The Tax Court concluded that a taxpayer was required to pay taxes and interest on income resulting from the disallowance of more than $10 million in equity investments erroneously deducted on his return. In also upholding an accuracy-related penalty, the court held that the taxpayer should have known the deductions were ineligible, based on his professional experience.
Facts: John Sensenig, a licensed public accountant who at one time had owned an accounting practice and prepared hundreds of personal and business tax returns annually, was the sole shareholder and president of Conestoga Log Cabins Leasing Inc. (CLCL), an S corporation that manufactured and provided financing to buyers of log cabin home kits. CLCL provided high-risk capital to companies including several developing innovative building materials or production processes in which Sensenig or CLCL held an equity interest. No loan documents were created for the advances, no due-diligence analysis of borrowers was undertaken, and Sensenig did not seek repayment of the debt. To raise capital for investment, Sensenig solicited funds from individuals in return for demand notes payable by him or CLCL that bore interest but had no maturity date.
A bad-debt deduction was claimed on CLCL's Form 1120S, U.S. Income Tax Return for an S Corporation, for 2005. The tax return did not identify the source of the deduction, but during an IRS examination and in his Tax Court petition, Sensenig identified three companies CLCL had invested in.
Meanwhile, the Pennsylvania Securities Commission (PSC) investigated Sensenig for issuing unregulated securities and issued a cease-and-desist order that shut down his receipt of investors' funds in 2005.
Sensenig maintained that he lacked additional funds to keep the companies going, and the alleged loans to them thus became worthless. However, CLCL continued loaning the companies money after 2005 and did not make any repayment demand or hold them in default.
Issues: A taxpayer is entitled under Sec. 166(a)(1) to a deduction for any bona fide debt that becomes worthless within the tax year. For the bad debt to be deducted, a taxpayer must show that (1) the advances made were in fact debt (not equity); (2) the debt became worthless in the tax year in which a deduction is claimed; and (3) the debt was incurred not as an investment but in connection with a trade or business.
A bona fide debt arises from a "debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money" (Kean, 91 T.C. 575, 594 (1988); Regs. Sec. 1.166-1(c)). A capital contribution, by definition, is not a debt for purposes of Sec. 166.
Holding: The Tax Court denied the bad-debt deduction and assessed an accuracy-related penalty under Sec. 6662.
Sec. 385 addresses the classification of an interest in a corporation as either debt or equity. (The IRS promulgated final regulations under Sec. 385 in October 2016, but those regulations did not apply to the tax years at issue in this case.) Sec. 385(b) provides five factors for determining whether a debtor-creditor or a corporation-shareholder relationship exists, the first of which is "a written unconditional promise to pay on demand or on a specified date a sum certain in money in return for an adequate consideration in money or money's worth, and to pay a fixed rate of interest." In Fin Hay Realty Co., 398 F.2d 694, 696 (3d Cir. 1968), the Third Circuit enumerated 16 criteria to determine the true nature of an investment. The Tax Court noted that no single criterion or group of criteria can provide a conclusive answer and that the factors in Fin Hay fall into three categories: (1) the intent of the parties, (2) the form of the instrument, and (3) the objective economic reality of the transaction as it relates to risks taken by investors.
The Tax Court found that Sensenig's investment had little or no form, noting a lack of written evidence demonstrating a valid and enforceable obligation to repay on the part of any of the companies. As for the parties' intent, the court noted that other than Sensenig's testimony of an understanding that the parties would account for the advances as loans, there were only a few journal entries by CLCL offered as corroboration. Consequently, no loans were documented, the court concluded. Economic reality of loans was likewise tenuous, the court said, since any reasonable expectation of repayment was remote at best.
Regarding the debt being worthless in 2005, Sensenig claimed that after the PSC issued a cease-and-desist order for selling unregistered securities, the resulting halt in investment flow caused the alleged debts to be worthless. The court accepted that the 2005 cease-and-desist order was a major harmful event for CLCL and the companies in which it invested but held that Sensenig had failed to demonstrate whether and when that event caused worthlessness.
Having concluded that Sensenig failed to prove that the advances were bona fide loans rather than contributions to capital or equity investments, and even if they were loans, they did not become worthless in 2005, the Tax Court sustained the IRS's disallowance of the bad-debt deductions. It also upheld the imposition of the accuracy-related penalty under Sec. 6662, pointing to Sensenig's failure to claim reliance upon the CPA who prepared his 2005 return and his own professional experience in accounting and tax return preparation.
- Sensenig, T.C. Memo. 2017-1
—By Maria M. Pirrone, CPA, LL.M., assistant professor of taxation, St. John's University, New York City.
