TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Monday, February 26, 2018

Lesson From The Tax Court: Underwater Debtors

Tax Court (2017)Last week’s lesson was about the tax consequences to the borrower when the lender cancels the debt. This week’s case looks at the other side of the transaction to teach a lesson about what constitutes debt. Section 166 allows a lender who gives up trying to get back borrowed money to deduct the bad debt, effectively treating current income as a return of the lost capital. Similarly, a lender who sells debt to a third party for less than basis can calculate a loss under §1001 and may be able to treat that loss as a long-term capital loss.

But to have either a bad debt under §166 or a loss under §1001, there must be a “debt” in the first place. That is the lesson from last week’s case of Michael J. Burke and Jane S. Burke v. Commissioner, T.C. Memo. 2018-18. There, the taxpayer attempted to take both long-term and short-term capital losses in 2010 and 2011 through a mix of §166 deductions and claimed capital losses from sale of debt at less than basis. The alleged bad debts arose in connection with a scuba diving business in Belize. On audit, the IRS disallowed the deductions, creating a deficiency in taxes totaling some $444,000. The dispute was whether the Burkes had “debt” to lose. Judge Holmes’ opinion does a deep dive into the meaning of “debt” and shows why the taxpayer’s arguments here were all wet. If you think I’ve gone overboard in my water metaphors, Judge Holmes’ opinion is drenched with them. Makes for a splashy opinion.

More below the fold.

Mr. Burke had been a scuba instructor in college. After college he became an urban planner with RBF Consulting, an engineering firm founded in 1944. Mr. Burke eventually held the title of Executive Vice President. According to this article RBF was sold in 2011 for $50 million to another engineering firm.

In 1995 Mr. Burke reconnected with a college friend, Hugh Parkey, who also been a fellow scuba diver and had pursued a scuba diving career in Belize. Mr. Parkey asked Mr. Burke for money to help start a scuba diving business in Belize. Mr. Burke provided $30,000 and the two men formed a Belize corporation called Hugh Parkey’s Belize Dive Connection (“Belize Dive”). TripAdvisor currently ranks it 31 of 65 boating and water operations in San Pedro.

Over the years Mr. Parkey kept coming to Mr. Burke for more funding. After Mr. Parkey died in 2002, his widow kept coming to Mr. Burke for more funding. Each year for 16 years---from 1995 to 2011---Mr Burke provided additional funding for the business. The contributions grew each year and, over time, totaled more than $11 million, with over $2 million of that contributed in 2011. None of the contributions were memorialized at the time they were made. Mr. Burke kept a record of the amounts but there were no formal agreements of any sort to reflect the terms and conditions, if any, of the loans. At most there was only a verbal agreement, later memorialized, that Mr. Burke would receive an ownership interest in the Belize corporation.

Mr. Burke apparently had substantial capital gains to report in 2010 and 2011. He consulted with tax attorneys and in January 2010 they decided he should treat his multi-year funding of the Belize dive business as loans. So they created three promissory notes to evidence the claimed debt. They then sold one of the promissory notes for $1 to the friend’s widow. Mr. Burke took both short term capital losses and long term capital losses in 2010 and 2011, apparently under the authority of §166 and §1001.

In all cases, one cannot take a deduction under §166 for a bad debt, nor calculate a loss under §1001 for the sale of debt, unless there is actual “debt” to start with. The Tax Court has dealt with this issue in many cases and found multiple reasons why an advance of funds is something other than debt. You can find many of them in the classic case of Bugbee v. Commissioner, T.C. Memo 1975-45.  Sometimes the advance of funds may be simply a gift.  Other times repayment may be conditioned on a particular future source of funding.  And in other cases, the funding represents a joint venture or infusion of equity and there is an expectation of profit-sharing rather than specific repayment.  None of these are debts.

It’s this latter alternative that the IRS believed was going on with Mr. Burke’s 16 years of funding the Belize dive corporation. Judge Holmes notes that “his first advance got him a 50% interest Belize Dive, and his later advances got him a 10% increase in his ownership share.” That sure looks like an equity investment more than a loan.

The other main fact that seems to have convinced Judge Holmes that Mr. Burke’s advances were equity and not debt was that “Burke did not get formal loan documentation when he made each advance.” This lack of documentation was “inconsistent with how Belize Dive treated unrelated lenders.” Judge Holmes concluded that “the absence of the normal incidents of a loan---especially a maturity date and a stated interest rate---are most telling here.”

It is useful to contrast this case with a Tax Court case where the taxpayer DID convince the Court that the debt was bona fide. That would be the Bugbee case, which I call the friendly barkeep case. There, the taxpayer owned a bar and advanced money over a period of 10 years to one of his regular customers, who was chronically unemployed but always on the verge of the next big thing. The taxpayer continued to advance funds even though he knew the customer was using them mostly for living expenses. Nonetheless, the Court found the advances to be bona fide debt, in large part because the parties had executed promissory notes for each advance and because both the taxpayer and the borrower testified credibly at trial that the advances were intended to be loans, repayable as soon as the lush lurched to his feet.

In contrast, Mr. Burke had only post-hoc documentation and his testimony was contradictory. For example, Judge Holmes reports that “Burke decided that he’d ‘loan’ money to Parkey, but only if Parkey gave him an ‘interest’ in the business.” Hmmmm. That cuts both ways. The taxpayer in Bugbee also had contradictory testimony but what rescued him was the clear testimony of the borrower. Here, Mr. Burke’s borrower could not testify.

I would note too that the loan documents simply look fishy. According to Judge Holmes, Mr. Burke advanced about $2 million of the total $11 million in 2011. And the three promissory notes evidencing the debt total just over $11 million. But it appears all three were created on January 1, 2010. That would be over a year before $2 of the millions was even advanced.  Finally, if these really were loans, I would whether section 7872 might apply since the loans appear to have been interest-free until 2010 and even after that no interest was actually paid.  I welcome any thoughts on that. 

Regardless of whether the numbers add up or what other consequences would attend the taxpayer's successful characterization of these expenditures as loans, the question before the Court was whether the amounts were in fact debt and the Court said no.  In so doing, the Court gives us a lesson on what is not debt.

Coda: The IRS had asserted some $174,000 in accuracy-related penalties but the taxpayers here got lucky on that issue.  The IRS had not created the proper paperwork chain to prove up the newly-discovered requirement in §6751 that the penalties had been personally approved by a manager before being proposed.  So the Court disallowed the penalty. Our colleagues over at Procedurally Taxing have been covering this issue.  This February 9th post by Caleb Smith is a great place to start if you are interested in further reading.

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