Tax losses for worthless debts often trigger IRS audits. On audit, it is common practice for the IRS to disallow the losses based on the debt not being worthless, the amount of the loss not being correct, and that the taxpayer took the loss in the wrong tax year. Taxpayers can take steps to limit the IRS’s ability to succeed with these arguments. The recent Rutter v. Commissioner, T.C. Memo. 2017-174, case highlights the facts needed to support a worthless debt deduction.
Facts & Procedural History
Rutter is a world-renowned biotech scientist with a successful track record in operating and profiting from science and technology-related companies.
Rutter acquired the technology company in 1999 that was the subject of this court case. Rutter made significant cash advances to the company. At first, the advances were documented with convertible promissory notes. The notes bore 7% interest and the interest payments were accrued and recorded on the company’s books. Subsequent advances were not documented with promissory notes and interest was not paid.
The company had minimal earnings in comparison to its expenses and was dependent upon Rutter’s cash advances to continue operating. From July of 2009 to February of 2010, the company was in talks with Google to partner on a potentially lucrative project. The deal never came to fruition. By 2011, the company had $83 million in net operating losses.
In December of 2009, Rutter had decided to write down the debt owed to him by $8.55 million. This amount was apparently equal to the amount of gain Rutter received from a separate venture in 2009. This was based on the idea that the cash advances to the company were debt and that they could be written off on a first-in, first-out approach.
Rutter’s personal attorney prepared a promissory note to consolidate all but the $8.55 million into one note. This note along with an agreement to forgive $8.55 million of debt were signed in March of 2010 and backdated to December of 2009. Rutter continued to make cash advances to the company during this time.
The IRS audited and denied the tax loss.
What Went Wrong: Bad Planning and Bad Facts
Contributions Not Debt
The court concluded that the advances were not debt, but rather capital contributions. There are a number of factors courts use to determine whether advances are debts or capital contributions. These factors ask whether the advances were loans and that the lender intended to be repaid. The court had no difficulty in concluding that they were not loans: no promissory notes, no interest paid or collected, no collateral provided, not a transaction an outside lender would have entered into, etc.
Not Business Debt
The court also concluded that any debt was not “business debt.” This is required by Sec. 166 for businesses that are not incorporated. Sec. 166 limits tax losses to those that are for business debt. The court noted that the advances here were made by Rutter personally and Rutter was not in the business of lending money.
Not Worthless; Wrong Tax Year
Last, the court also concluded that any debt was not worthless in 2009 and the tax loss was not allowable in the 2009 tax year. On this point, it appears that Rutter received bad advice from his tax attorneys. The cash advances were not separate loans documented by separate promissory notes, payments, etc. They were an open account according to the court. This results in the whole amount of the advances, not just the $8.55 million, having to be worthless to support a tax loss deduction.
Moreover, the court concluded that Rutter’s tax attorney’s positions as to why the alleged debt was worthless had no merit. The court flatly rejected the opinions of the big four accounting firm expert who opined on this issue. The court even noted that the expert cited a triggering event for the worthlessness that had no basis. That Rutter’s expert missed the mark by such a wide margin no doubt played into the court’s decision to uphold accuracy related penalties.
While it’s not a separate factor, the court noted the fact that the tax loss amount approximated the gain Rutter received from another venture in 2009. The mention of this fact seems to imply that the tax loss was an artificial construct to reduce taxes in a particular tax year rather than a legitimate tax loss taken in the year the loss was actually incurred.