Loan Loss Held Not Personal

The Tax Court ruled that a taxpayer’s loan to a business associate was made in connection with the taxpayer’s trade or business, and therefore, the forgiveness of that loan was a bad-debt loss under IRC § 166(a). The IRS had argued that the loan was personal and therefore subject to the limitations of section 1211.

During the years relevant to the case, Todd Dagres was a member manager of several limited liability companies that managed venture capital funds. At the same time, he was a salaried employee of Battery Management Co. (BMC), an S corporation that provided management services to the LLCs. Dagres’ responsibilities as member manager included finding and researching investment opportunities for the venture capital funds.

Prior to this, Dagres had worked as an analyst for a San Francisco investment bank, focusing on the computer networking industry. In the mid-1990s, Dagres met William L. Schrader, whom Dagres considered a pioneer in the development of the Internet. Schrader’s company, PSINet, provided Internet connectivity to commercial customers, and Dagres served as the lead investment banker for its initial public offering in 1995 and 1996. Schrader’s contacts within the burgeoning Internet put him in a prime position to provide Dagres with leads on promising companies for Dagres to investigate as potential investments for the venture capital funds.

When the Internet stock bubble burst in 2000, PSINet’s share price fell by more than 85%, while the stock of many of the company’s customers also plummeted, further eroding Schrader’s financial position. Schrader’s personal holdings of PSINet stock were pledged as collateral for loans, and his bankers began demanding additional security or repayment. After exhausting his personal funds and money he could obtain from family and friends, Schrader asked Dagres to lend him $5 million.

Dagres did so, with an unsecured demand note at 8% interest, in late 2000. In return, Schrader would tell Dagres about new companies that might provide Dagres, as member manager of the various capital venture funds, opportunities to profit from Schrader’s industry knowledge and contacts. Schrader repaid $800,000 in 2002. As Schrader’s financial position grew worse, Dagres forgave the original loan in exchange for a new, nondemand promissory note for $4 million with 1.84% interest.

Schrader made interest payments totaling $30,000 in 2003 but then notified Dagres that he would not be able to make any further payments. In a settlement agreement, Dagres accepted $364,782 in securities from Schrader and forgave the balance of the $4 million loan. On Schedule C of his 2003 individual tax return, Dagres claimed a business bad-debt loss of $3,635,218, the difference between the $4 million loan balance and the securities received. The IRS disallowed the loss, claiming it was a personal loan, not made in conjunction with a trade or business. The IRS calculated a tax deficiency of $981,980 and an accuracy-related penalty of $196,396.

The Tax Court found that Dagres was in the trade or business of working as an employee of BMC, but he was also a member manager of the venture capital LLCs, each of which was in the trade or business of managing venture capital funds. The venture capital business was attributable to Dagres, and the dominant motivation for making the loan to Schrader was to gain preferential access to companies in which the venture capital funds might invest. Since the loan was proximately related to his venture capital management activities, its forgiveness constituted a business bad-debt loss. Because the loss offset all his income, there was no understatement of tax and hence no accuracy-related penalty, the court said.

By Alice A. Upshaw, CPA, MPA, instructor of accounting, and Darlene Pulliam, CPA, Ph.D., Regents Professor and McCray Professor of Business, both of the College of Business, West Texas A&M University, Canyon, Texas.

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