Taxpayers often structure their affairs to their advantage. Our legal system and even our tax laws allow for this.
With many transactions, one way this is done is structuring transfers as either loans or capital contributions. The tax ramifications for the transfers can vary widely based on this type of broad classification. This distinction is a big deal. It can result in thousands, millions or even more in income taxes being imposed or even avoided.
In some cases, the circumstances do not make it easy to document the facts that establish the nature of transfers. This is particularly true when parties are in litigation or not in a position to cooperate with each other.
This can make it very difficult to discern whether the transfer is actually a loan or a capital contribution. One has to then rely on a very close reading of the court cases in this area. The court cases are not all that clear. This lack of clarity often means that taxpayers pay more tax than they should.
The recent Devine v. United States, No. 18-871 (Ct. Cl. 2021) case provides an opportunity to consider the nuances presented in this line of court cases. The case addresses the distinction between a loan and a capital contribution in the context of a worthless loan.
Facts & Procedural History
The taxpayer purchased real estate with the intent of repairing the property and selling it for a profit. He purchased the property in 2004 in the name of an LLC that he was the sole owner of. The purchase price was $4 million.
At the time of purchase, he entered into a written side agreement with a real estate professional. The real estate professional owned a fifty percent tenant in common interest in the real estate.
The taxpayer apparently advanced monies to repair and/or carry the property.
The real estate professional borrowed against the property and eventually, in 2008, filed bankruptcy.
The taxpayer had not timely filed his tax returns for 2008-2013. In 2014, he filed all three late tax returns. He then filed an amended return to take a bad debt deduction in 2008 and tried to carry the resulting net operating loss (NOL) back five years.
Whether the loss was to be carried back 5 or 3 years under the prior rules depended on whether the loss was a business bad debt. The trial court concluded that the transfers to purchase and repair or carry the property were not a business bad debt. The trial court concluded that the transfers were capital contributions. This appeal followed.
Significance of the Loan vs. Capital Contribution Classification
Loans are advances made to a third party with the expectation of repayment. They entitle the lender to interest usually. Capital contributions are more akin to investments. They are transfers made with the hope of earning a profit or gain.
There are several significant tax ramifications that depend on a transfer being debt stemming from a loan the taxpayer made versus a capital contribution. The timing issue the court considered in this case is an example. There are other tax ramifications that also have to be considered, which is why it is critical that one correctly identify whether a transfer is a loan or a capital contribution. This can include either the lender or the borrower having taxable income or deductions. This can also impact the reporting responsibilities for the parties, which can also trigger tax penalties.
It may be helpful to pause to consider a few of the nuances of loans and capital contributions before getting into the court case that is the subject of this post.
Tax Consequences of Loans
From the borrower’s perspective, the taxpayer who borrows money does not have to pay tax on the receipt of the loan. The loan proceeds are usually not subject to income taxes for the borrower.
If the borrower is on the hook for the loan, i.e., it is a recourse debt, the borrower is usually credited with “tax basis” due to the loan. This often means that the borrower can deduct the cost of purchasing the asset that was purchased with the loan proceeds. So not only is the loan not taxable, the loan may generate tax deductions for the borrower.
From the lender’s perspective, loans entitle the lender to the repayment of principal and, usually, interest. The lender reports the interest income as taxable income.
As in this case, loans that are not paid can sometimes be deducted as bad debts. Since bad debt deductions are usually large and one-time entries on tax returns, the IRS often spots and audits tax returns that have bad debt deductions. The result is a body of court cases that consider bad debt deductions for worthless loans.
Tax Consequences for Capital Contributions
Compare this to capital contributions. Capital contributions are also usually not taxable to the party who receives the capital contribution. The party who receives the contribution is usually a partnership, LLC, trust, etc. It may even be an informal joint venture arrangement that is considered as a partnership for tax purposes, as in this case.
Capital contributions usually do not entitle the borrower to “tax basis” in the asset purchased. Thus, the borrower does not get to recover the cost to purchase the asset purchased with the contribution.
The party who makes the contribution usually also does not have to pay income taxes on interest for the contribution. Instead, they report the gain or loss from the activity, if any, and the gain or loss from the sale of the assets, etc., if any. If the entity is defunct or no longer viable, they can also take a worthless security loss in some instances. This can be similar to the bad debt deduction for worthless loans.
Identifying a Loan or a Capital Contribution
This background helps explain why the distinction between a loan and capital contribution is so important. The relevance of the case that is addressed in this post is that it helps explain whether a transaction is a loan or a capital contribution. The distinction is not always clear.
The taxpayer in this case cites the Iowa S. Util. Co. v. United States, 172 Ct. Cl. 21, 27 (1965) case. The Iowa Southern Utility case involved corporate officers who sold property to the company at an inflated price. The minority shareholders sued the company and obtained a judgment against the corporate officers. The company took a bad debt deduction when it was not able to recover the amount of the judgment from the officers. The court concluded that the debt was a debt for tax purposes. The court reached this conclusion even though there was no promissory note, etc. establishing that there was a debtor-creditor relationship or an intention to create or enter into a loan. It based its decision on there being a fiduciary relationship between the corporate officers and the shareholders.
Compare that to the facts of this case. The taxpayer had entered into a side agreement that incorporated joint venture language. He later attempted to create a creditor-debtor relationship in the negotiations with the real estate professional. This included drawing up an agreement that said that the transfers were loans. The agreement was never fully finalized due to the 2008 financial crisis.
The court in the present case concluded that the Iowa Southern Utilities Company case did not require it to find that a debt existed. The court dismissed the notion that there was a fiduciary duty owed by the real estate professional to the taxpayer. The court focused on the actual documents that were executed. It did not focus on the negotiated documents. To the court, the executed documents and the absence of a real fiduciary relationship were sufficient to find that the transfer was not a debt.
This case shows how difficult it can be to discern when a transfer is a loan or a capital contribution. While a loan document is not always required, absent a loan document, there usually has to be some fiduciary relationship involved. The nature and extent of this relationship and duty can dictate whether a transfer is a loan or a capital contribution.
Instead of relying on factors like this, it is usually advisable to do some tax planning and document the nature of the transaction. This can go a long way in avoiding tax disputes over whether a transfer was a loan or a capital contribution.