The IRS Does Not Believe You Made A Loan

The issue came up here at command center this past week. It is worth discussing, as the issue is repetitive and – if the IRS aims it your way – the results can be brutal.

We are talking about loans.

More specifically, loans to/from yourself and among companies you own.

What’s the big deal, right? It is all your money.

Yep, it’s your money. What it might not be, however, is a loan.

Let’s walk through the story of James Polvony.

In 1996 he joined his wife’s company, Archetone Limited (Limited) as a 49% owner. Limited was a general contractor.

In 2002 he started his own company, Povolny Group (PG). PG was a real estate brokerage.

The real estate market died in 2008. Povolny was looking for other sources of income.

He won a bid to build a hospital for the Algerian Ministry of Health.

He formed another company, Archetone International LLC (LLC), for this purpose.

The Algerian job required a bank guaranty. This created an issue, as the best he could obtain was a line of credit from Wells Fargo. He took that line of credit to a UK bank and got a guarantee, but he still had to collateralize the US bank. He did this by borrowing and moving monies around his three companies.

The Algerian government stopped paying him. Why? While the job was for the Algerian government, it was being funded by a non-Algerian third party. This third party wanted a cut of the action. Povolny did not go along, and – shockingly – progress payments, and then actual job progress, ceased.

The deal was put together using borrowed money, so things started unravelling quickly.

International was drowning. Povolny had Limited pay approximately $241,000 of International’s debts.

PG also loaned International and Limited approximately $70 grand. PG initially showed this amount as a loan, but PG amended its return to show the amount as “Cost of Goods Sold.”

COMMENT: PG was making money. Cost of goods sold is a deduction, whereas a loan is not, at least not until it becomes uncollectible. I can see the allure of another deduction on a profitable tax return. Still, to amend a return for this reason strikes me as aggressive.

Limited also deducted its $241 grand, not as cost-of-goods-sold but as a bad-debt deduction.

Let’s regroup here for a moment.

• Povolny moved approximately $311 grand among his companies, and
• He deducted the whole thing using one description or another.

This caught the IRS’ attention.

Why?

Because it matters how Polvony moved monies around.

A loan can result in a bad debt deduction.

A capital contribution cannot. Granted, you may have a capital loss somewhere down the road, but that loss happens when you finally shut down the company or otherwise dispose of your stock or ownership interest.

Timing is a BIG deal in this area.

If you want the IRS to respect your assertion of a loan, then be prepared to show the incidents of a loan, such as:

• A written note
• An interest rate
• A maturity date
• Repayment schedule
• Recourse if the debtor does not perform (think collateral)

Think of yourself as SunTrust or Fifth Third Bank making a loan and you will get the idea.

The Court made short work of Povolny:

·       The $241 thousand loan did not have a written note, no maturity date and no required interest payments.

·       Ditto for the $70 grand.

The Court did not find the commercially routine attributes of debt, so it decided that there was no debt.

Povolny was moving his own capital around.

He as much said so when he said that he “didn’t see the merit” in creating written notes, interest rates and repayment terms.

The Polvony case is not remarkable. It happens all the time. What it does, however, is to tentpole how important it is to follow commercially customary banking procedures when moving monies among related companies.

But is it all your money, isn’t it?

Yep, it is. Be lax and the IRS will take you at your word and figure you are just moving your own capital around.

And there is no bad debt deduction on capital.

Our case this time was Povolny Group, Incorporated et al v Commissioner, TC Memo 2018-37.

When The IRS Says Loan Repayments Are Taxable Wages

Here is a common-enough fact pattern:

(1) You have a company.

(2) You loan the company money.

(3) The company has an unprofitable stretch.

(4) Your accountant tells you to reduce or stop your paycheck.

(5) You still have bills to pay. The company pays them for you, reporting them as repayments of your loan.

What could go wrong?

Let’s look at the Singer Installations, Inc v Commissioner case.

Mr. Singer started Singer Installations in 1981. It was primarily involved with servicing, repairing and modifying recreational vehicles, although it also sold cabinets used in the home construction.

After a rough start, the business started to grow. The company was short of working capital, so Mr. Singer borrowed personally and relent the money to the company. All in all, he put in around two-thirds of a million dollars.

PROBLEM: Forget about the formalities of debt: there was no written note, no interest, no repayment schedule, nothing. All that existed was a bookkeeping entry.

The business was growing. Singer had problems, but they were good problems.

Let’s fast-forward to 2008 and the Great Recession. No one was modifying recreational vehicles, and construction was drying up. Business went south. Singer had tapped-out his banks, and he was now borrowing from family.

He lost over $330 grand in 2010 and 2011 alone. The company stopped paying him a salary. The company paid approximately $180,000 in personal expenses, which were reported as loan repayments.

The IRS disagreed. They said the $180 grand was wages. He was drawing money before and after. And – anyway – that note did not walk or quack like a real note, so it could not be a loan repayment. It had to be wages. What else could it be?

Would his failure to observe the niceties of a loan cost him?

Here is the Court:

We recognize that Mr. Singer’s advances have some of the characteristics of equity – the lack of a promissory note, the lack of a definitive maturity date, and the lack of a repayment schedule …”

This is going to end poorly.

 … but we do not believe those factors outweigh the evidence of intent.”

Wait, is he going to pull this out …?

 … because intent of parties to create [a] loan was overwhelming and outweighed other factors.”

He won …!

However, we cannot find that all of the advances were loans.”

Then what would they be?

While we believe that Mr. Singer had a reasonable expectation of repayment for advances made between 2006 and 2008, we do not find that a similarly reasonable expectation of repayment existed for later advances.”

Why not, Sheldon?

 After 2008 the only source of capital was from Mr. Singer’s family and Mr. Singer’s personal credit cards.”

And …?

No reasonable creditor would lend to petitioner.”

Ouch.

The Court decided that advances in 2008 and earlier were bona fide loans. Business fortunes changed drastically, and advances made after 2008 were not loans but instead were capital contributions.

This “no reasonable creditor would lend” can be a difficult standard to work with. I have known multimillionaires who became such because they did not know when to give up. I remember one who became worth over $30 million – on his third try.

Still, the Court is not saying to fold the company. It is just saying that – past a certain point – you have injected capital rather than made a loan. That point is when an independent third party would refuse to lend money, no matter how sweet the deal.

Why would the IRS care?

The real-world difference is that it is more difficult tax-wise to withdraw capital from a business than it is to repay a loan. Repay a loan and you – with the exception of interest – have no tax consequence.

Withdraw capital – assuming state law even allows it – and the weight of the tax Code will grind you to dust trying to make it taxable – as a dividend, as a capital gain, as glitter from the tax fairy.

It was a mixed win for Singer, but at least he did not have to pay taxes on those phantom wages.

What Does It Take To Claim a Business Bad Debt Deduction?

Do you know what it takes to support a bad debt deduction?

I am not talking about a business sale to a customer on open account, which account the customer is later unable or unwilling to pay. No, what I am talking about is loaning money.

Then the loan goes south, other partially or in full.

And I –as the CPA - find out about it, sometimes years after the fact. The client assures me this is deductible because he/she had a business purpose – being repaid is surely a business purpose, right?

Unless you are Wells Fargo or Fifth Third Bank, the IRS will not automatically assume that you are in the business of making loans. It wants to see that you have a valid debt with all its attributes: repayment schedule, required interest payments, collateral and so forth. The more of these you have, the better your case. The fewer, the weaker your case. What makes this tax issue frustrating is that the tax advisor is frequently uninformed of a loan until later – much later – when it is too late to implement any tax planning.

Ronald Dickinson (Dickinson) and Terry DuPont (DuPont) worked together in Indianapolis. DuPont moved to Illinois to be closer to his children. DuPont was having financial issues, including obligations to his former wife and support for his children.

Dickinson started up a new business, and he reached out to DuPont. Knowing his financial issues, Dickinson agreed to help:

Anyway, I want to reiterate again my commitment to you financially, and what I would expect from you in paying me back. I am not going to prepare a note, or any form of contract, because I trust you to be honest about this matter, just like all of the other people I have loaned money.

Anyway, I agree you loan you money to get settled in over here, and help you out financially as long as I see our new company is working, and you are going to work as hard as you did for me the last time we worked together.”

Sounds like Dickinson was a nice guy.

Between 1998 and 2002, Dickinson wrote checks to DuPont totaling approximately $27,000.

DuPont acquired a debit card on a couple of business bank accounts, and he helped himself to additional monies. He was eventually found out, and it appears that he was not supposed to have had a debit card. By 2003 the business relationship ended.

Dickinson filed a lawsuit in 2004. He wanted DuPont to pay him back approximately $33,000. The suit went back and forth, and in 2009 the Court dismissed the lawsuit.

Dickinson, apparently seeing the writing on the wall, filed his 2007 tax return showing the (approximately) $33,000 as a bad debt. He included a long and detailed explanation 0f the DuPont debacle with his return, thereby explaining his (likely largest) business deduction to the IRS.

The IRS disallowed the bad deduction and wanted another $15,000-plus from him in taxes. But - hey – thanks for the memo.

Dickinson took the matter pro se to Tax Court.

And there began the tax lesson:

(1)   Only a bona fide debt qualifies for purposes of the bad debt deduction.

(2)   For a debt to be bona fide, at the time of the loan the following should exist:

a.      An unconditional obligation to repay

b.      And unconditional intention to repay

c.       A debt instrument

d.      Collateral securing the loan

e.      Interest accruing on the loan

f.        Ability of the borrower to repay the alleged loan

Let’s be honest: Dickinson was not able to show any of the items from (a) to (f). The Court noted this.

But Dickinson had one last card. Remember the wording in his letter:

            … just like all of the other people I have loaned money.”

Dickinson needed to trot out other people he had made loans to, and had received repayment from, under circumstances similar to DuPont. While not dispositive, it would go a long way to showing the Court that he had a repetitive activity – that of loaning money – and, while unconventional, had worked out satisfactorily for him in the past. Would this convince the Court? Who knows, because…

… Dickinson did not trot out anybody.

Why not? I have no idea. Without presenting witnesses, the Court considered the testimony to be self-serving and dismissed it.

Dickinson lost his case. He took so many strikes at the plate the Court did not believe him when he said that he made a loan with the expectation of being repaid. The Court simply had to point out that, whatever Dickinson meant to do, the transaction was so removed from the routine trappings of a business loan that the Court had to assume it was something else.

Is there a lesson here? If you want the IRS to buy-in to a business bad debt deduction, you must follow at least some standard business practices in making the loan.

Otherwise it’s not business.

When Is a Loan a Sale?

Sometimes I am amazed at the lengths to which some people will go to not pay taxes.

I was reading Sollberger v Commissioner, recently decided by the Court of Appeals for the Ninth Circuit.

Before getting into Sollberger, let’s talk about Derivium Capital.  Derivium was based in Charleston, South Carolina, and was headed by Charles D. Cathcart, an economist whose resume included a University of Virginia Ph.D., a stint at the CIA and a term at Citicorp working with derivatives.  Derivium presented a way for taxpayers to dispose of significant stock positions without triggering immediate tax. At least that was their pitch. They would lend up to 90% of a stock position on a nonrecourse basis. Nonrecourse means that the borrower could walk away from the debt. If memory serves, their deals generally ran approximately three years, and their loans did not require interest payments. Rather the interest was added to the loan. At the end of the term, the borrower could repay the loan, plus interest, and get the stock back. It goes without saying that one would do this only if the stock had appreciated. Otherwise the borrower would simply walk away from the loan.

Derivium would immediately sell the stock, providing money for the loan back to the borrower. In addition, they wrapped the loans using offshore lenders, first using a company in Ireland and then another company in the Isle of Man. This was apparently a good deal for Derivium, as it received approximately $1 billion in stock, originated $900 million in loans, kept $20 million and sent the rest to the offshore lenders.

Nice payday, when you can get it.

You can guess how this tuned out. Derivium was investigated by the IRS and the state of California and then filed for bankruptcy. Once the IRS stepped-in, they began looking at the other side of the transaction, which meant looking at the individual returns of the people who had transacted with Derivium.

Enter Kurt Sollberger. He transacted with a company called Optech, not Derivium, but it was a Derivium-inspired deal. Sollberger was president of Swiss Micron, which adopted an Employee Stock Ownership Plan (ESOP). In 2000 he sold his shares to the ESOP for a little more than $1 million. With the money he bought floating rate notes (which is pretty esoteric by itself). In 2004 he entered into the loan deal with Optech. That deal was pretty sweet. Optech loaned him 90% on a seven year nonrecourse debt, with the option of adding interest into the loan. Optech would collect interest from the notes (at least, until Optech sold them) and in turn charge Sollberger interest. If there was net interest due, Sollberger could pay the interest or add it into the note. He could not prepay the loan for seven years, however, at which time he could get retrieve the notes by repaying the loan with accrued interest.  That would be awkward for Optech, seeing how it had SOLD the notes.

Then it gets weird.

Sollberger received quarterly statements from Optech for less than one year. He diligently paid the net interest due. Then Optech quite sending statements and he quit paying interest.

Sure, happens all the time. When was the last time Fifth Third forgot to bill the interest on your loan?

The IRS audited Sollberger, said he sold the notes in 2004 and sent him a bill for $128,979, plus interest and penalties.

Sollberger went to Tax Court, which recognized the Derivium-inspired deals. It did not go well. After losing there, Sollberger petitioned the Ninth Court of Appeals. The Court had some trenchant observations:

If the FRN’s lost value after Sollberger transferred them to Optech, he would have been foolish to repay the nonrecourse loan at the end of the loan term, as he had no personal liability for the principal or interest allegedly due.”

Sollberger’s and Optech’s conduct also confirms our conclusion that the transaction was, in substance, a sale. Although interest accrued on the loan, Sollberger stopped receiving account statements and making interest payments after the first quarter of 2005, less than one year into the seven-year term. Thus, neither Sollberger nor Optech maintained the appearance that a genuine debt existed for long.”

Although the transaction is byzantine, the tax concept involved is simple: how far can someone push the limits of a “loan” before a reasonable person simply concludes that there was a sale. A seven-year nonrecourse loan looks very aggressive, and stopping interest payments less than a year into the loan sounds like tax suicide. The Ninth Circuit decided against Sollberger and told him to pay the taxes.

My Take: Let me see. Sollberger received a little over $1 million and the IRS wanted approximately $129,000. This leaves him approximately $871,000, although there is still state tax. For this he enters into a complicated scheme involving folded interest, a “put” seven years out and bankers from Ireland and the Isle of Man?

A word of advice from a tax pro: one does not tax shelter at a 15% tax rate. The government could virtually eradicate tax shelters (and many tax advisors) by lowering the tax rate to a flat 15% and requiring everyone to pay-in their fair share.

Good grief, man. Just pay the tax.