Tax Court denies bad-debt deduction

The Tax Court found that advances made by Anaheim Arena Management LLC (AAM) did not constitute bona fide debt and therefore upheld the IRS’s disallowance of AAM’s bad-debt deduction for the advances. However, the Tax Court denied the IRS’s imposition of an accuracy-related penalty because AAM, in claiming the bad-debt deduction, acted with reasonable cause and in good faith on the advice of its accountants.

Facts: AAM, a duly organized limited liability company under California law, was classified as a partnership for federal income tax purposes. From Dec. 31, 2003, to June 30, 2011, AAM had three members: H&S Investments, H&S Management LP, and H&S Ventures LLC. From July 1, 2011, through Dec. 31, 2015, AAM had two members: H&S Investments and HS Portfolio LP. Together, AAM and its members functioned as a network of related parties owned and controlled by Henry Samueli and his family. The Tax Court referred to the five entities collectively as the “Samueli entities.”

In 2003, AAM entered into a contract with the city of Anaheim, Calif., to manage the Honda Center, an arena in the city. This facility management agreement was structured such that AAM had the exclusive right to manage the Honda Center on behalf of the city, subject to specified terms and provisions, while the city maintained its ownership of the Honda Center and the funds AAM used to manage it. Thus, while AAM managed the Honda Center and controlled four bank accounts to do so, at no point did AAM own the Honda Center or the funds in those accounts. To ensure that AAM allocated the Honda Center’s revenues as specified in the management agreement, an international accounting firm was engaged to provide reports of AAM’s compliance with the facility management agreement, in addition to annual financial statements for both the Honda Center’s business activities and the combined business activities of the Honda Center and AAM.

From 2003 to 2015, AAM routinely advanced funds to sustain the Honda Center’s operating expenses, debt service, and capital expenditures. These advances were either operating or debt service loans, as defined in the management agreement, or capital expenditure loans. Every advance was extensively documented, with a promissory note (listing the Honda Center as the borrower) specifying the amount advanced and the terms on which the advance was to be repaid.

In 2015, the new CFO of the Samueli entities conducted an internal review of AAM’s finances and determined that its advances to the Honda Center were unlikely to be repaid. CPAs engaged by the Samueli entities concurred with that determination and advised that the advances be deducted as bad debt. AAM thus claimed a bad-debt deduction of more than $51 million for its tax year ended Dec. 31, 2015.

In 2019, the IRS conducted an audit of AAM’s 2015 tax return, resulting in the disallowance of the bad-debt deduction and the imposition of an accuracy-related penalty under Secs. 6662(a) and (b). H&S Investments, in its capacity as a partner of AAM, filed a petition in Tax Court to challenge the IRS’s determination.

Issues: The Tax Court addressed two distinct issues in this case. First, Sec. 166(a)(1) provides for the deduction of a bad debt against ordinary income if the taxpayer is owed a debt and that debt becomes worthless during the tax year. The parties agreed that AAM’s advances were worthless and had rightly been determined to be so during the tax year. The issue, therefore, was whether the advances could be considered bona fide debt pursuant to Regs. Sec. 1.166-1(c).

Second, Secs. 6662(a) and (b) provide that an accuracy-related penalty of 20% of an applicable portion of a tax underpayment may apply to the portion of any underpayment that is attributable to one or more of 10 criteria, including (1) a substantial understatement of income tax and (2) negligence or disregard of rules or regulations. The IRS asserted an accuracy-related penalty against AAM for its underpayment attributable to the disallowance of its bad-debt deduction.

Regarding the Sec. 166 issue, the Tax Court considered the 11 debt factors established by the Ninth Circuit (the circuit to which an appeal of the case would lie) in determining whether AAM’s advances were bona fide debt for the purposes of federal income tax. The 11 factors are: (1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a maturity date; (3) the source of the payments; (4) the right to enforce the payment of principal and interest; (5) participation and management; (6) a status equal to or inferior to that of regular corporate creditors; (7) the intent of the parties; (8) “thin” or adequate capitalization; (9) identity of interest between creditor and stockholder; (10) payment of interest only out of “dividend” money; and (11) the ability of the corporation to obtain loans from outside lending institutions (A.R. Lantz Co., 424 F.2d 1330, 1333 (9th Cir. 1970)).

After applying the debt factors to the advances made by AAM, the court determined that none of them indicated that the advances were debt. For example, under the first factor, the names given to the loans, the Tax Court noted that although the promissory notes for the AAM advances were titled “subordinated promissory notes,” the notes were signed by the Honda Center, which could not enter into contracts, as it was a building owned by the city and not, the Tax Court noted, a legal person in any sense. Therefore, the Tax Court held that none of the notes constituted valid, enforceable contracts for purposes of this factor.

Under the second factor, the presence or absence of a maturity date, although each note specified a maturity date at which repayment was due in full, AAM could extend the maturity date of each note at its sole discretion and routinely did so. Thus, the advances effectively had no maturity date, indicating that they were not debt.

With regard to the fifth factor, participation and management, the Tax Court found that the terms of the management agreement and the way AAM was obligated and entitled to manage the Honda Center’s operations and finances did not give any indication of a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money, as required under Regs. Sec. 1.166-1(c) for a finding of bona fide debt. In addition, with regard to the seventh factor, the parties’ intent, the court found that the advances were actually made by AAM to the city rather than to the Honda Center. Reviewing the documents supporting the advances, the court determined that they did not show that AAM and the city had objectively manifested their intent to treat the advances as debt.

Having reviewed all the factors, the Tax Court held that none of the AAM advances were debt. Thus, it further held that Sec. 166(a)(1) did not apply and sustained the IRS’s disallowance of AAM’s bad-debt deduction.

The court next considered whether a Sec. 6662(a) accuracy-related penalty applied to AAM’s underpayment related to its claim for the bad-debt deduction. Under Sec. 6664(c)(1), the penalty cannot be imposed if the taxpayer had reasonable cause for and acted in good faith in claiming a deduction. H&S Investments argued that AAM had reasonable cause for and acted in good faith in claiming the bad-debt deduction because it had reasonably relied upon the advice of its accountants, CPAs who had decades of experience and were competent professionals with sufficient expertise to justify reliance. The IRS contended that AAM’s accountants had not advised specifically on the character of the advances and whether they could be considered bona fide debt, and therefore, it was not reasonable for AAM to rely on their opinion as reasonable cause for claiming the bad-debt deduction.

The Tax Court found that, while the CPAs did not directly address the character of the advances, they did advise that the advances were deductible under Sec. 166, which necessitated the conclusion that they were debt. Furthermore, the Samueli entities’ executives credibly testified that AAM would not have claimed a bad-debt deduction absent its accountants’ advice to do so. Thus, the Tax Court found that AAM had reasonable cause for and acted in good faith in claiming the bad-debt deduction and that the Sec. 6662(a) penalty did not apply to it.

Holding: The Tax Court held that despite their extensive documentation and despite being referred to as loans, AAM’s advances were not debt because none of the debt factors it considered indicated that the advances constituted bona fide debt. Therefore, the court sustained the IRS’s disallowance of AAM’s Sec. 166(a)(1) bad-debt deduction for the advances.

However, because AAM’s accountants were competent professionals and had advised AAM to claim the bad-debt deduction, the Tax Court held that Sec. 6664(c)(1) prevented the imposition of any Sec. 6662(a) accuracy-related penalty because AAM had relied on their advice with reasonable cause and in good faith.

• Anaheim Arena Management, LLC, T.C. Memo. 2025-68

— Jack Horner is a student in the Charles H. Dyson School of Applied Economics and Management, and John McKinley, CPA, CGMA, J.D., LL.M., and Thomas Godwin, CPA, CGMA, Ph.D., are both professors of the practice in accounting and taxation in the SC Johnson College of Business, all at Cornell University. To comment on this column, contact Paul Bonner the JofA‘s tax editor.