Is a Bad Debt Deduction Triggered by Cease-and-Desist Court Order

Determining the allowable tax year for a loss is a common challenge for taxpayers, often relying on identifying a triggering event. There is very little guidance as to what can qualify as a triggering event for tax purposes.

In the case of a cease-and-desist order from a state regulator, does it qualify as a triggering event to establish a start-up company as worthless for the year the order was received? The recent Sensenig v. Commissioner, T.C. Memo. 2017-1 case answers whether a cease-and-desist letter is a valid triggering event for a bad debt deduction.

Facts & Procedural History

The taxpayer operated a business that raised money to invest in start-up companies. In return for the money his business invested, the taxpayer would acquire an equity interest in the start-up companies and he acquired financial control over each of the companies by becoming a director, a bank account signatory, the chief financial officer, and the tax return preparer. The taxpayer had raised $50 million from third parties to invest in these start-up companies.  The taxpayer’s business invested in 15-20 start-up companies.

The Pennsylvania Securities Commission (“PSC”) determined that the practice of issuing demand notes to investors in return for receipt of borrowed funds constituted the sale of unregistered securities. In June 2005, the PSC issued the taxpayer an order to cease and desist the offering and sale of unregistered securities.  In January 2006 the PSC accepted the taxpayer’s offer of settlement and rescinded the summary order to cease and desist.

The taxpayer and his fund were permanently barred from offering or selling securities in Pennsylvania unless he received a valid registration statement.  The taxpayer took steps to try to register with the U.S. Securities and Exchange Commission, but it proved too costly and he abandoned the effort.

The taxpayer claimed a $10,695,581 bad debt loss on his 2005 tax return for three of these start-up companies.  The IRS audited the taxpayer’s return and disallowed the loss.

Bad Debt Deduction

Section 166 of the tax code allows taxpayers to claim bad debt losses, but strict requirements must be followed to avoid issues with the IRS. And there are quite a few requirements.

The debt must become wholly or partially worthless during the taxable year, and the amount owed must be specific and known. Loans that are contingent on future events may not qualify as bona fide debts under Section 166. Additionally, contributions to capital are not considered to be bona fide debts, and the debt must arise from a debtor-creditor relationship based on an enforceable obligation to repay.

It is important to document that the borrower has sufficient credit to repay the loan and that it is a loan. The IRS may audit tax losses years after they are reported, and taxpayers should take care to ensure that the deduction is taken in the correct year as the facts and circumstances matter.

Debt vs. Capital Contribution

The court started by considering whether the monies advanced to the start-up companies were even a debt. The court considered the factors that indicate whether an advance is a loan or a capital investment:

(1) the intent of the parties;
(2) the identity between creditors and shareholders;
(3) the extent of participation in management by the holder of the instrument;
(4) the ability of the corporation to obtain funds from outside sources;
(5) the thinness of the capital structure in relation to debt;
(6) the risk involved;
(7) the formal indicia of the arrangement;
(8) the relative position of the obligees as to other creditors regarding the payment of interest and principal;
(9) the voting power of the holder of the instrument;
(10) the provision of a fixed rate of interest;
(11) a contingency on the obligation to repay;
(12) the source of the interest payments;
(13) the presence or absence of a fixed maturity date;
(14) a provision for redemption by the corporation;
(15) a provision for redemption at the option of the holder; and
(16) the timing of the advance with reference to the organization of the corporation.

After considering all these factors, the court ruled that the funds were capital investments and not debt, which meant that the taxpayer could not claim a bad debt deduction. This is not the most interesting aspect of this case. The interesting aspect is whether the cease and desist order is a triggering event for a loss.

Whether the Cease-and-Desist Order Establishes Worthlessness

The court then assumes that the advances were debt, to consider whether the loans were worthless if the advances were debt. It focused on whether the cease-and-desist order was a triggering event.

The taxpayer argued that the securities regulators shut down his investment activity with the June 2005 cease-and-desist order and he lacked additional funds with which he could keep the companies going. According to the taxpayer, it was obvious that the companies were therefore doomed and that the loans from the investment funds to them became worthless.

The court noted that the receipt of the cease-and-desist order was significant, but that this fact alone was not sufficient to establish that the debt was worthless. The court asked the taxpayer to provide evidence of the company’s finances as of 2005. The taxpayer failed to do this, which resulted in the court concluding that the debt was not worthless. This is consistent with how the courts have treated guaranteed payments and other businesses that have yet to fail.

It should be noted that the taxpayer could also be entitled to take a deduction for worthless securities for its investment in the start-up companies. It does not seem that this worthless securities deduction would have been available in 2005 either, as the start-up companies were still operating in 2005.

The Takeaway

When it comes to bad debt and worthless securities deductions, timing is critical. The question is, in what year can the deduction be claimed? Investment funds should take note that a cease-and-desist order from a state regulator is not enough to establish worthlessness as a triggering event. Taxpayers must also be prepared to provide financial records that demonstrate the start-up companies’ worthlessness in the same year that the cease-and-desist order was received.