Sunday, November 6, 2016

The Mary And Brad Story

"With respect to petitioner wife’s Federal income tax for 2008, the Internal Revenue Service … determined a deficiency of $106,733 and an accuracy-related penalty of $21,347 under section 6662(a). With respect to petitioners’ joint federal tax for 2010, the IRS determined a deficiency of $100,924 and a section 6662(a) penalty of $20,185.”
Someone went into Tax Court for a quarter of a million dollars. Let’s check it out.

Oh, oh. The issue was whether the taxpayers had a business or nonbusiness bad debt. If they did not, then other tax dominoes would tumble, such as whether a net operating loss existed.

We have Mary Bell. She was single in 2008. She married in 2010. They lived in Texas.

Mary had an MBA, and through 2010 she worked at Blockbuster Corp. You may recall how that turned out, and since 2011 Mary had been a partner with a private equity 

Her husband also brought some financial chops to the relationship. He was involved with real estate loans, but he lost his job with the 2009 crash. His health thereafter became an issue, but he hoped to get back into the business. His previous clients would eventually have their loans mature, and he wanted to be there when they refinanced.

Our story involves Mary.

Before marrying, Mary dated Brad. Brad was unemployed but full of hope and hype. He was working on a comic strip called “In the Rough,” involving golf.

Mary was making a couple of nickles, and she loaned Brad $75,000. Mary did not go through the due diligence a bank would do, though: investigate his credit rating, request tax returns, obtain other financial information.

She loaned him another $50,000. Brad, being a mature and responsible guy, bought a Hummer with it. He clearly was a keeper.

In all she loaned $430,500 to Brad.

She obtained a written note. It had interest at 5% and matured on December 31, 2007.

How did our tale turn out?

Yep. Our protagonist – the enigmatic, charismatic, problematic Brad – defaulted.

To be fair, he did repay $7,000, so it wasn’t a complete loss.

In 2010 Mary sent an e-mail demanding payment. Brad replied:
"I have no money.”
She continued trying.

In 2011 she filed suit for performance.

In 2012 she received a judgement against Brad.

In 2014 she reasoned that if Brad could get his comic strip syndicated, then he might have enough money to pay her back. She introduced Brad to people. She did not however get any interest, ride or other participation should Brad ever get the comic published.

In 2010 Mary set up an LLC to take-over the note. She then claimed it as a business bad debt on her/their 2010 joint tax return. The note, including interest, was over $600,000 at that time. Not surprisingly, this created a net operating loss, which she carried-back to 2008 for a refund.

We already know that they went to Tax Court.

While there were several issues in the case, we are concerned with only one today 

There are two pieces here:
You made a loan that went south, and
You are in the trade or business of making loans
The IRS quite agreed that Mary made a loan, but they argued that she did not meet the second requirement.

You do not need a building and employees to be in the trade or business of making loans, but you do need to make loans repetitively. That is what “trade or business” means: Jimmy John's does not make one sandwich and call it a day. One loan does not rise to the level of “repetitively.” It also helps to meet the routine requirements that banks and other lenders observe: perform credit checks, obtain financial information, obtain security for the loan, etc.

Mary in turn argued that she worked on content deals all the time at Blockbuster, and Brad’s comic strip was “content” by another name. She was in a “trade or business” because she had done something similar at work.

Not a bad argument, but it had two holes:

Mary did not loan money to Brad in the context of her job at Blockbuster. As a consequence, what she did at Blockbuster was not particularly relevant to the tax outcome of her loan.

Even allowing for that, she did not have an interest, royalty, or other equity participation in the comic strip. She could have demanded it from Brad, but she did not. The only thing she had was a creditor interest, the same as Fifth Third or SunTrust have when they lend money. We are still talking about a loan.

The Court decided that Mary had a nonbusiness bad debt.

The tax difference is huge.

If you have a business bad debt, you can deduct the loan the same way you would deduct your rent, payroll or any other expense. If the sum goes negative, you might have a net operating loss that you can carryback and/or carryforward, offsetting taxable income in other years. If you can carryback, you might even get a refund of taxes previously paid.

If you have a nonbusiness bad debt, the most you can do is offset your capital gains plus $3,000. That’s it. The biggest net subtraction you get can on your tax return is $3 grand. And there is no carryback. Mind you, you can carryforward indefinitely, but at $600 grand Mary would be carrying-forward until the cows came home.

Which is why Mary wanted the business bad debt so badly.

But she was not in the business of making loans. The best she could do was the $3,000. 

She owed the tax. She owed the penalty. It was a loser for her all around.

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