All too often, we see cases where failure to properly document a transaction or keep good records is a taxpayer’s undoing. A case recently handed down by the Tax Court illustrates how that can happen. In Moore v. Commissioner the taxpayer sought to expand his tax preparation business.1 To finance that expansion, Mr. Moore was able to obtain funds from five individuals. After claiming investment expenses related to purported loans from those individuals, the Tax Court addressed the question of whether the advances were bona fide loans.2
Deducting Interest Expenses
In order to deduct interest expenses, payments must have been made with respect to a bona fide loan “where both the parties have an actual, good-faith intent to establish a debtor-creditor relationship at the time the funds are advanced.” The debtor must intend to repay the loan and the creditor must intend to enforce repayment. In Moore, the court addressed seven factors to determine whether these conditions were satisfied. The Tax Court looked for the presence of:
- A debt instrument;
- A statement that interest will be charged;
- A fixed schedule for repayment;
- Collateral to secure payment;
- Actual repayment;
- Reasonable prospects of advancement and repayment of the funds; and
- The parties’ conducting themselves as if the transaction were a loan.
In Mr. Moore’s case, there were nine outstanding “promissory notes.” Certain relevant factors the Tax Court cited in determining whether the loans were bona fide include:
- Moore interchangeably referred to the advances as investments and loans.
- No testimony or other evidence was presented from the purported lenders to prove their intent to treat the advances as loans, their intent to enforce repayment, or how they treated the advances.
- Only one of the nine “promissory notes” was signed.
- None of the “promissory notes” evidenced an execution date.
- There was no stated interest rate. Rather, they referred to a “return on investment” which Moore argued constituted interest.
- No collateral or other security was provided.
An additional issue the Tax Court discussed was the requirement of showing that the funds were received from the purported lender.3 At trial, Moore “introduced no canceled check or other evidence tying the funds directly to the alleged creditor.” Based on these facts, the Tax Court held that no bona fide indebtedness existed. As a result, Moore’s interest deduction was denied.
From a reading of this case, there is no reason to believe the advances at issue were not actual loans. However, Moore failed to properly document those loans. If he had ensured the promissory notes were signed, simply referred to interest rather than “return on investment,” and acted consistent with that structure, it appears likely he could have won the issue. Instead, he lost the issue and, as a parting gift, was hit with a 20% substantial understatement penalty.
The Moore case is not alone in illustrating how lack of proper documentation can come back to cost a taxpayer, whether the issue involves bona fide debt or any number of other issues. However, over the years, there have been numerous cases where the Tax Court has analyzed whether bona fide debt exists. That issue comes up in the context of interest deductions, bad debt deductions, and in other contexts.
Examples from some recent cases where taxpayers lost in Tax Court on the issue of bona fide debt include:
- Rutter: In this case, the Tax Court analyzed 11 factors from the Ninth Circuit Court of Appeals to determine lack of bona fide indebtedness. Importantly, the Tax Court cited to the proposition that “even if all the formal indicia of an obligation were meticulously made to appear [as debt]”, the debt may be recharacterized as equity if the economic realities illustrate that to be the correct outcome. Clearly, more than mere documents is required.4
In Rutter, a scientist made a series of advances to a business in which he held the overwhelming majority of stock. There were no written promissory notes, no proof of any intended maturity date, no collateral, no likelihood there would be funds to repay the debt other than through additional contributions by the taxpayer, no other creditors which had been willing to loan funds to the business, and no history of interest payments being made. Therefore, although the taxpayer had made bona fide loans to the business in the past which were evidenced by written promissory notes, paid interest, etc., the advances at issue were classified by the Tax Court as capital contributions.
- Povolny: Here, the advances which were purported to be loans were not reflected in any written promissory note, did not bear interest, were unsecured, had no set maturity date, and were made to an insolvent “borrower.” Further, the taxpayer deducted certain payments as “purchases” only to seek classification as debt later. Other advances were almost wholly dependent on earnings for repayment, making them look more like equity. Although the Tax Court acknowledged that “transactions between closely held corporations and their shareholders are often conducted in an informal manner,” the Court ultimately found these facts would not allow the advances to be classified as debt. Interestingly, although the Tax Court acknowledges here that closely held corporations sometimes act informally, they often also view related party transactions with a high degree of skepticism.5
- Yaryan: In this case, promissory notes were issued by a corporation in exchange for advances to acquire and develop real property for resale. The property acquired secured repayment. On its face, this would typically seem to favor the taxpayer. However, the Tax Court, stating that “a genuine debtor-creditor relationship must be accompanied by more than the existence of corporate paper encrusted with the appropriate nomenclature captions,” found otherwise. The promissory notes had no stated maturity date. Although the promissory notes were secured, without a stated maturity date, there was no way they could be called into default to exercise rights to the collateral. No periodic interest was required or paid. Further, the only way the advance ever could be repaid was a sale of the property it funded, making repayment appear more like an equity interest. In the end, the Tax Court felt these other factors outweighed the existence of a writing.6
There is, however, a relatively recent case where the taxpayer prevailed on the issue of the existence of bona fide debt. In Owens, advances were respected as debt based on the following facts:7
- Written promissory notes existed.
- There was a stated maturity date. Although the creditor did not enforce collection, credible testimony was presented that this forbearance was merely to increase the chance of ultimate repayment.
- The debt was adequately secured. Before making advances and accepting that security, the creditor obtained appraisals of the debtor’s equipment and property.
- Although the source of repayment likely would come from profits, due to the adequacy of security, repayment was not contingent on profits.
- Other lenders advanced funds while the taxpayer’s loans were outstanding. The taxpayer subordinated to those lenders, but only in an attempt to secure additional funds for the business to increase the taxpayer’s ultimate likelihood of repayment.
- When funds were advanced, the borrower was adequately capitalized relative to the amount of the loans.
What the Owens case makes clear is that bona fide debt can exist even when a creditor does not satisfy every single factor the Tax Court could consider (i.e. here, the lender did not enforce the stated maturity date and subordinated to future lenders). Where the facts and circumstances, taken as a whole, indicate a true debtor-creditor relationship, bona fide debt can be found. It is likely important that the parties in Owens were not related.
There are different tests to determine the existence of bona fide debt depending on the purpose for which it is relevant and the Circuit Court of Appeals to which the case would be appealable. A full description of these tests is beyond the scope of this writing. However, the factors addressed in in the cases above are universally relevant.
Proper documentation and administration can make or break the results. This is important not only for tax purposes, but also for other purposes such as asset protection. If a sole shareholder, for example, wants advances to the corporation to be treated as debt senior to a judgment creditor, then it will be critically important that the purported debt not be recharacterized as equity. With written documents reflecting the parties’ intentions, payments of interest, adequate security, etc., many of the taxpayers in these cases could have prevailed. Clients sometimes wonder why we recommend detailed documentation and compliance. Consistently, courts prove that those recommendations are important. It clearly is important to structure debt transactions similar to what a third-party creditor would require, fully document the transaction, and act in conformity with the structure and documentation. Proper legal counsel can assist in ensuring the desired treatment is respected.
- Moore v. Commissioner, T.C. Memo 2019-100.
- The court addressed these “investment expenses” as interest deductions under §163. It is worth noting that Moore claimed investment expense of $161,750 on his original return and $115,500 on an amended return. However, at trial, he acknowledged that he only had paid $39,500 to his purported creditors.
- This point made by the Tax Court can be important. For payments to a person to constitute interest on debt, that person must have advanced the funds. To see a case where a taxpayer lost due to the source of funds being other than the purported lender, see Meruelo v. Commissioner, T.C. Memo 2018-16, where the taxpayer lost the ability to deduct S corporation losses due to insufficient debt basis when another related S corporation was the source of loans rather than the taxpayer (i.e. he did not obtain the debt basis he claimed since he was not the lender).
- Rutter v. Commissioner, T.C. Memo 2017-208.
- Povolny Group, Inc. v. Commissioner, T.C. Memo 2018-37.
- Yaryan v. Commissioner, T.C. Memo 2018-129.
- Owens v. Commissioner, T.C. Memo 2017-157.