as a dividend.
The Year At Issue
In 2010, Taxpayer wrote off millions of dollars of debt owing from Borrower to Lender, all of which Taxpayer reported on his individual income tax return as short-term capital losses from the write-off of bad debts.[viii]
On the same tax return, Taxpayer also reported income from the cancellation-of-debt (“COD”) owing from Borrower to Lender.[ix]
Audit
The IRS audited Taxpayer’s personal federal income tax return for 2010.
Following its examination, the agency disallowed the “bad debt” deduction that Taxpayer claimed on the basis of Lender’s cancelation of the purported loans to Borrower.
As a result of this adjustment, a notice of deficiency was issued to Taxpayer which reflected a substantial underpayment of income tax. Taxpayer petitioned the U.S. Tax Court to challenge the asserted income tax deficiency.[x]
Tax Court
Following a trial and post-trial briefing, the Tax Court rejected Taxpayer’s theory that a bad-debt deduction arises for a creditor when the creditor cancels a debt owed to them by a debtor, and the cancelation gives rise to COD income in the debtor.
The Tax Court first considered whether the series of transfers from Lender to Borrower were bona fide loans, as maintained by Taxpayer, or should be reclassified as taxable distributions. According to the IRS, an intent to establish a debtor-creditor relationship exists if, when the transfers were made, the debtor intended to repay the funds, and the creditor intended to enforce repayment.
Next, the Tax Court outlined the objective factors to be considered when determining whether a bona fide debtor-creditor relationship exists: (1) whether the promise to repay is evidenced by a note or other instrument that evidences 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.
According to the Tax Court, by the time of the financial crisis Taxpayer no longer had a reasonable prospect of repaying the “loans.”
Still, Taxpayer argued there were other factors that supported the characterization of the transfers as true loans. Taxpayer explained that the amounts transferred were supported by the accrual of interest and by the formal documentation of the transfers as loans.[xi]
The Tax Court found this argument may have been reasonable through 2007, but it lost credibility after 2007 when Taxpayer was well aware the downturn in the economy was having an adverse effect on his businesses but continued to have funds transferred from Lender with less and less expectation of repayment.
The respect for loan formalities also waned, the Tax Court continued, as the recession made repayment all but impossible beginning in 2008. Taxpayer’s companies followed a practice of careful accounting of loans with some repayments through 2007, but respect for the loan characterization and repayments gradually disappear after 2007.
Accordingly, the Tax Court held that all of Lender’s transfers and other intercompany transfers were not properly characterized as loans beginning on January 1, 2008.
The Tax Court noted that this holding affected the IRS’s position on whether the transfers were capital distributions or dividends and, alternatively, whether Taxpayer had COD income for 2010. The Tax Court concluded that the transfers beginning on January 1, 2008 were shareholder distributions.[xii]
Taxpayer disagreed with the Tax Court’s conclusion that the post-2007 transfers were not loans and with its determination on the worthlessness of Borrower’s loans at the time of their cancellation, and filed a notice of appeal to the Ninth Circuit Court of Appeals.[xiii]
Ninth Circuit
The Circuit focused on the short-term capital loss that Taxpayer claimed based upon the “bad debt write off,” noting Taxpayer’s rationale that a cancelled debt automatically became worthless, thus creating COD income for the debtor and a simultaneous bad-debt deduction for the creditor.
The Circuit began by summarizing the Tax Court’s findings that Lender’s transfers to Borrower in and after 2008 were not bona fide loans and, if they had been, Taxpayer failed to establish the debts were worthless in 2010; therefore, they could not be deducted as bad debts.
To claim a nonbusiness bad-debt deduction,[xiv] the Circuit explained, a taxpayer must establish: (1) the debt is bona fide,[xv] (2) the taxpayer has an adjusted-tax basis in the debt sufficient to claim the deduction;[xvi] and (3) the debt became “wholly worthless within the taxable year.”[xvii]
The taxpayer has the burden to show worthlessness by “establish[ing] sufficient objective facts,” the Circuit stated. A “mere belief of worthlessness is insufficient.”
“Cancelled Debt” = “Worthless Debt”?
It was Taxpayer’s position, the Circuit continued, that the Tax Court had erred by not construing “worthless” debt the same as “discharged” debt.[xviii]
Under Taxpayer’s theory, the Circuit stated, a cancelled debt becomes “undeniably worthless and beyond any hope of recovery.” Thus, Taxpayer argued, by acknowledging Borrower’s realization of COD income, the Tax Court should have acknowledged a reciprocal worthless-debt deduction as a matter of law.
The Tax Court had rejected this argument, stating that Taxpayer “cannot create a deduction by recording intercompany debt and then canceling it,” and the Circuit agreed.[xix]
To determine the meaning of a statute, the Circuit explained, one has to begin with its plain text and then consider its structure, object, and policy. Where a statutory term is undefined, the Circuit continued, it must be interpreted “pursuant to its ordinary meaning.”
According to the Circuit Court, the terms “worthless” and “discharge,” as used in the Code, were not “mere synonyms,” as Taxpayer contended. Something was “worthless,” the Cicuit stated, if it lacked value or utility, while a debt was “discharged” if the obligor was released from its obligation to repay it.
Although a debt obligation might lack value at the time of discharge, determining lack of value requires an examination of the objective facts. The discharge of debt does not, as a matter of law, eliminate the debt’s prior “objective value” and render it worthless. The Circuit explained that, “without objective evidence demonstrating worthlessness, any monetary transfer could be categorized as a loan and later cancelled to produce an illegitimate tax benefit to the putative creditor,” especially where the parties are not dealing at arm’s-length and the creditor stands to benefit from the cancellation. Congress enacted an objective test of actual worthlessness to subvert this risk, the Circuit stated.
Consequently, the realization of COD income by the debtor arising from debt discharge does not presumptively render the discharged debt worthless to the creditor.
The Circuit stated that, on their face, the Code provisions that address COD income have no relation to the worthless debt provision and the determination of worthlessness. It explained that both sets of rules adopt the “freeing-of-assets” theory, whereby discharged debt creates a potential gain, or accretion in value – depending on the taxpayer’s solvency – which has “neither a relation to worthlessness nor any reciprocal effect on the creditor.” In contrast, the Circuit observed, the worthless-debt deduction is closer to a “casualty loss.”[xx]
The Tax Court acted properly by requiring Taxpayer to prove the worthlessness of the discharged debts and not presuming worthlessness because COD income arose from that discharge.
Nor did the Tax Court commit clear error when it determined that Taxpayer’s debt was not worthless and that Taxpayer failed to show otherwise. According to the Circuit, worthlessness was not determined by comparing the face value of the debt to the debtor’s assets; rather, “the relevant benchmark is ‘zero.’” If any debt is recoverable – even a “modest fraction” – it is not worthless, the Circuit stated.
The evidence before the Tax Court supported the conclusion that the dets in question were not wholly worthless and some part of the debt was recoverable. Moreover, Taxpayer failed to show the debts were uncollectible; for example, by demonstrating that any legal action to collect would have been entirely unsuccessful.[xxi] Taxpayer’s subjective determination that the loans became wholly worthless by December 31, 2010 was not enough to sustain the deduction claimed; mere belief of worthlessness, the Circuit reiterated, was insufficient.
Based on the foregoing, the Circuit concluded the Tax Court did not err by requiring Taxpayer to prove the worthlessness of the discharged debts and declining to presume worthlessness because COD income arose from that discharge.
Economic Reality
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.
The factors identified by the Courts, above, provide helpful guidance for structuring and documenting a loan between related persons, including related businesses. 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. As illustrated by Taxpayer’s experience, described above, this will include an objective determination of worthlessness if the creditor party hopes to support a bad debt deduction.
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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] Loans from a business to an owner should almost always be viewed with some skepticism, especially in the absence of an obvious business purpose.
[ii] It should be noted that, while business entity tax returns include lines for reporting loans between the owners and the entity, there is no line on such return for loans between related entities. .” Instead, such intercompany loans are usually found in the balance sheet line for “Other assets,” which directs the taxpayer to attach a statement in which the taxpayer must, presumably, identify the asset. However, because the return instructions do not provide any guidance on this point, many taxpayers will provide the barest description of the loan; for example, “loan to affiliate,” without identifying the borrower or the nature of the relationship.
In that regard, the returns of any related entities may be helpful – there should be a corresponding entry reported thereon.
In addition, the IRS has, over the years, added schedules to the basic business tax return forms that require the identification of certain related persons.
[iii] Basically, what would an unrelated lender do under comparable circumstances?
[iv] It would almost certainly expose the loan agreement to the charge of window-dressing.
[v] How many times have you encountered the following scenario: you find a record of funds having been transferred between two related taxpayers but the character of the transfer is not apparent; you ask the client or their adviser about it; their response: what would you like it to be, or which treatment will give us the best tax result?
[vi] For example, what was treated as a non-taxable receipt of loan proceeds by the borrower, and as a nondeductible payment by the lender, may, instead, be recharacterized as something else.
[vii] Michael R. Kelly v. Comm’r, T.C. Memo 2021-76, aff’d 2025 WL 1584985 (9th Cir. 2025), No. 23-70040.
[viii] The debts were treated as nonbusiness debts under IRC Sec. 166(d). A bad debt deduction may be claimed with respect to such a debt only if the debt is wholly worthless. See also Rev. Rul. 93-36 regarding a nonbusiness bad debt held by an S corporation.
[ix] IRC Sec. 61(a)(11). Taxpayer excluded the COD from gross income on the basis of Borrower’s or his own insolvency. IRC Sec. 108(a)(1)(B). The Tax Court determined that Taxpayer had not established that Borrower was insolvent, such that its COD income would not flow through to Taxpayer; and although Taxpayer was insolvent at the end of 2010, the COD income from Borrower could not be excluded from his income. IRC Sec. 108(d)(7).
[x] IRC Sec. 6212, Sec. 6213; Tax Court Rule 34.
[xi] Taxpayer also maintained that the repayment was derailed only by the downturn in the economy that adversely affected his investments and the profit potential of his numerous transactions.
[xii] Under IRC Sec. 301 and Sec. 1368.
[xiii] IRC Sec. 7482, Sec. 7483; Tax Court Rules 190 and 191.
[xiv] Under IRC Sec. 166.
[xv] Reg. Sec. 1.166-1(c).
[xvi] IRC Sec. 166(b).
[xvii] Reg. Sec. 1.166-5(a)(2).
[xviii] “Worthless” within the meaning of IRC Sec. 166, and “discharged” within the meaning of IRC Sec. 61(a)(11).
[xix] The Circuit stated that the Tax Court had properly construed the relevant sections of the Code to reject Taxpayer’s argument. IRC Sec. 61(a)(11), Sec. 108, and Sec. 166.
[xx] “Allowing a discharging creditor to claim a worthless-debt deduction would be like allowing an insurance payout to someone who intentionally burned down his own house.”
[xxi] This comported with the Tax Court’s finding that Taxpayer failed to prove Borrower was insolvent, which finding Taxpayer did not dispute on appeal.