Bad debt deduction denied

The Tax Court held that a corporation’s shareholder resolution canceled all shareholder loans and converted them to paid-in capital, removing the existence of any debts that could have supported the claimed bad debt deduction of a limited liability company (LLC) passed through to its owners, who were also shareholders in the corporation. The court further reasoned that the 11 factors used to distinguish debt from equity articulated in Hardman, 827 F.2d 1409 (9th Cir. 1987), did not establish the existence of a bona fide debt.

Facts: In 1992, two married couples, Arland and Ima Jean Keeton and Robert and Lorene Riemenschneider, formed a 50/50 LLC taxed as a partnership, Keeton-Riemenschneider LLC (KRLLC), to “invest in various real estate and farming projects.” However, during the years in question, KRLLC was largely inactive, with its 2016 to 2020 returns reflecting no business operations or income. Around the time that KRLLC was created, the couples also became involved with Idaho Waste Systems Inc. (IWS), of which each couple owned 34.5%. As a result, the Keetons and Riemenschneiders together controlled KRLLC and IWS throughout the relevant period.

IWS was formed to operate a landfill near Boise, Idaho, and primarily processed waste from demolition and construction projects. However, IWS “was poorly capitalized from the outset and lacked reliable access to standard commercial financing.” To fund its operations, the Keetons and Riemenschneiders funneled cash to IWS through KRLLC. These advances to IWS were recorded in KRLLC’s books as “Due from IWS.” In 1999 through 2007, KRLLC recorded 112 such entries, with a balance due in 2007 of $7,424,926. IWS also secured a $5 million bank financing arrangement in August 2007 to comply with a local environmental remediation bond requirement of $2.5 million and obtain a $2.5 million line of credit. As security for this financing arrangement, the bank received a deed of trust granting it a security interest in the IWS landfill property. KRLLC did not advance any additional funds to IWS following the August 2007 bank financing arrangement.

In October 2008, Robert Riemenschneider, as president of IWS, executed a one-page document in which IWS promised to repay KRLLC more than $3.2 million “on demand” plus 9% interest from Oct. 31, 2008, “until paid.” This purported promissory note did not specify any collateral to secure the loan, and there was no indication that it required a guaranty from any of the IWS shareholders. Additionally, there was no evidence that IWS ever paid interest on the note.

IWS’s financial condition continued to decline between 2008 and 2011. On Jan. 1, 2012, to present a stronger financial position to potential lenders, IWS’s shareholders agreed to convert their alleged loans to equity and to cancel any accrued interest. The agreement was memorialized in a “Unanimous Written Consent in Lieu of Special Meeting.” Consistent with the agreement, IWS’s 2012 financial statements did not report any notes payable to shareholders or to KRLLC. Similarly, IWS’s additional paid-in capital increased by the total amount of the loans converted to equity. KRLLC’s records, on the other hand, did not reflect the effect of the document, with the penultimate entry from July 2, 2013, showing a balance due. The final entry to the “Due from IWS” account was recorded on Dec. 31, 2017, when its balance was zeroed out as a “bad debt loss.”

KRLLC’s 2017 Form 1065, U.S. Return of Partnership Income, reported an ordinary business loss of $2,095,757, which was entirely attributable to its claimed bad debt deduction. KRLLC issued Schedules K-1, Partner’s Share of Income, Deductions, Credits, etc., to the Keetons and Riemenschneiders, each reporting an ordinary business loss of $1,047,878.

The Keetons reported their share of the loss on their 2017 return, resulting in zero tax due. The following year, the Keetons claimed a carryover net operating loss (NOL) deduction that also resulted in no tax due for 2018.

In 2020, the IRS sent the Keetons a notice of deficiency for 2017 and 2018, disallowing the loss deduction for 2017 and the carryover NOL deduction for 2018, explaining that it had determined that no bona fide debt existed between KRLLC and IWS. In addition, the IRS determined accuracy-related penalties for both years.

Issues: Sec. 166(a) permits a deduction for business debts that become wholly or partially worthless within the tax year. Regs. Sec. 1.166-1(c) further clarifies that only bona fide debt qualifies for the purposes of Sec. 166, which is “a debt that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money” (see also Zimmerman, 318 F.2d 611 (9th Cir. 1963); Kean, 91 T.C. 575 (1988)). Regs. Sec. 1.166-1(c) also clarifies that a gift or contribution to capital is not considered a debt for purposes of Sec. 166 (see also Kean, 91 T.C. at 594).

Advances of funds may or may not be considered genuine debt and require an examination of the taxpayer’s actual intent, as evidenced by the circumstances and conditions of the advance, not the outward form of the transaction (Bauer, 748 F.2d 1365 (9th Cir. 1984), rev’g T.C. Memo. 1983-120). Therefore, the primary issue for the Tax Court was determining whether the purported loans between KRLLC and IWS constituted a bona fide debt. Its analysis, however, was “greatly simplified” by the resolution the IWS shareholders executed. The court reasoned that, as of 2017, no debt from IWS could have gone bad because all loans made to IWS had been converted to equity on Jan. 1, 2012, and the Keetons did not advance any funds to IWS after that date. Ultimately, the court concluded that these facts alone were sufficient to disallow the bad debt deduction.

For “completeness,” however, the court further considered the 11 factors articulated by the Ninth Circuit in Hardman for determining whether an advance or transfer is debt or a contribution to capital: (1) the terminology the parties used in reference to the purported debt; (2) the presence or absence of a maturity date; (3) the source of the payments, particularly whether they depend upon earnings; (4) the right to enforce payment of principal and interest; (5) whether the advances increase participation in management; (6) whether the purported lender has a status equal or inferior to that of regular creditors; (7) objective indicators of the parties’ intent; (8) whether the capital structure of the purported borrower is thin or adequate; (9) the extent to which advances are proportional to one or more shareholders’ capital interests; (10) the extent to which interest payments come from dividends; and (11) the ability of the alleged borrower to obtain loans from outside lending institutions. The court found that all but one factor favored treating the advances made to IWS by KRLLC as equity and not debt. Factor No. 5 was determined to be neutral because “KRLLC’s advances did not explicitly entitle them to any greater role in IWS’s management.”

Holding: The Tax Court concluded that “KRLLC’s advances to IWS from inception through August 2007 did not give rise to bona fide debt, but rather constituted capital contributions.” Furthermore, even if some of the advances might have constituted debt, “that debt was extinguished by the Unanimous Consent resolution in January 2012, when all loans from shareholders were converted to paid-in capital.” As a result, there was no debt to become worthless in 2017. Thus, the court sustained the disallowance of the Keetons’ passthrough loss deduction for 2017 and the 2018 carryover NOL deduction and sustained the accuracy-related penalties for both years.

■ Keeton, T.C. Memo. 2023-35

— David Salerno, CPA, Ph.D., is an associate professor of accounting in the Kania School of Management at the University of Scranton in Scranton, Pa.; John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business at Cornell University in Ithaca, N.Y.; and Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.