There are two pains in life. There is the pain of discipline and the pain of disappointment. If you can handle the pain of discipline, then you’ll never have to deal with the pain of disappointment.
Nick Saban may be a great coach, but that aphorism is unhelpful in its opaqueness. Perhaps he means that if you are disciplined enough, or prepared enough, no type of disappointment can hurt you because you will have done your best. If that’s his idea, litigators likely disagree. The pain of disappointment permeates any litigator’s professional life. Even the most disciplined litigators have to deal with the disappointment of adverse fact finding by a judge or jury.
Last week it was government litigators’ turn to feel the pain of disappointment, in the case of 2590 Associates v. Commissioner, T.C. Memo. 2019-3 (Jan. 31, 2019). The case teaches a substantive lesson about the §166 bad debt deduction and a procedural lesson about the power of fact-finders, here Judge Goeke. It's a fun case to follow a Super Bowl Sunday because it tangentially involves Nick Saben. The mainstream press erroneously types it as Nick Saban's win over the IRS. That is wrong. Saban was neither a party to the litigation nor did its outcome affect his taxes. He had already taken his winnings long before the litigation even commenced. Details and lessons below the fold.
Facts of the Case
In 2006, a Louisiana real estate developer named Joseph Spinosa had several projects underway. He needed a $2 million bridge loan for one of them, the Perkins Rowe project. He turned to his friend and sometimes business associate Nick Saban, who lent him the money, evidenced by a Promissory Note with a 1-year maturity date, an interest rate of $16% and all the other appropriate formalities. The Note was unsecured.
In 2007, Mr. Spinosa’s Perkins Rowe project sputtered. Unable to repay, the company and Mr. Saban executed a second Promissory note for $2.3 million (being the amount of the first note’s principal plus the accrued and unpaid interest). Again, it had a 1-year maturity with a due date of June 1, 2008 and all the bells and whistles of an arms-length transaction.
When 2008 slurched in, matters went from bad to worse. The main problem was, of course, the ongoing Great Recession. Even though Mr. Spinosa’s main lender, KeyBank, was already into the project for $170 million and had obtained a favorable appraisal in January, it refused to extend more funds for the project. .
By mid-2008 Mr. Saban was ready to be paid off. The due date of June 1, 2008 came and went. In July, Mr. Spinosa offered him some other options, including swapping the debt for an equity position in another one of Mr. Spinosa’s projects, the Rouzan project. This was a project of about 120 acres of land in Baton Rouge that Spinosa planned to develop into single-family homes. The land was owned by the entity 2590 Associates LLC, an entity controlled by Mr. Spinosa and in which he held a 24% equity share, indirectly through two other entities.
Mr. Saban agreed to that idea. So in December 2008---almost six months from the due date of the 2008 Promissory Note---Perkins-Rowe and Mr. Saban executed a third Promissory Note. This time the amount was $2.9 million, again representing the unpaid but accrued interest from the prior notes. Mr. Saban then turned around and contributed that Note to 2590 Associates in exchange for a 15% interest in the entity, representing a valuation of the 2008 Note at its face value.
In November and December 2008, at the same time Perkins Rowe created the new Promissory Note to Saban and he flipped it into 2590 Associates for an equity stake, Perkins Rowe was missing its required interest payments to KeyBank. KeyBank then turned from friend to foe, filing suit against Mr. Spinosa in early 2009. The suit sought foreclosure of the previous $170 million loan, among other complaints.
In June 2011, as a sanction against Perkins-Rowe for discovery abuses, the federal district court dismissed Perkins-Rowe’s affirmative defenses and counterclaims. In August 2011 the court granted KeyBank summary judgment on the foreclosure action. Perkins-Rowe appealed and the 5th Circuit affirmed in 2013. See KeyBank Nat'l Ass'n v. Perkins Rowe Assocs., L.L.C., 539 Fed. Appx. 414 (5th Cir. 2013).
So much for Perkins Rowe. And so much for any possible repayment of the 2008 Promissory Note! In 2011, 2590 Associates decided that was a good year to take a §166 deduction for the face value of the 2008 Note. Also in 2011 Perkins Rowe reported COD income of almost that amount from the 2008 Note.
In an audit of 2590 Associates, the IRS disallowed the §166 deduction because there was no bona fide debt. The NOD did not assert an alternative rationale for disallowance, such as that 2011 was not the year the debt became worthless. The NOD just said: “Since the partnership did not establish that the cash transfer was a bona fide loan, the amount has been determined to be a contribution to capital.”
2590 Associates petitioned the Tax Court and, during the litigation, the IRS added an argument for why the §166 deduction was improper: the taxpayer took the deduction in the wrong year.
Section 166 allows a deduction for worthless debts when a taxpayer can show (1) there was a bona fide debt to them that (2) became worthless in (3) the year they took the deduction.
To prove a bona-fide debt, taxpayers must show that at the time of the transfer of cash from the putative lender to the putative debtor, the parties intended to establish a true debtor-creditor relationship. Haag v. Commissioner, 88 T.C. 604 (1987). As the Tax Court there explained: “Because direct evidence of a taxpayer's state of mind is not generally available, courts have focused on certain objective factors to distinguish bona fide loans from disguised dividends, compensation, and contributions to capital.”
Similarly, to prove the appropriate year of deduction, taxpayers must show that the debt was viable at the start of the tax year and then became worthless at some point during the year. As Judge Goeke explains: “Some objective factors considered by the Court in determining worthlessness include the value of property securing the debt, the debtor’s earning capacity, events of default, the debtor’s refusal to pay, actions to collect the debt, any subsequent dealings between the parties, and the debtor’s lack of assets.”
In other words, dear readers, we are here looking at a the classic indeterminate multi-factor tests for both issues of legitimacy and timing. Judge Goeke emphasizes the indeterminacy of the factors, saying: “the object of the inquiry is not to count the factors but to evaluate them.” Yep. That’s what makes them indeterminate. And that is what makes it so necessary for litigators to have the discipline to deal with each and every factors. One just never knows which factor the fact-finder will decide is more important in its evaluation.
Normally, this is a burden the taxpayer bears. As we all know, deductions are a matter of legislative grace. Under certain circumstances, however, the burden can shift to the IRS. One such circumstance is when, as here, the IRS asserts a new position before the Tax Court. If a position asserted before the Tax Court was not taken in the NOD, the IRS must convince the court of the correctness of its position. Shea v. Commissioner, 112 T.C. 183 (1999)(“When the Commissioner attempts to rely on a basis that is beyond the scope of the original deficiency determination, the Commissioner must generally assume the burden of proof as to the new matter.”).
(1) the taxpayer here, 2590 Associates, had the burden to prove that what Saban transferred to it in December 2008 was a bona fide debt sufficient to generate a §166 deduction when it later became worthless.
(2) the IRS had the burden to prove that what Saban transferred to 2590 Associates in 2008 became worthless in some year other than 2011, the year 2590 Associates took the deduction.
Let the pain begin.
(1) Bona Fide Debt
Judge Goeke addresses first the issue of bona fide debt. He starts by noting that both parties agree the initial loan, represented by the 2006 Promissory Note was bona fide. But that’s not the real question. The real question is whether the 2008 Note represents a bona fide debt.
There are some pretty strong facts that favor the IRS determination that the 2008 Note was not a bona fide debt. The main fact is that the 2008 Note was made as part of a plan to insulate Saban from non-payment of the 2007 Note. As Judge Goeke explains: “Mr Saban wanted to be repaid, or at the least, he no longer wanted to have his money at risk in the Perkins Rowe development.” Hmmm. Saban’s desire to eliminate the risk of nonpayment from Perkins Rowe does seem to contradict the bona fides of a new debt instrument that does exactly that! But then why execute a new Promissory Note? Why, because that was the formal path necessary for the functional payoff of his now $3 million at risk. There was every reason for a creditor to think Perkins-Rowe could not pay of the debt. By December 2008 real estate ventures around the country were failing. By December 2008, Perkins Rowe had failed to make two key interest payments to its major lender, KeyBank. By December 2008, there was no way Saban would have been able to assign the Perkins Rowe obligation for 100% of its face value to any entity other than one that Mr. Spinosa controlled. As Judge Goeke recognizes: “An unrelated third party may not have accepted the 2008 note at its fact value...” No kidding.
Yet whether the 2008 Promissory Note was a bona fide debt is a question of fact and Judge Goeke is the fact-finder. And no matter what you or I or the IRS may think, Judge Goeke's opinion is the one that counts. His opinion is this: “We find that Mr. Saban entered into a legitimate debt with Perkins Rowe.” This conclusion will be insulated from reversal so long as there are adequate facts in the record to support his finding that the 2008 Note was legit. And there are indeed such facts.
What appears key to Judge Goeke's decision is Mr. Spinosa’s credible testimony. He was a veritable Bob the Builder on the stand. Even as the vultures circled over the Perkins Rowe project, Mr. Spinosa told Judge Goeke that he had good reasons to believe the project would succeed and Perkins Rowe would pay off the loan. Judge Goeke was convinced that, from the borrower’s viewpoint, the re-affirmation of debt was legitimate. That was important here because of the common control exercised by Mr. Spinosa over both Perkins Rowe and 2590 Associates. That is why Judge Goeke finds that “2590 Associates intended to collect the debt from Perkins Rowe.” In effect, Mr. Spinosa transferred the risk of non-payment to himself. The 2008 Promissory Note became, functionally, a promise from himself to himself. So the borrower’s viewpoint becomes, functionally, the creditor’s viewpoint. And that makes the 2008 Note legit. Judge Goeke places a great deal of reliance on the relationships in this case as being the deciding factor for him, writing: “the transaction may not have been typical of a normal business relationship [but] because of Mr. Spinosa’s personal relationship with Mr. Saban, it was a transfer of a legitimate debt.”
All in all, a painful finding of fact for the IRS. But the pain was not over.
(2) Timing of Deduction
The IRS asserted that 2011 was the wrong year for the taxpayer to take the deduction. It tried to convince Judge Goeke that the debt was worthless either before that time (in 2009) or after that time (in 2012). He was unmoved, finding that “respondent has failed to satisfy his burden of proof.” Key to rejecting the 2009 year was, again, Mr. Spinosa’s testimony that he had a reasonable belief he could reach a deal---even in the midst of increasingly antagonistic litigation---to avoid foreclosure. Judge Goeke points out that Mr. Spinosa actually “came close to a deal, with only one creditor holding out.” Key to rejecting 2012 as the proper year was that so much bad stuff happened during 2011---the district court’s summary judgment granting foreclosure, the busted dealmaking, the district court’s sanctions against Perkins-Rowe for discovery abuse---that “it was reasonable to abandon hope of recovery on the 2008 note by the end of 2011."
There are two pains in litigation. There is the pain of preparation and the pain of disappointment in an adverse decision. Even if you can handle the pain of preparation, you still must deal with the pain of disappointment.
And you can quote me on that.
Coda 1: But what about Mr. Saban and his 15% interest in 2590 Associates? Why he was able to cash out in 2015 for $2.8-$2.9 million! All in all, not a bad result considering the original debt went down the toilet.
Coda 2: Perhaps a more appropriate motivational quote for litigators is this one commonly attributed to Satchel Paige: “You win a few, you lose a few. Some get rained out. But you got to dress for all of them.” The pain of disappointment exists. One has to deal with it. Successful litigators deal with it by letting it go and girding for the next contest. But the pain persists. I find no truer statement than these words that Princess Bride author and screen-writer William Goldman put in the mouth of The Man In Black: "Life is pain, Highness. Anyone who says differently is selling something."
Bryan Camp has the mostly painless position of Professor of Law at Texas Tech University School Thereof.