The Tax Court held that a taxpayer properly took a deduction for a business bad debt. According to the court, the taxpayer was engaged in the business of lending money and correctly wrote off a bona fide loan related to that business that had become worthless during the year it was deducted.
Facts: William Owens was president and majority owner of Owens Financial Group Inc. (OFG), a lending company that specialized in providing short-term financing to companies while they attempted to obtain long-term financing from other sources. Owens also loaned money from his personal assets, including his personal trust, to borrowers that were too risky for OFG and from 1999 to 2013 made at least 89 loans. He conducted his personal lending from his OFG office and used OFG staff to document and service those loans.
From 2003 to 2008, Owens personally loaned Lohrey Investments, a financially distressed laundry business, over $16 million. In 2005, after Lohrey Investments fell behind in its payments, Owens entered into an operating agreement under which his personal trust was given a share of Lohrey Investments' profits, losses, and capital. Also in 2005, when Lohrey Investments needed more capital, Owens agreed to subordinate his debt to Vestin Mortgage Inc. Lohrey Investments filed for bankruptcy in 2008, and after the bankruptcy case was closed in 2012, Owens received nothing. David Lohrey, Lohrey Investments' owner, who had personally guaranteed the company's loans, also filed for bankruptcy in 2009, and Owens received nothing when this bankruptcy case was closed, as well.
On his 2008 federal income tax return, Owens claimed a business bad debt deduction of $9.5 million, creating a net operating loss (NOL) for 2008 that he used as a carryback deduction for 2003, 2004, and 2005 and a carry-forward deduction for 2009 and 2010. The IRS assessed deficiencies totaling over $3 million after it disallowed the 2008 deduction and the related NOL carrybacks and carryforwards. Owens petitioned the Tax Court for relief.
Issues: A taxpayer may take a deduction for the write-off of a business bad debt if (1) the debt was created in connection with the taxpayer's trade or business; (2) a bona fide creditor-debtor relationship existed; and (3) the debt became worthless in the year the deduction was claimed. Those three requirements are determined by the facts and circumstances of each situation. To determine whether a taxpayer is in the business of lending money, the Tax Court has developed seven nonexhaustive factors: (1) the total number of loans made; (2) the period over which the loans were made; (3) the taxpayer's recordkeeping; (4) whether the loan activities were segregated from the taxpayer's other activities; (5) whether the taxpayer sought out the lending business; (6) the amount of time and effort devoted to lending; and (7) the taxpayer's relationship with the debtor or debtors.
The Ninth Circuit has developed 11 factors to determine whether a loan is a bona fide debt: (1) the names on the loan agreements; (2) whether there is a maturity date; (3) whether the source of the repayment is earnings; (4) the right to enforce the payment of principal and interest; (5) the right to participate in management; (6) a status equal to or less than that of regular creditors; (7) the parties' intent; (8) thin capitalization; (9) identity of interest between creditor and stockholder; (10) how the parties treated interest payments; and (11) the ability of the debtor to obtain loans from other sources.
The Tax Court has also developed criteria to indicate the worthlessness of a debt: (1) a decline in the debtor's business or value of the debtor's assets; (2) the overall business climate; (3) a debtor's serious financial hardship; (4) the debtor's earning capacity; (5) events of default; (6) the debtor's insolvency; (7) a refusal of the debtor to pay the debt; (8) the creditor's efforts to collect the debt; and (9) subsequent dealings between the debtor and creditor.
The IRS argued that the facts of the case indicated that the taxpayer was not engaged in the business of lending money, the loan was not a bona fide debt, and the taxpayer had not proved the debt was worthless in 2008, the year of deduction.
Holding: After examining the relevant factors, the court held that Owens was in the trade or business of lending money because he had lent money continuously and regularly with the intent of making a profit. It found Owens had made 33 loans totaling more than $21 million from 2003 to 2008; maintained excellent documentation, although it was prepared by OFG's personnel; acted as a prudent businessman by using his OFG office to reduce expenses; spent sufficient time related to his personal lending; developed a reputation that brought in loan customers, which negated the fact that he did not actively seek customers; and made a sound business decision to increase his chance of repayment when he subordinated his loan to another creditor.
The court also held that the loans to Lohrey Investments were bona fide debt. When applying the 11 factors developed by the Ninth Circuit, the court found that a majority of the factors indicated the loans were debt. The court observed that the promissory notes included the names of both parties with maturity dates. Even though Owens did not strictly enforce the maturity dates, the court was convinced that he did so to help Lohrey Investments grow and to increase the chance of being repaid. Repayment was not contingent upon future earnings, although any future earnings of Lohrey Investments would increase his chance of repayment. Owens had a definite right to enforce repayment, and the documents indicated that the parties intended the advances to be debt. Furthermore, Lohrey Investments obtained additional debt financing from outside lenders after borrowing from Owens.
The court stated that subordination of debt to other creditors usually indicates an equity investment. However, the court found this action by Owens was reasonable, as he did so as an attempt to recover his original loan investments. The court also held that, under the operating agreement, Owens did not receive an equity interest from his previous advances due to the time lapse and that his increased participation in the affairs of Lohrey Investments was intended to help stabilize its finances, although the court considered this factor to be neutral.
The court also held that the debt became worthless in 2008, not when David Lohrey filed for bankruptcy in 2009, as argued by the IRS. According to the court, Lohrey's laundry business had been in financial trouble for years, and Lohrey told Owens in 2008 that Lohrey Investments was going to file for bankruptcy that year. Furthermore, Owens's belief that Lohrey's collateral had relatively little value was later confirmed by the fact that he ultimately received nothing on his loan. Finally, the court found that Owens's filing of a bankruptcy proof of claim may have indicated his hope of some recovery, but that factor should not outweigh the other factors that indicated worthlessness just because Owens was establishing his place in the liquidation line.
- Owens, T.C. Memo. 2017-157
—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.