When taxpayers claim a deduction for a bad debt, it can trigger an audit by the IRS. The IRS has a vested interest in ensuring that taxpayers are not taking advantage of tax laws to reduce their tax liability. As a result, they will closely scrutinize bad debt deductions to ensure that they meet the requirements set forth by the tax code.
One of the most common reasons that the IRS will disallow a bad debt deduction is because they determine that the debt was not actually worthless. Taxpayers must be able to demonstrate that they have taken reasonable steps to collect the debt, but have been unsuccessful in doing so. This requirement can be difficult to meet, and taxpayers must be able to provide evidence that they have pursued all available avenues for collecting the debt before they can claim a bad debt deduction.
Another common reason for the IRS to disallow a bad debt deduction is that the taxpayer has taken the deduction in the wrong tax year. The tax code sets forth specific rules regarding when bad debt deductions can be taken, and taxpayers must ensure that they are following these rules in order to avoid an audit.
Lastly, taxpayers must be able to demonstrate that the amount of the bad debt deduction claimed is accurate. The IRS will examine the taxpayer’s records to ensure that the amount claimed is reasonable and reflects the true value of the debt.
The recent Rutter v. Commissioner, T.C. Memo. 2017-174, case provides valuable insights into the facts needed to support a worthless debt deduction. By analyzing the court’s decision, taxpayers can better understand the factors that the IRS will consider when examining bad debt deductions, and take steps to avoid an audit.
Facts & Procedural History
This case involves a biotech scientist who acquired a technology company and made significant cash advances to it. Initially, the advances were documented with convertible promissory notes bearing 7% interest, which was accrued and recorded on the company’s books. However, subsequent advances were not documented, and no interest was paid.
The technology company had minimal earnings in comparison to its expenses and was dependent on the taxpayer’s cash advances to continue operating. From July 2009 to February 2010, the company was in negotiations with Google to partner on a potentially profitable project, which ultimately fell through. By 2011, the company had incurred $83 million in net operating losses.
In December 2009, the taxpayer decided to write down the debt owed to him by $8.55 million, which he believed could be written off on a first-in, first-out approach. This amount apparently equaled the amount of gain the taxpayer received from a separate venture in 2009. The taxpayer’s personal attorney prepared a promissory note to consolidate all but the $8.55 million into one note, which he signed in March 2010 along with an agreement to forgive $8.55 million of debt, backdated to December 2009. During this time, the taxpayer continued to provide cash advances to the company.
The IRS audited and denied the tax loss claimed by the taxpayer, and the case centered on whether the advances constituted bona fide debts or capital contributions.
What Went Wrong: Bad Planning and Bad Facts
The court’s decision hinged on several factors that ultimately led to the disallowance of a bad debt deduction. This included the court’s determination that the advances were not bona fide debts but rather capital contributions, that any debt was not business debt as required by Sec. 166, and that the debt was not worthless in 2009 and the tax loss was not allowable in that year.
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 whether 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 the taxpayer personally and the taxpayer was not in the business of lending money (see this case for one where the court reached the opposite conclusion).
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 the taxpayer’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’s 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.
Taxpayers who claim tax losses for worthless debts may face scrutiny from the IRS, which often disallows such losses. This court case highlights the factors needed to support a worthless debt deduction. Taxpayers should ensure that any advances made to a company are properly documented as loans and not capital contributions. Additionally, taxpayers should ensure that any claimed debt is business debt and that the debt is actually worthless in the year the loss is claimed. Taxpayers should also seek competent tax advice to avoid accuracy-related penalties. Finally, taxpayers should avoid artificially constructing tax losses to reduce taxes in a particular year. By following these steps, taxpayers can limit the IRS’s ability to challenge their claimed tax losses for worthless debts.