EDITED BY STEPHEN R. CORNICE, CPA. I.D. PERSONAL

The Value of Worthlessness: Non-Business Bad Deductions for Intra-Family

MICHAEL S. STRAUSS

Although the deductibility of a debt as a non-business bad debt is fact spe- cific, there are ways to increase the likelihood that a worthless debt can be deductible, including preparing formal agreements and promissory notes, paying , and treating a as such in the books.

Intra-family loans can be beneficial tax consequences under Section 1272.' in many circumstances. A parent can However, even when a loan is prop- lend money to a child to buy a home erly structured, economic risk some- when the child either would not qual- times results in the borrower being ify for traditional financing or when unable to repay the loan. Under what the parent's loan can be made on circumstances can the lender of an in- more favorable terms. A grantor can tra-family loan benefit from a non- lend money to an irrevocable trust to business bad debt deduction under allow the trust to purchase an asset Section 166(d)? from the grantor, such as an interest in a closely held entity. Or, a person can lend money to a family member HYPOTHETICAL FACTS to allow that family member to enter Consider the following facts. Dan cre- into or continue a business venture ates an irrevocable trust (Trust) for the he or she would otherwise be unable benefit of his son Steve. Dan gifts to afford. Practitioners assisting clients $100,000 to Trust and then sells to in making such loans need to be care- Trust, through a written sale agree- ful to properly structure the loans to ment, shares in their dosely held fam- bear interest at or above the applica- ily business, Doomed To Fail, Inc. ble federal rate (AFR) and to require (Doomed), for their appraised value and insure that interest will be paid of $1 million. Trust, lacking sufficient at least annually, so as to avoid un- funds, pays for the purchased shares expected gift tax consequences under by issuing a nine-year promissory Section 7872 or unexpected income note (Note) paying interest only to

222 JOURNAL OF TAXATION • MAY 2017 Dan annually at the mid-term AFR der Section 166(d)]: (1) There must be which may be rebutted by showing and with all of the principal due on a bona fide debt in a proven amount; that, in making the loan, there was the ninth anniversary of the Note. (2) the debt must have value at the both a real expectation of, and intent Trust also gives Dan a security interest beginning of the year; and (3) it must to enforce, repayment." Indeed, the in- in the purchased shares that grants become worthless during the yeae4 tent of the parties will be given "con- Dan the right to accelerate payment Also, the taxpayer must have basis in siderable weight" in evaluating an in- in full if the value of the shares mate- the debt for it to be deductibles Spe- tra-family loan.12 "[Blecause family rially declines below the then current cial rules apply for worthless debt re- members are free to document a amount due on the Note. Interest is sulting from a payment as a guaran- transaction among themselves in any timely and fully paid in years one tor, endorser, or indemnitor.6 manner they choose, the form selected through four. In year five, Doomed has little probative force.... In any fails and is liquidated, leaving Trust event, we may look behind the loan with total assets of $150,000 and the WHAT CONSTITUTES documentation to apprehend the true outstanding Note. Exercising his rights BONA FIDE DEBT? nature of the transaction" Among under the security agreement, Dan The Regulations and numerous court other concerns, courts seek to deter- makes a written demand to Trust for cases provide additional guidance as mine whether the parties have effec- full payment. Trust pays to Dan its to what constitutes bad debt for which tively agreed that a debt that goes bad $150,000 of assets and is unable to pay the deduction is permitted. "Only a need not be 'repaid. the balance. Can Dan take a bad debt bona fide debt qualifies for purposes deduction under Section 166 in year of section 166. A bona fide debt is a Factors Evidencing Bona Fide Debt five, and if so, for how much? debt which arises from a debtor-cred- In determining whether a bona fide Section 166(a) provides that a de- itor relationship based upon a valid debt exists, courts have considered in- duction is permitted for any debt that and enforceable obligation to pay a dicative factors including whether: becomes wholly worthless during the fixed or determinable sum of money'? 1. Evidence of indebtedness exists, tax year, or may permit a deduction "It is elementary that one of the essen- such as a note. for the amount by which a debt be- tial prerequisites for a bad debt deduc- 2. There is a fixed schedule for repay- comes partially worthless during the tion is that the debt must have an ex- ment tax year. The amount of the deduction istence in fact% "Mhe ultimate question 3. Any collateral or security is re- is the adjusted basis of the bad debt is whether there was a genuine inten- quested. as provided in Section 1011.2 How- tion to create a debt, with a reasonable 4. A demand for repayment has been ever, Section 166(d) provides that for expectation of repayment and whether made. a taxpayer other than a corporation, that intention comports with the eco- 5. There is a written loan agreement. Section 166(a) does not apply to any nomic reality of creating a debtor- 6. The parties' records reflect the trans- nonbusiness debt, and allows a de- creditor relationshijY9 action as a loan. duction only as a short term capital Additional limitations apply to in- 7. Any repayments have been made. loss for nonbusiness debt that be- tra-family loans. A number of cases 8. The borrower was solvent at the comes wholly worthless during the have stated that lilntra-family trans- time the loan was made. tax year.3 According to the Tax Court, actions are subject to rigid scrutiny'.'m 9. Any interest was charged 14 "ftlhree elements are essential to al- The presumption with intra-family While the factors provide a basis lowance of a bad debt deduction [un- transfers is that the transfer is a gift, for determining whether a bona fide

NOTES

1 For a discussion of the gift tax consequences of an as a guarantor, endorser, or indemnitor of an obligation 12 Bragg, TCM 1993-479. citing Hunt. TCM 1989-335. intra-family that bears interest at less is allowed only if the taxpayer demonstrates that rea- 13 Shaw, TCM 2013-170. afftl without published opinion. than the AFR, see Strauss, "Unwrap Some 'Gift Loan' sonable consideration was received for entering into 623 Fed.Appx. 467, 116 AFTR 2d 2015-6915 (CA-9, Complexities of Section 7872: 122 JTAX 274 (June the agreement... However, consideration received from 2015). 2015). Fora discussion of the income tax conse- a taxpayer's spouse or any individual listed in section 14 Dickinson. TCM 2014-136 (factors 1-3, 7, 9); Alpert, supra quences of an intra-family promissory note, which 152(a) must be direct consideration in the form of cash note 10 (factors 1, 3, 4, 6, 7, 9); Sufi, TCM 2004-71, aff'd does not require and insure that interest is paid at or property" See also Lair. 95 TC 484 (1990). 96 AFTR2d 2005-6526 (CA-2.2005) (factors 1-4.7-9); least annually, see Strauss, "Applying the OID Rules to 7 Reg 1.166-1(c). Sundby, TCM 2003-204 (factors 1, 3, 4, 6, 7, 9); McFad- an Intra-Family Promissory Note,' 125 JTAX 126 (Sep- 8 Rodgers, TCM 1985-220, citing Estate of Van Anda,12 den. TCM 2002-166 (all factors); Mann Construction tember 2016). TC 1158 (1949), aff'd per curiam 192 F.2d 391, 41 AFTR Co. Inc., TCM 1999-183 (all factors); Klaue, TCM 1999- 2 Section 166(b). 355 (CA-2,1951). 151 (all factors): Barr.supra note 10 (factors 1-4, 6-9); Es- tate of Trompeter, TCM 1998-35 rev'd on other 3 Section 166 does not apply to worthless securities, or 9 Schenk, TCM 1996-113, citing Dixie Dairies Corp.. 74 TC grounds, 279 F.3d 767, 89 AFTR2d 2002-734 (CA-9. worthless bonds. , notes, or certificates 476 (1980); Litton Business Sys., Inc., 61 TC 367 (1973). with interest coupons or in registered form issued by 2002). TCM 2004-27, afftl in part and revel in part on 10 Alpert, TCM 2014-70. citing Clark.18 TC 780 09521205 a government or corporation. See Reg.1.166-1(9). other grounds without published opinion, 170 F.2d 353.44 AFTR 70 (CA-2.1953). See also Barr, TCM Fed.Appx. 484, 97 AFTR2d 2006-1447 (CA-9, 2006) 4 Sarcone, TCM 1991-647. 1999-40, citing Caligiuri. 549 F.2d 1155, 39 AFTR2d 77- (all factors); Clanton, TCM 1995-416 (all factors); Bragg. 5 See Reg.1.166-1(e). 842 (CA-8,1977). supra note 12 (factors 1, 3, 4. 6, 7 9); Crotty, TCM 1990- 6 See Reg.1166-9(e)(1), which states that "[t]reatment as a 11 Barr. supra note 10, citing Perry, 92 TC 470 (1989), aff'd 261 (factors 1, 3, 4, 6, 7); Rodgers, supra note 8 (factors worthless debt of a payment made by a taxpayer in dis- without published opinion. 912 F.2d 1466 (CA-5,1990); 1-4,6, 8.9); Goldstein, TCM 1980-273 (all factors). Other charge of part or all of the taxpayer's agreement to act Estate of Van Anda. supra note 8. cases also cite these factors.

PERSONAL MAY 2 017 • JOURNAL OF TAXATION 0 223 debt existed, they are not exclusive be repaid. The existence of this risk before a deduction under Section and no one factor controls 15 does not mean, however, that repay- 166(d) is allowed.28 A court also may "[A] distinguishing characteristic of ment is contingent on the nonoccur- consider how the taxpayer would a loan is the knowledge of each party rence of that risle23 have benefitted from the loan or to the transaction that there is a loan, guarantee had it not gone bad.29 and the intention of each party that the money advanced be repaid."16 GUARANTEES While formal indicia of debt are help- A bona fide bad debt for purposes of DEBT V. EQUITY ful, they are not alone sufficient to es- Section 166(d) also can arise from While a bad debt may be deductible tablish the existence of a bona fide payment on a guarantee. Guarantors, under Section 166, an equity invest- debt 17 Indeed, bona fide debt may ex- endorsers, or indemnitors who make ment in a business is not. In deter- ist even without the formalities of a a payment on a debt in discharge of mining whether a debt is bona fide, it note,'8 although "[a] mere declaration their obligation may be entitled to is essential to distinguish which pay- of intent by the taxpayer is insufficient deduct the payment as a worthless ments are equity investments rather if the transaction fails to exhibit more nonbusiness debt under Reg. 1.166- than debt "[T]he ultimate question [is] reliable indices of debt:19 In determin- 9(b). 'When a guarantor pays a debt whether the investment, analyzed in ing whether a debt is bona fide, a he or she has guaranteed, that debt is terms of its economic reality, consti- tutes risk capital entirely subject to the fortunes of the corporate venture or A number of cases have stated that represents a strict debtor-creditor re- "[Antra-family transactions are subject to lationship:'30 rigid scrutiny." As with bona fide debt discussed above or worthlessness discussed below, there are many (and some- court "must examine the facts before preserved, with the guarantor being times overlapping) factors that courts [it] in light of 'the realities of the busi- substituted for the original creditor. have considered in determining ness world and the manner in which The debtor is usually not able to re- whether a payment is debt or an eq- transactions are handled in the nor- imburse the guarantor, and in such uity investment, including the fol- mal and ordinary course of doing cases the value of the debt is lost at lowing: business"28 the instant the guarantor pays the 1. The names given to the certificates original creditof.'24 evidencing the indebtedness. This does not apply, however, if 2. The presence or absence of a fixed CONTINGENCIES the payment is a contribution to the maturity date. In addition to evaluating whether a capital of a corporation by a share- 3. The source of the payments. debt is bona fide, it also must not be holder,25 and it further requires that 4. The right to enforce payments. contingent on the occurrence of a the guarantor, endorser, or indemnitor 5. Participation in management as a subsequent event?' "If a borrower's have entered into the obligation in the result of the advances. legal obligation to repay is subject to course of their trade or business, or a 6. The status of the advances in rela- a contingency, no valid and enforce- transaction for profit, that there is an tion to the regular corporate cred- able debt exists - and no bad debt de- enforceable legal duty to make the itors. duction is therefore allowable - if the payment, and that the obligation was 7. The intent of the parties. contingency has not occurred.... [I]t entered into before the underlying 8. The identity of interest between the is useful to distinguish contingencies debt became worthless.26 The guaran- creditor and the stockholder. that affect a borrower's legal obligation tor, endorser, or indemnitor must 9. The "thinness" of capitalization in to repay (such as conditions prece- have received reasonable considera- relation to debt. dent, which must be satisfied before tion for entering into the agreement, 10.The ability of the corporation to the borrower is contractually obli- consideration received from a tax- obtain from outside sources.31 gated to repay), from contingencies payer's spouse or any person listed in 11.The uses to which the advances that affect the borrower's financial abil- Section 152(a) must be in cash or were put, including acquiring cap- ity to repar22 "There is always some property,27 and any subrogation rights ital assets. element of risk that a loan might not similarly must be wholly worthless 12.The failure of the debtor to repay. 13.The risk involved in making the MICHAEL S. STRAUSS is a partner at Strauss & Malk LLP, with offices in Northbrook, Chicago. and advances. Lake Forest, Illinois. He concentrates his practice in estate and trust planning, including estate tax re- 14.Whether there was a written agree- duction, asset protection, wealth succession, probate and estate administration, and technology-re- ment. lated matters. Mr. Strauss has previously written for THE JOURNAL and is also a co-author of Post Mortem Tax Planning (Thomson Reuters/WG&L) and Estate and Gift Planning for the Business Owner, and is 15.Whether stockholders' advances to the current author of Post Mortem Estate Planning. Copyright © 2017 Michael S. Strauss. the corporation are in the same

224 JOURNAL OF TAXATION • MAY 2017 PERSONAL

proportion as their equity owner- holder's advance is far more specula- taxpayer, and where the loss did not ship . tive than what an outsider would occur in the taxpayer's trade or busi- 16.The payment of interest out of make, it is obviously a loan in name ness. The determination of whether a only "dividend money or profits. only'.'36 Additionally, guarantee liability debt is a nonbusiness debt is a ques- 17. Whether the corporation gave the can be characterized as equity (if pay- tion of fact to be determined in each lender any security. ment on the guarantee is made), case.4° Further, "not every income- 18.Whether there was a sinking fund rather than debt.36 Finally, whether in- producing and profit-making en- to retire the loan. terest was paid or accrued is of "par- deavor constitutes a trade or busi- 19. The voting power of the lender. ticular importance" as "[a] true lender ness... [T]o be engaged in a trade or 20.A provision for redemption by the is concerned with interest"37 (See fac- business, the taxpayer must be in- corporation. tor 16 above). volved in the activity with continuity 21.A provision for redemption at the Note that new regulations have and regularity'm Since this article is option of the lender. been issued under Section 385, effec- focused on nonbusiness debt, busi- 22.The timing of the advance relative tive for tax years ending on or after ness debt factors will be considered to the organization of the corpo- 1/19/17.38 These regulations provide only as necessary to determine that a ration. guidance on determining whether a debt is not a business debt. 23.The length of the transaction. contribution to a corporation is eq- In seeking deductions for bad 24.A pattern of repeated shareholder uity or debt, although, except as pro- , many taxpayers have claimed advances, rather than a single out- vided in the Code and the regulations to be in the business of making loans lay. thereunder, this determination re- so as to avoid the deductibility limi- 25. Provision of a fixed rate of interest. mains "based on common law, in- tations of Section 166(d). The Tax 26.A contingency on the obligation to cluding the factors prescribed under Court, in Cooper, TCM 2015-191, dis- repay.32 such common law."39 A detailed cussed the requirements for business "The identified factors are not analysis of the new regulations is be- debt and the issue of being in the equally significant, nor is any single yond the scope of this article and pri- business of lending. Fred Cooper was factor determinative. Moreover, due marily would be relevant to an analy- a full-time employee of a corporation to the myriad factual circumstances sis of the deductibility of a business while simultaneously owning several under which debt-equity questions debt under Section 166(a). other diverse business interests. The can arise, all of the factors are not rel- records reflected that Mr. Cooper evant to each case.'33 As with intra- made twelve loans over a five-year family loans discussed above, the NON-BUSINESS DEBT period, which were for short terms "form does not necessarily correspond to the Having examined the indicia of bona and with high interest rates. "Mr. intrinsic economic nature of the transac- fide debt, when is such debt nonbusi- Cooper did almost none of the due tion."34 The degree of risk involved in ness debt? Section 166(d)(2) defines diligence that would be customary in making the advance is significant in nonbusiness debt in the negative as a lending business. He did not con- distinguishing equity from debt, as the debt not created or acquired in con- duct credit checks or verify collateral Tax Court has stated, "[i]f the share- nection with a trade or business of the through title searches, and he did not

NOTES

15 Barr, supra note 10. citing Litton. supra note 9. 28 Reg.1.166-9(eX2). 292 (factors 7,10.141 Lagoy, TCM 1992-213 (factors 1- 13): Cashman, TCM 1991-359, citing Fin Hay. supra note 16 CCA 200451030. 29 Froehlich, TCM 1996-487. citing Tennessee Sec., Inc. 30 (factors Z 5-10.13.14,16.19-22 25. 26): Sigmag TCM 674 F.2d 570.49 AFTR2d 82-1102 (CA-6,1982). affg 17 Sundby, supra note 14. citing Hotel Continental. Inc. 1988-377 (factors 6.8.10,11.14,15,17,23-25); Dixie Dairies. TCM 1978-434. TCM 1995-364, aff'd without published opinion,113 F.3d supra note 9 (factors 1-13); Estate of Mixon, 464 F.2d 30 1241, 79 AFTR2d 97-2843 (CA-9,1997). See also Alpert. Herrera, TCM 2012-308, aff'd 544 Fed.Appx. 592.112 394, 30 AFTR2d 72-5094 (CA-5,1972) (factors 1-12,16). supra note 10. AFTR2d 2013-6858 (CA-5 2013), citing Fin Hay Realty Other cases also cite these factors. Co., 398 F.2d 694.22 AFTR2d 5004 (CA-3,1968). 18 Bowman, TCM 1995-259, citing Byerlite Corp. v. 33 Dixie Dairies, supra note 9, citing Estate of Mixon, supra 31 Williams,192 F.2d 391, 6 AFTR2d 6069 (CA-6,1960). "The acid test of the economic reality of a purported note 32, and John Kelley Co.. 326 U.S. 521, 34 AFTR314 19 Barr, supra note 10, citing Williams. 627 F.2d 1032, 46 debt is whether an unrelated outside party would (1946). have advanced funds under like circumstances: Fus- AFTR2d 80-5300 (CA-10.1980). 34 Dixie Dairies. supra note 9. citing Fin Hay. supra note caldo, 88 AFTR2d 2001-6833 (DC Pa., 2001), citing Fis- 2° Bowman, supra note18, citing Kean. 91 TC 575 (1988). 32 (emphasis added). cher, 441 F.Supp. 32. 40 AFTR2d 77-5755 (DC Pa..1977), See also Mann. supra note 14. 35 aff'd, 582 F.2d 1274 (CA-3,1978). Dixie Dairies, supra note 9, citing Fin Hay, supra note 21 See Dickinson, supra note 14. 32. 32 Sensenig, TCM 2017-1(factors 2, 5-10,13,14,16,19-22,25, 36 22 Mann, supra note 14. See also Zimmerman., 318 F.2d 26); Bishop, TCM 2013-98 (factors 1-10,16); Herrera, Slater, TCM 1989-35, citing In re Lane, 742 F.2d 1311.54 611,12 AFTR2d 5053 (CA-9,1963). supra note 30 (factors 1-8.10-12); Ramig, TCM 2011-147. AFTR2d 84-6098 (CA-11.1984). 23 Goldstein, supra note 14. See also Klaue, supra note affd without published opinion, 496 Fed.Appx. 756,110 37 Herrera, supra note 30. quoting Curry, 396 F2d 630. 14. AFTR2d 2012-6450 (CA-9, 2012) (factors1-7,9,10.15.16): 22 AFTR2d 5039 (CA-5,1968). 24 Viani, TCM 1994-471. citing Putnam, 352 U.S. 82. 50 CMA Consolidated. Inc.. TCM 2005-16 (factors1-10,161, 38 See TD 9790,10/21/16. Flint Industries Inc. TCM 2001-276 (factors1-11,161Shea, AFTR 502 (1956). 39 Reg.1.385-1(b). TCM 2000-179 (factors1-6,941,13); Peterson, TCM 1997- 25 Reg.1.166-9(c). 40 377 (factors 1, 6, 7, 9,10.16,17); Lease, TCM 1993-493 Reg.1.166-5(b)(2). 26 Reg. 1.166-9(d). See also Herrera, 544 Fed.Appx. 592, (factors 1-7, 9-12,15.25); Baldwin, TCM 1993-433, citing 41 Bell, 200 F.3d 545 85 AFTR2d 2000-301(CA-8, 2000), 112 AFTR2d 2013-6858 (CA-5, 2013). Uneco. Inc., 532 F2d 1204, 37 AFTR 2d 76-1119 (CA-8, quoting Groetzinger, 480 U.S. 23, 59 AFTR2d 87-532 27 Reg.1.166-9(e)(1). 1976) (factors 2. 5. 9, 10, 15-18); Greenberg, TCM 1992- (1987).

PERSONAL MAY 2017 • JOURNAL OF TAXATION © 225 collect information through any loan the low number of loans over the 3. Other sources of income available applications before extending loans7 period in question, his full-time em- to the taxpayer. Mr. Cooper also did not report all of ployment with another business, 4. The ability of the corporation to the interest income he received. In its how he lent money to "friends and remain in business without the analysis, the Tax Court stated that tax- acquaintances," and that he did not taxpayer's guarantee. payers "must show that the bad debt satisfy other factors discussed above. 5. The degree to which the taxpayer's loss is 'proximately related' to the con- employment is protected by the duct of trade or business, or that the taxpayer's equity position in the debt was created in the course of trade PROXIMATELY RELATED corporation.46 or business: When a lender is a shareholder and "Generally, a trade or business is Factors the Tax Court has consid- also an employee of a corporate bor- an activity that is pursued full time, ered to determine if a taxpayer is in rower, the lender has two separate in- in good faith, with continuity and reg- the business of lending include: "(1) terests. The lender's status as a share- ularity, and for the production of in- ftlhe total number of loans made; (2) holder is a non-business interest, come'.'47 However, "investing is not a the time period over which the loans which is capital in nature and com- trade or business:'48 Thus, for pur- were made; (3) the adequacy and na- prised initially of after-tax dollars, poses of Section 166(d), one need de- ture of the taxpayer's records; (4) whereas the lender's status as an em- termine only that the debt is not whether the loan activities were kept ployee is a business interest for which proximately related to the lender's separate and apart from the tax- a salary, comprised of pre-tax dollars, trade or business. payer's other activities; (5) whether would be received!" the taxpayer sought out the lending The question is whether the bad business; and (6) the amount of time debt has a "proximate" relation to the WORTHLESSNESS and effort expended in the lending lender's trade or business, which exists After determining that a debt is bona activity; and the relationship between if the lender's "dominant motivation" fide, not contingent, not an equity the taxpayer and his debtors:'42 The in making the loan was to support his contribution, and a non-business debt, Tax Court also discussed additional or her status as an employee." A sig- one must then examine whether that factors including "whether taxpayer nificant motivation is insufficient!" As non-business debt became entirely used normal money-lending meth- discussed in Cooper above, a bad debt worthless during the tax year in order ods and practices, advertised, had a must be proximately related to the for the debt to qualify for the deduc- tion; partial worthlessness is not suf- ficient." A debt is not wholly worth- In determining whether a debt is bona less until its "last vestige of value" is fide, it is essential to distinguish which gone.'° The worthlessness of a debt is payments are equity investments rather determined at the time the deduction than debt. is claimed.m However, a debt can be worthless even if it is not yet due.52 How is worthlessness determined? business office, had a business or- taxpayer's trade or business in order "Mt is generally accepted that the year ganization, had loan forms, and to be deductible as a business bad of worthlessness is fixed by identifi- maintained business books: In deter- debt. In determining a taxpayer's able events that form the basis of rea- mining that Mr. Cooper was not in dominant motivation, courts have sonable grounds for abandoning any the business of lending (and thus the considered: hope of recovery:'53 "The taxpayer's loans Mr. Cooper made were non- 1. The size of the taxpayer's invest- determination that the debt became business debts which, if deductible, ment. wholly worthless 'must be made in could be deducted only under Sec- 2. The size of the taxpayer's after-tax the exercise of sound business judg- tion 166(d)), the Tax Court discussed salary. ment based upon as complete infor- mation as is reasonably obtainablC NOTES A taxpayer's subjective opinion of 49 Reg. 1.166-5(a)(2). See also McFadden. supra note 14; 42 Cooper, supra note 42. Other cases also have dis- Bodzy, 321 F.2d 331,12 AFTR2d 5166 (CA-5.1963). worthlessness, standing alone, is not cussed various indicative factors, such as Scallan, TCM 50 Cooper, TCM 2015-191. See also Rodgers, supra note 2002-294. enougl-054 8. citing Bodzy, supra note 49. 43 Generes 405 U.S. 93.29 AFTR2d 72-609 (1972). "The criterion of worthlessness is 51 Vianello, TCM 2010-17. citing Estate of Scofield, 266 " Id.; Reg.1.166-5(b)(2). F.2d 154, 3 AFTR2d 1054 (CA-6,1959), aff'g in part and interpreted strictly: the deduction is 45 Generes, supra note 43. revg in part 25 TC 774 (1956). unavailable if even a modest fraction " Litwin. 983 F.2d 997, 71 AFTR2d 93-647 (CA-10,1993) 52 Reg.1.166-1(c). of the debt can be recovered "This (factors 1-3): Brooks, TCM 1990-259 (all factors). 53 Bowman, supra note 18: Serot, TCM 1994-532, aff'd 'hard line' approach is taken because 47 Carraway. TCM 1994-295, citing Groetzinger, supra without published opinion, 74 F.3d 1227, 76 AFTR2d note 41. 95-8094 (CA-3,1995). See also Hatcher, TCM 2016-188. the parties to nonbusiness debts are 48 Whipple, 373 U.S.193,11AFTR2d 1454 (1963). 54 Cooper, supra note 50. typically members of the same family.

226 © JOURNAL OF TAXATION • MAY 2017 PERSONAL The requirement of total worthless- as "enemy property": White Dental receives security or collateral for a debt, ness minimizes the opportunities for charged off its investment in the Ger- the debt cannot be considered worth- taxpayers to claim deductions for gifts man corporation in 1918 and deducted less unless the security or collateral also to family members'56 However, if it on its income tax return. Although becomes worthless.66 "[r]ecovery of a trivial fraction of the the deduction was under a much ear- debt would be unlikely to cover the lier statute than Section 166, the con- Factors Evidencing Worthlessness costs of collection, while a miraculous, cept of worthlessness (and the timing As with the question of whether a unforeseen, unforeseeable, totally un- thereof) remains primarily the same. debt is bona fide and whether a con- expected recovery of part or even the The Supreme Court, in analyzing the tribution to a corporation is debt or whole of a debt properly written off loss and allowing the deduction, dis- equity, courts have considered a va- as worthless years before - the kind cussed how the taxpayer is not re- riety of factors in determining whether of recovery that might have occurred quired to be an "incorrigible optimist" a debt is worthless, including: here if... [debtor] had won first prize and that the loss occurred when the 1. The debtor's earning capacity. in the Illinois state lottery - would be German corporation was seized.63 In- 2. The solvency of the debtor. consistent with the debt's having terestingly, following the end of the 3. The debtor's refusal to pay properly been deemed worthless in war, White Dental filed a claim with a 4. Actions of the creditor in pursuing the year it was written off. A judgment government commission seeking a collection. of worthlessness has an inescapable recovery from the loss, which was al- 5. Subsequent dealings between the predictive element, and no prediction lowed in 1924, although what would creditor and debtor. can attain metaphysical certainty'57 be recovered, as of the date of the case, 6. The debtor's lack of assets or their taxpayer is not required to 'wait until was uncertain. The Court of Claims, decline in value. some turn of the wheel of fortune citing White Dental many years later, col- 7. A decline in the debtor's business. may bring the debtor into affluence:"59 orfully summarized the process of de- 8. The overall business climate. Legal action is not always required termining whether a debt was worth- 9. Serious financial reverses suffered before a bad debt deduction is allow- less, stating that "the taxpayer must by the debtor. able, when the surrounding circum- follow a rule of reason, avoiding alike 10.Events of . stances indicate that the debt is worth- the Scyllian role of the 'incorrigible op- 11.The debtor's ill health. less and uncollectible, and legal action timist' and the Charybdian character 12.The debtor's death. to enforce payment would in all prob- of the 'stygian pessimist:"64 13.The debtor's disappearance. ability not result in the collection of In making the determination of the 14.The debtor's abandonment of bus- the debt.59 Indeed, under certain cir- worthlessness of a debt, there must be iness. cumstances, no action to collect the some evidence to support the determi- 15.The debtor's . debt is required. "Where a creditor is nation, as the Tax Court stated in Green- 16.Receivership. familiar with the debtor's business and berg, TCM 1992-292, "[w]hile petitioner 17.The unsecured and subordinated knows that the debtor is hopelessly testified that [the business] had gone status of the debt. insolvent, he need not attempt to col- 'ka-flooey' sometime during 1985, no 18.The expiration of the statute of lim- lect the debt where his or her attempts other proof of the specific cause or time itations. to do so would be futile'60 "Of course of [its] financial demise was presented. 19. Claims of prior creditors far in ex- a debt is not worthless merely because The facts, however, indicated that [the cess of the market value of all as- the debtor is insolvent. Secured cred- business] was not dissolved until 1988:' sets available for payment.67 itors often recover the full amount of In addition to evidence, worthless is In contrast, other factors indicate their debt from an insolvent debtor, limited when a creditor receives prop- that a debt is not worthless, including: and unsecured creditors often recover erty on account of a recourse debt, as 1. The creditor's failure to pursue a significant fraction, at least, of what the debt is satisfied to the extent of the payment, especially if the debtor is they are owed by such a debtoe.'61 In property received.65 Further, if a creditor a relative or friend. contrast, value is not created in a par- MOTES ticular year when, in subsequent years, 55 Buchanan. 87 F.3d 197 78 AFTR 2d 96-5001(CA-7,1996). salvage from the wreck of the war. The taxing act does the business improves, receives addi- 56 McFadden, supra note 14, citing Id.. not require the taxpayer to be an incorrigible optimist" 64 tional investments, or similarly in- 57 Buchanan. supra note 55. Minneapolis. St. Paul & Sault Ste. Marie R. R. Co., 13 AFTR2d 472 (Ct CI.1964). 55 McFadden, supra note 14. citing Andrew. 54 TC 239 creases in value.62 65 (1970). McFadden. supra note 14. An often cited case in considering 66 55 Reg.1.166-2(b). Serot, supra note 53. citing Orrell, TCM 1979-129, and Jessup, TCM 1977-289. whether a debt is worthless is S. S. White 60 Bowman, supra note 18. 67 Alpert, supra note 10 (factors 1-6); Shaw, supra note 13 Dental Mfg. Co., 6 AFTR6750 (1927). In 61 Buchanan, supra note 55. (factors 1-10); Bishop, supra note 32 (factors 1-10); Mc- that case, a Pennsylvania corporation 62 Baldwin, supra note 32, citing Textron Inc.. 561 F.2d Fadden, supra note 14, citing Am. Offshore, Inc., 97 TC owned a German corporation that, 1023, 40 AFTR2d 77-5452 (CA-1,1977). 579 (1991) (factors 1-6); Lencke, TCM 1997-284 (factors 63 "It would require a high degree of optimism to discern 2, 3.6.9,11-18); Lagoy, supra note 32 (factors 3.71719); during the First World War in 1918, in the seizure of enemy property by the German gov- Cole, 871 F.2d 64, 63 AFTR2d 89-1172 (CA-71989) (fac- was seized by the German government ernment in 1918 more than a remote hope of ultimate tors 2.3, 6, 9,11-18).

PERSONAL MAY 2017 • JOURNAL OF TAXATION 227 2. The creditor's willingness to make were previously included on an in- provements were made and the house further advances. come tax return for that year or a prior was later listed for sale, but it did not 3. The availability of collateral or year, as otherwise they have no tax ba- sell and was withdrawn from the guarantees by third parties. sis.26 This also applies to unpaid interest market. Stephanie and David consol- 4. The debtor's earning capacity (this not reported as income,22 unpaid al- idated the 33 loans into one "Note Se- can be a positive or negative factor). imony or child supportn and uncol- cured By Second Deed Of Trust" with 5. Minor defaults. lected awards of punitive damages.79 interest at 12.5% (a rate well in excess 6. The payment of interest. Similarly, no deduction is available of the then current AFR), a 24-month 7. Sluggish business conditions.68 when a guarantor "pays" a guaranteed maturity date, and with Stephanie and The determination of whether a debt through the issuance of a prom- David jointly and severally liable. The debt becomes worthless during a spe- issory note on which no payments note was secured by a second deed of cific tax year is made on the basis of were made,80or a guarantee on which trust and an assignment of rents. Sev- "all the facts and circumstances,"69 and no payments have been made.81 Like- eral years later, with the house unsold, "[filo single factor is condusive20 The wise, Iplayment made on one's own Stephanie informed McFadden that failure of the debtor to pay a debt on obligation does not give rise to a bad she was unable to continue making demand is not, by itself, proof that the debt deduction"82 and the deduction payments on the first mortgage and debt is worthless?' The decline in value also is unavailable for the payment of was going to default, while consider- of a business, its failure to earn a profit, the worthless debt of another.83 ing filing for bankruptcy. Believing or difficulty in collection are likewise that neither Stephanie nor David had insufficient to prove the worthlessness the resources to make the payments, of a debt,n particularly when the busi- WHEN HAS THE McFadden accepted a deed in lieu of ness remains in operation and has the DEDUCTION BEEN ALLOWED? foreclosure to the property, made the potential to earn future profits 73 Finally Consider how the Tax Court has ap- monthly payments on the first mort- "[w]here a creditor voluntarily ad- plied these rules and factors to other gage and sold the property a few vances further large sums to a debtor situations. In McFadden, TCM 2002- months later. McFadden then claimed "k", [the creditor] can hardly assert the 166. Wayne McFadden's daughter a deduction for the worthless debt. worthlessness of the account on which Stephanie and her boyfriend David The Tax Court permitted a non-busi- the new advances were made:'24 sought to borrow money from him ness bad debt deduction for McFad- to purchase, refurbish, and eventually den's now worthless loan, although, sell a house.84 McFadden "was dili- as the fair market value of the prop- BASIS gent in reviewing the feasibility of erty on the date it was transferred to In addition to the requirements dis- Stephanie and David's proposal," in- him exceeded the amount of the first cussed above, a taxpayer also must quiring about the location and con- mortgage, the excess partially satisfied have a basis in a worthless debt in or- dition of the property, the nature and the loan to him and thus only the un- der to be able to deduct it under Sec- extent of the proposed improvements, satisfied portion of the loan was de- tion 166(d). Section 166(b) provides consulting real estate agents to "con- ductible under Section 166(d). This that the basis for determining a Section firm the adequacy of the security of a case illustrates the value of proper 166 deduction is the same as the ad- potential loan': and ultimately viewing business process and documentation. justed basis under Section 1011 for de- the loan as an "appropriate invest- As will be discussed further below, termining the loss from the sale or ment' McFadden then made the loans while courts may forgive some defi- other disposition of property.75 Further, in a series of 33 installments over an ciencies in formalities, an absence of a worthless debt "arising from unpaid 18-month period. The house was formalities can be fatal to deductibility. wages, salaries, fees, rents and similar purchased by Stephanie and David Other noteworthy intra-family items of taxable income" are not de- using a commercial first mortgage and cases where the deduction under Sec- ductible as worthless debts unless they McFadden's loan for the balance. Im- tion 166(d) was allowed include:

NOTES 68 Lencke, supra note 67 (all factors). Cole, supra note 67 73 Shaw, supra note 13, citing Roth Steel Tube Co., 620 79 Walter, TCM 1996-200. affg 68 (all factors). F.2d 1176, 45 AFTR 2d 80-1568 (CA-6,1980), 80 Yamamoto, TCM 1990-549, affd without published TC 213 (1977). 69 Alpert. supra note10, citing Halliburton Ca, 93 TC 758 opinion. 958 F.2d 380 (CA-9,1992). (1989), aff'd 946 F.2d 395, 68 AFTR2d 91-5798 (CA-5, 74 Hawkins, TCM 1987-91, citing New York Water Service 81 Black Gold Energy Corp. 99 TC 482 (1992), aff'd with- 1991). Corp.,12 TC 780 0949). See also FSA 199908005. out published opinion,33 F.3d 62.73 AFTR2d 941752 79 See also Reg.1.166-1(0)0). 70 Shaw, supra note 13, citing Am. Offshore, supra note (CA-10,1994). 67 76 Reg:11661(e). See also Natkunanathan. TCM 2010-15, 82 Perry, supra note 11, citing Dreyfuss.140 F.2d 922, 32 71 Sutherland. TCM 1991-619 citing Prescott State Bank, aff'd without published opinion, 479 Fed.Appx. 775, AFTR 198 (CA-5.1944). 11 BTA 147 (1928). 110 AFTR2d 2012-5193. 83 Alpert, supra note10, citing Anderson. 5 TC 482 (1945), 72 Shaw, supra note 13, citing Intergraph Corp. & 77 Douglas, TCM 1998-165, aff'd without published opin- aff'd156 F.2d 591,35 AFTR 8 (CA-2,1946). See also Har- Subs.. 106 TC 312 (1996), aff'd without published ion.181F.3d 87,83 AFTR2d 99-2986 (CA-4,1999). ris, TCM 1973150. opinion. 121 F.3d 723, 80 AFTR2d 97-5721 (CA-11, 78 Beshear, TCM 1990-544; Perry. supra note 11; Rev. Rul. 1997). 93-2719931 CB 32; FSA 989A. 84 McFadden, supra note 14.

228 JOURNAL OF TAXATION • MAY 2017 PERSONAL • Barr, TCM 1999-40, in which one may exist between related parties further (though potentially im- son loaned $100,000 to his without the formalities of a note proper) repayments in 1987 and brother's business, with a written • Alt, TC Summary Opinion 2006- 1988, and thus the debt was not promissory note and an expecta- 96, in which the petitioners loaned worthless in 1986. tion of repayment from pending money to their son to buy a pet • Caligiuri, 549 F.2d 1155, 39 AFTR2d (though ultimately never col- store. The petitioners consulted an 77-842 (CA-8, 1977), in which the lected) insurance proceeds. The attorney and had their son sign petitioners loaned money to the note was then sold to their father an unsecured promissory note for wife's brothers for their business, with a written agreement. Interest a portion of the funds, with the without a note or other written payments were made, although balance not being expected to be evidence, without interest, and the note did not have a fixed repaid (and not daimed as a de- with no fixed maturity date. No schedule for repayment, it had no duction). Subsequent increased payments were ever made, no ef- fixed maturity date, and no secu- competition in the local pet busi- forts were made to collect the rity or collateral was requested. ness caused the pet store to close, debt, and the business receiving the funds was operating at a loss at the time the loan was made. In seeking deductions for bad debts, • Kidder, TCM 1999-345, affd without many taxpayers have claimed to be in the published opinion, 4 Fed.Appx. 515, business of making loans so as to avoid 87 AFTR2d 2001-1081 (CA-9, the deductibility limitations of Section 2001), in which the petitioner and 166(d). his wife made numerous ad- vances and payments to the wife's son or to third parties on However, "[a] formal demand for and the son filed for bankruptcy. the son's behalf. No written payment was made': the parties The petitioners filed a claim in the promissory notes or loan agree- records reflected the transaction as bankruptcy but there were no as- ments were prepared, no collat- a loan, and the lender was solvent sets available to unsecured credi- eral or security was provided, at the time the loan was made. tors. The Tax Court found the and no written demands for re- • Bowman, TCM 1995-259, in which debt to be bona fide and allowed payment were made. When the the petitioner loaned money to a Section 166(d) deduction, despite son subsequently declared bank- his daughter to operate a skating the promissory note having no ruptcy, the petitioner and his wife rink business where the daughter repayment schedule, no maturity were uncertain as to how much had been involved in skating for date, and no default provisions, they had paid and made a claim years, both parties made inquiries which the court construed as a in the bankruptcy for $75,000. of different owners of existing demand note. They later determined the skating rink businesses, and they amount paid to have been believed that the new business $145,267 and sought a bad debt would be profitable. The loans WHEN HAS THE deduction for that amount. The were made without a promissory DEDUCTION BEEN DENIED? Tax Court noted that the pay- note but the amounts loaned by In contrast, consider Cooper, which ments "were randomly made check had a notation of "loan:' was discussed above. In that case, the without any apparent formality When it became clear that the Tax Court denied the deduction under or expectation of repayment' business was not in fact prof- Section 166(d) because Cooper, among • Clanton, TCM 1995-416, in which itable, the petitioner refused to other issues, "did not establish that he the petitioner borrowed funds make additional loans. The busi- had reasonable grounds to abandon from a bank, with a demand note, ness failed and the daughter's un- any hope of recovery" and "did not to pay for his father's medical bills. secured debts were discharged in treat the loan as worthless" in the year The petitioner repaid the bank and bankruptcy. The petitioner had in which he claimed the deduction. expected to be repaid by his father, made eight other loans to family Other instructive intra-family cases but his father's health declined and members or friends, seven of denying the deduction include: the debt was not repaid prior to which were repaid or being re- • Buchanan, 87 E3d 197, 78 AFTR 2d his father's death. The petitioner's paid, and most of which were 96-5001 (CA-7, 1996), in which mother then promised to pay the made without formal documen- the taxpayers had loaned or debt to the petitioner but repay- tation. "Although the formalities guaranteed loans to their son-in- ment was not made. The petitioner of a note are helpful in showing a law's business and claimed a argued that "it was customary in debtor-creditor relationship, nonbusiness bad debt deduction 1976, in Big Springs, Texas, to con- courts have found valid debt for 1986. However, they received firm a loan with nothing more

PERSONAL MAY 2017 • JOURNAL OF TAXATION 229 than a handshake," but the Tax If the debt was bona fide, when did were prepared. The promissory notes Court found that no bona fide it became wholly worthless? In year were not interest bearing,86 were not debt had been created between the five, Doomed failed. Upon Dan's de- secured by a mortgage, were not guar- petitioner and his father. mand, Trust paid all of its assets to anteed by any third party, and had no him and then was unable to pay the fixed schedule for repayment. How- balance of $850,000 due on the Note. ever, the books and records of the par- ANALYSIS The facts should be evaluated against ties "consistently reflected these notes OF THE HYPOTHETICAL the applicable factors indicative of as loans," and some repayments were Having discussed the myriad factors, worthlessness. Following payment, made that were credited against the issues, and limitations that can be in- Trust appears to have no earning ca- amounts loaned. Also, the sisters, as volved in the determination of pacity since it has no assets and has co-trustees, were partners in the part- whether a bad debt is deductible un- suffered a serious financial reversal, it nership that owned the apartment der Section 166(d), consider the facts is insolvent and has "refused" to pay building and thus had knowledge of of the hypothetical stated above. Be- the amount due in excess of its assets, its operations and some degree of gin by evaluating the facts against the its business has failed, and the failure control (which was a form of security). factors indicative of a bona fide debt. of Doomed was an event of default When, due to new rent stabilization In this hypothetical, evidence of in- on the loan. While the facts do not laws, the apai It hent building ceased to debtedness exists in the form of the indicate that Dan filed suit against be profitable, it was sold. The trusts' Note, and it has a fixed schedule for Trust to compel payment, as discussed share of the proceeds was used to re- repayment of annual interest with the above, litigation is not required where pay the loans, and the sisters deducted principal due on maturity in nine Dan is familiar with Trust's business, the unpaid balance under Section years. A security interest in the pur- Trust is "hopelessly insolvent;' and 166(d). Discussing the requirements for chased shares was given to the seller/ collection efforts would be futile.85 bona fide debt, the factors to be con- lender, and there was a written sale There is an assumption that, as of sidered, and the issue of whether the agreement, although the facts are un- the beginning of year five, Doomed loans were contingent on the profitable clear as to whether it included pro- had value and then lost that value operation of the apai l -nent building, visions typically found in a loan during year five. Although it appears the Tax Court upheld the deduction, agreement. It does appear as if the that the unpaid portion of the debt is even as it noted that the sisters "de- parties' records reflected the transac- wholly worthless during year five, the signed the transactions with the trusts tion as a loan, as interest payments loss must have occurred in year five to minimize gift taxes and to retain were timely and fully paid in years to be deductible in that year. Because ownership of the amounts loaned.' one through four, which also is re- the facts do not indicate the condition What if, rather than Doomed fail- flective of the factor considering re- of Doomed during years one through ing in year five, Doomed instead suf- payments (though of interest only, as four, it would need to be determined fers a material diminution in value no principal was then due). It may be that the loss (i.e. the worthlessness of due to changing business conditions, assumed that Trust was solvent when the unpaid portion of the Note) actu- sufficient to trigger Dan's right to ac- the loan was made, as it had $100,000 ally occurred in year five to obtain the celerate payment, but remains in busi- of assets and purchased shares of deduction at that time. ness. All other facts being the same, Doomed, appraised at $1 million, for Based on this analysis that the debt can Dan claim a Section 166(d) de- that amount. Finally, interest was was bona fide and assuming the loss duction for the amount of the Note charged, and indeed it was timely and that caused the balance of the Note to that Trust is unable to pay in year five fully paid in years one through four. become worthless occurred in year (which presumably would be an Although the factors are not neces- five, it would appear that Dan should amount in excess of $150,000 but less sarily of equal weight, it appears that be able to deduct the unpaid balance than $1 million)? That is unlikely. there are eight positive factors (factors under Section 166(d) in year five. The While Trust appears insolvent, that 1-4 and 6-9 as listed above) and one Tax Court considered a similar set of by itself is insufficient to constitute factor that is unclear (factor 5 as listed facts in Goldstein, TCM 1980-273. In worthlessness, and the collateral (the above). Without any other facts to Goldstein, two sisters decided to create shares of Doomed) is not worthless.87 consider, and assuming that the par- trusts for their children to invest in an Indeed, as Doomed remains in busi- ties' intent to create a bona fide debt apai tment building with their brother. ness, that fact alone may prevent the was determined, it would seem that Each sister created three trusts for chil- debt from being treated as worthless8 8 the loan should be considered a bona dren, gifted $20,000 to each trust, However, if Trust, pursuant to the fide debt. which was reported on federal gift tax Note, distributes to Dan all of its assets returns, and loaned $300,000 to each including the shares, which would be trust. A demand promissory note was valued at less than $1 million, and 85 Bowman, supra note 18 86 Note that this case predates the enactment of Section signed by the trustees of each trust, al- then is unable to pay the remaining 7872. though no written loan agreements balance, the result could be the same

230 JOURNAL OF TAXATION • MAY 2017 PERSONAL as in the scenario above, as again loan was payable on demand, and loan were made, and she made 74 ad- Trust would have no assets and thus there was a written promissory note vances totaling more than $800,000 to no future ability to repay. that bore a fixed rate of interest. Also, the corporation, including a number Steve did not make a loan to Doomed, made after the corporation had insuf- so loans were not made proportion- ficient funds to pay all creditors and HYPOTHETICAL TWO ately to equity ownership interests. as its financial situation worsened. Consider a revised set of facts. Dan While these factors are indicative of When the development ended un- owns half of the shares of Doomed, bona fide debt, consider that Dan, as completed, Shaw claimed a deduction with Steve owning the remaining half. the owner of half of the shares of for the amounts advanced. Steve works for Doomed and runs its Doomed, would have been motivated In finding that the advances did not day-to-day operations; Dan does not to protect his equity investment in constitute a bona fide debt and finding work for Doomed. Doomed is having Doomed. By not making demand for that the worthlessness of the debt had significant financial difficulties and is payment during years one through not been established, the Tax Court unable to pay its current debts. Dan five, even as Doomed continued to discussed how the corporation con- has previously loaned funds to operate at a loss, Dan would be pro- tinued to own the real estate, as well Doomed, and agrees to make a new tecting his equity investment at the risk as several other income producing loan of $1 million to Doomed in year of his loan. Most importantly, it seems properties, and Shaw, as the corpora- one in exchange for a promissory unlikely that Doomed, being a closely tion's bookkeeper, independently de- note payable on demand and bearing held corporation that was unable to termined that the corporation would interest at the AFR (Demand Note). pay its current debts and was experi- never be able to repay the funds ad- Doomed continues to do poorly, op- encing financial difficulties, would vanced. "In determining whether an erating at a loss each year until in year have been able to obtain a similar in- advance of funds constitutes a bona five it fails and files for bankruptcy. terest-only unsecured demand loan fide debt, economic reality provides Interest was timely paid annually to from outside lenders. It would there- the touchstone. If an outside lender Dan, but Dan did not make demand fore appear that the loan was in fact would not have loaned funds to the on the Demand Note. In bankruptcy, an equity investment in Doomed. corporation on the same terms as did it is likely that Dan will recover about However, regardless of whether the the insider, an inference arises that the one-tenth of the amount due on the Note is considered to be bona fide advance is not a bona fide loan.... The Note when the assets are ultimately debt, it does not appear as if the Note Court may properly characterize a distributed. Is Dan entitled to a Section was wholly worthless in year five transfer of funds to a corporation as 166(d) deduction for the unpaid bal- when Doomed filed for bankruptcy. other than a debt even if 'all the formal ance of the Demand Note in year five? Even if Dan ultimately can recover indicia of an obligation were meticu- To evaluate whether Dan is entitled only a small portion of the loan lously made to appear.91 to a Section 166(d) deduction, first de- through the bankruptcy process, that termine whether the loan to Doomed means that in year five the loan was constitutes bona fide debt, rather than not wholly worthless, and thus no de- CONCLUSION an equity investment. In the context duction under Section 166(d) should The analysis of whether a debt or ad- of a payment to a corporation, con- be allowed in year five. While recovery vance is deductible as a non-business sider the debt v. equity factors dis- of a trivial amount, such as one or two bad debt under Section 166(d) is de- cussed above. In doing so, note that cents on the dollar, should not prevent pendent on the specific facts and cir- the Demand Note lacked a fixed ma- a finding of worthlessness, the facts cumstances of each case. However, turity date and Dan was both a credi- here indicate that Dan's future recovery preparing formal agreements and tor and a shareholder. Further, the loan is likely to be larger and non-trivia1.90 promissory notes, paying interest, involved a high degree of risk given The Tax Court addressed a similar treating a loan as such in the books Doomed's financial difficulties at the factual situation in Shaw, TCM 2013- and records of each party, and intend- time of the loan, and the facts do not 170, aff'd without published opinion, 623 ing to create a binding and enforce- indicate that Doomed gave Dan any Fed.Appx. 467, 116 AFTR 2d 2015- able debt, among other factors, can security. Also, it appears that the De- 6915 (CA-9, 2015). June Shaw was a enhance the likelihood that, if the ad- mand Note was on equal footing with shareholder and employee of a family vance were to become wholly worth- other unsecured creditors of Doomed, owned corporation that owned real less, it could be deductible. • as there is no evidence of subordina- estate. To help fund a new develop- .1=1111111.11111111.111.1.1111111111111.11.1 tion.89 These factors all appear to weigh ment, she agreed to provide a $1 mil- 87 See Buchanan. supra note 55. in favor of finding that the loan was lion revolving credit line to the cor- 88 See Shaw, supra note 13. actually an equity investment and not poration, to be repaid with principal 89 See debt v. equity factor 6 above; Bishop, supra note 32. a potentially deductible debt. and 10% annual interest in two years. 99 Buchanan, supra note 55; Rev. Rul. 71-577,1971-2 CB Conversely, there was a right to en- No collateral was provided, the loan 129. force payment in the sense that the was unsecured, no payments on the 91 Citing Fin Hay. supra note 30.

PERSONAL MAY 2017 • JOURNAL OF TAXATION t 231