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.
