In a recent opinion out of the United States Court of Appeals for the Seventh Circuit, the Court upheld the Tax Court’s ruling that cash payments made from a family owned company to the son of the founder were not bona fide debts, and thus not deductible as bad debt expenses.[1] Additionally, the Court sided with the Tax Court that such payments were not deductible as ordinary and necessary expenses.[2] Lastly, the Court sided with the Tax Court on the reduction of company income for interest that had been accrued on such cash payments under the assumption they were bona fide debts, and in doing so fully affirmed the Tax Court’s holdings in the case.[3]
The issue of whether an arrangement is bona fide debt comes up quite often and has been written about extensively. My colleague Gray Edmondson wrote a great article about the Moore case which addressed this very issue which can be found here. Gray also wrote a short piece on the Burke case addressing properly documenting loans and treating arrangements as such which can be found here. Additionally, the Tax Court recently addressed this issue in Bolles v. Commissioner, TC Memo 2020-71 (2020) which was handed down June 1, 2020. That case has received quite a bit of commentary and the opinion can be found here.
Facts
VHC, Inc. (“VHC”) was founded in 1985 by Raymond Van Den Heuvel (“Raymond”). VHC was headquartered in Green Bay, Wisconsin and provided services related to the paper manufacturing industry. Raymond had five sons all of whom worked for VHC or a related company at one time or another, all in various capacities. One of Raymond’s sons, Ron Van Den Heuvel (“Ron”) started two of VHC’s subsidiaries as well as directed a number of other companies owned by or related to VHC. Ron also established several of his own companies outside of VHC.
From 1997 to 2013, VHC paid approximately $111 Million directly to Ron or one of Ron’s companies. The funds were used by Ron to pay his company related expenses, pay his personal taxes, and pay other various personal expenses including debts owed by Ron and/or his companies. Over time, Ron’s amount purportedly owed to VHC grew to $132 Million including interest. Of the amounts owed, Ron only paid back $39 Million to VHC.
These cash payments were recorded on the VHC books as loans and interest was accrued. The VHC bookkeeper provided a spreadsheet showing all the loans along with interest. In addition, there were numerous promissory notes for various loans to Ron and/or one of his companies. Some of these notes were signed by Ron, some by individuals imitating Ron’s signature, some were stamped with Ron’s signature, and some were not signed at all. Additionally, there were several discrepancies between what the spreadsheets showed and what the promissory notes showed, and the two sources could not be fully matched and reconciled.
Most of the promissory notes payable to VHC had fixed payment schedules. Payments were rarely made in accordance with such schedules, and the promissory note terms were routinely extended and/or renewed without VHC having received any payment of principal or interest. The Tax Court cited one particular promissory note which was renewed six times without a payment ever being made by Ron.
In addition to the cash paid to Ron, VHC also guaranteed some of Ron’s debt. Associated Bank (“Associated”) provided a line of credit to VHC and was a creditor of Ron. In 2002, Associated demanded a guaranty from VHC of almost $27 Million for Ron’s debts owed to Associated, and stated that VHC’s line of credit would be terminated should they not provide the requested guaranty. VHC provided the guaranty and made a similar arrangement to guarantee Ron’s debts to several other banks within the next few years.
VHC made some effort to collect on the purported loans to Ron. From 2002 to 2004, VHC met almost daily with Ron. In January of 2002, when Ron and his wife were going through a divorce, VHC issued separate demand letters to Ron and Ron’s wife demanding payment for a $2 Million loan to Ron and his wife in 1997 to pay taxes and other personal expenses. VHC never followed up on these demand letters and did not seek to collect or pursue litigation or any type of foreclosure.
In 2004, VHC began writing off some of its debts to Ron and/or Ron’s companies as bad debt expenses, taking a tax deduction for the balance of the debt written off. This continued through 2013 when the total amount of bad debt related to Ron was approximately $95 Million. VHC also stopped accruing interest on any of Ron’s loans at the end of 2007 when the expectation of being repaid had ceased.
Following a broad audit of 2004 through 2013, $92 Million of VHC’s claimed $95 Million bad debt deductions were denied. VHC petitioned the Tax Court and at trial, argued that the bad debt deduction was valid, or alternatively, the expenses related to payments made to Ron were ordinary and necessary business expenses due Associated and others forcing VHC to guarantee Ron’s debts or lose it’s line of credit and risk bankruptcy. VHC also argued that unpaid but accrued interest related to Ron’s debts should not be taxable income since VHC was an accrual basis taxpayer.
After a ten-day trial, the Tax Court found that VHC could not deduct the payments to Ron as “bad debts” because Ron and VHC lacked a bona fide debtor-creditor relationship. The Tax Court also held that such payments made to Ron were not ordinary and necessary business expenses due to VHC’s 2002 agreement with Associated. The Tax Court held that the deficiency assessed against VHC should be reduced in part since accrued but unpaid interest on Ron’s debts should not be taxable since the debts were not bona fide debts. However, the reduction was only a small win for VHC.
VHC appealed the Tax Court’s ruling and argued the following: 1) Ron’s debts were bona fide and deductible as bad debts; 2) alternatively, the payments to Ron were ordinary and necessary for VCH to avoid bankruptcy due to Associated having forced VHC’s hand in 2002 to guarantee Ron’s debts; and 3) the Tax Court failed to properly reduce income for accrued interest alleging all interest, even that which had been paid, should be deducted from its taxable income.
Analysis
In its opinion, the Court started with the two arguments put forth as to why VHC should be able to deduct the payments made to Ron and/or his companies. The Court started noted that the taxpayer faced a “steep climb” and included a familiar quote regarding income tax deductions, they are a “matter of legislative grace…the burden of clearly showing the right to the claimed deduction is on the taxpayer.”[4] Thus, the Commissioner’s assessment enjoys a presumption of correctness and the burden of proving the Commissioners assessment is wrong falls on the taxpayer unless the taxpayer can shift such burden by demonstrating that the assessment “lacks a rational foundation or is arbitrary and excessive.”[5] In making this determination, the Court reviews findings of the Tax Court as to legal questions de novo, meaning from the beginning on their own merits, while reviewing factual findings of the Tax Court for clear error, only to be disturbed when the Court is “left with the definite and firm conviction that a mistake has been committed.”[6] The Court goes on to state that the Tax Court’s determination that a taxpayer lacks sufficient evidence to substantiate a deduction is a factual finding, not a legal question, and thus is subject to the much more stringent clear error review.[7]
Payments as Bona Fide Debt and the Bad Debt Deduction
Pursuant to Section 166 of the Internal Revenue Code, a taxpayer can deduct a bad debt, or the part of such bad debt which “becomes worthless during the taxable year.”[8] However, such bad debt deduction is limited to only to a “bona fide debt” which is defined as a debt that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Accordingly, the threshold for a taxpayer to be eligible to claim a bad debt deduction under Section 166 is that the debt must first have been bona fide. Thus, the Court examined VHC’s relationship with Ron to determine if a valid debtor-creditor relationship did in fact exist which resulted in Ron having an enforceable obligation to pay VHC a fix sum.
The test for bona fide debt relies on a number of factors that must be considered, with no one factor being dispositive.[9] In analyzing such factors, intrafamily transactions are met with particular skepticism and subject to rigid scrutiny.[10] In its analysis, the Tax Court analyzed the following ten factors:
- the name given to the certificates evidencing the indebtedness,
- the presence or absence of a fixed maturity date,
- the source of payments,
- the right to enforce repayment,
- participation in management as a result of the advances,
- thin or adequate capitalization,
- the use to which the advances were put,
- the ability to obtain loans from outside lending institutions,
- the intent of the parties, and
- the payment and accrual of interest.
The Tax Court opinion provided a thorough analysis of each of these ten factors, with the end result being that each such factor weight against the payments being bona fide debt. The Court agreed with the Tax Court and affirmed this conclusion, noting that VHC did not confront these factors but instead argued that “the Tax Court’s reliance on indicia of a debtor-creditor relationship prevented it from seeing the forest for the trees and that the only relevant factor is the intent of the parties.” In response to this contention from VHC, the Court noted that, even if VHC were correct and only intent mattered, VHC would still lose.
While VHC may have described the payments as loans, this is certainly not how they treated them. Promissory notes with fixed maturity notes were routinely extended or renewed, and payments due were deferred. VHC did not expect repayment unless certain contingencies such as Ron securing other financing or outside investors occurred. This is more akin to an investor-type relationship rather than that of a creditor. Though VHC may have called the payments debt, its actions indicated otherwise leading the Court to conclude the Tax Court was correct in its determination that no debtor-creditor relationship existed, the debt was not bona fide debt, and VHC was not entitled to a bad debt deduction.
Payments as Ordinary and Necessary Business Expenses
As an alternative to its bad debt deduction argument, VHC argued that the payments to Ron were deductible as ordinary and necessary business expenses under Section 162 which allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”[11] Due to VHC’s relationship and reliance on Associated to provide its line of credit, and Associated requirement VHC to “float money to Ron to help him pay his own debts to Associated” or be forced in to bankruptcy due its loss of its line of credit from Associated, VHC contends it had not choice but to make such payments to Ron. Accordingly, they were “ordinary and necessary business expenses.”
In support of this position, VHC cited prior Tax Court precedent that payments made by a taxpayer for the benefit of a third party may qualify for the Section 162 deduction if the taxpayer also benefitted from such payments.[12] In Lohrke, the Tax Court did conclude that ” in some situations an individual may deduct the expenses of another person” but the general rule was that an expense incurred to satisfy the obligations of a third party is not an ordinary or necessary business expense. In making this determination, first the Tax Court must “ascertain the purpose or motive which cause the taxpayer to pay the obligations of the other person,” and then determine if that motive constitutes “an ordinary and necessary expense of the [taxpayer’s] trade or business.”[13]
In analyzing the Section 162 deduction, the Tax Court held that VHC had not substantiated its claimed expenses, and even if substantiated, had not proved that such expenses qualified for the Section 162 deduction. VHC provided a spreadsheet of the various purported loans that was “riddled with inconsistencies”. Further, the documents provided as evidence such as the various promissory notes either failed to support the spreadsheet or contradicted it. VHC failed to address the inconsistencies and failed to carry its burden that the Tax Court was in error in holding that VHC did not properly substantiate the deduction.
Taking the analysis one step further, the Court stated that even if properly substantiated, the payments to Ron did not qualify as ordinary and necessary business expenses. The fact that Associated required VHC to step in and assist with Ron’s loan did not in itself make the payments ordinary and necessary business expenses. For the Section 162 deduction, the expenses must be “(1) be paid or incurred during a taxable year, (2) be for the purpose of carrying on a business, (3) be an “expense, (4) that is “necessary, and (5) ordinary.”[14] Citing Lincoln Savings and Loan Association, the Court noted that “the fact that a payment is imposed compulsorily upon a taxpayer does not in and of itself make that payment an ordinary and necessary expense.”
Were the Court to conclude the payments were necessary, which they were not according to the Court, VHC put forth no evidence that such payments were ordinary in the paper production industry. In response, VHC noted that obtaining access to credit is ordinary in every business, an argument the Court did not buy, calling it an “oversimplification” since the arrangement with VHC was not merely a simple extension of credit but a “seemingly unusual arrangement” in which VHC’s access to credit depended on it supporting a third party, Ron. The Court concluded that VHC failed to carry its burden that such payments were ordinary and necessary and thus the denial of the deduction at the Tax Court level was proper and was sustained.
Interest as Taxable Income
In the last issue raised by VHC, VHC argued that since the debts to Ron were not bona fide debts, then its taxable income should be reduced by all of the interest accrued, both paid and unpaid. The Tax Court had agreed with VHC and removed the amounts of unpaid interest from taxable income but did not remove the small amount of interest that Ron did pay.
In its analysis, the Tax Court concluded that interest stopped accruing at the end of 2007 when VHC no longer had an expectation of any repayment, a finding the Court determined it had no reason to conclude was “clearly erroneous.” In its requests to the Tax Court, VHC asked that the Tax Court reduce its taxable income by the amount of unpaid but accrued interest to which the Tax Court agreed. VHC did not ask the Tax Court to reduce its taxable income by the interest that had been paid by Ron but was now asking for this further reduction on appeal. The Court noted that VHC may have “committed a tactical error by limiting its request to the Tax Court” but concluded that there was no error made by the Tax Court when it did exactly as VHC requested. Finding no error, the Court affirmed the Tax Court’s ruling on this issue as well.
Conclusion
There are several important take-aways that can be gleaned from this case. First, while planners will always hammer home the importance of properly documenting loans, especially intra-family loans, documentation only gets you so far. This is not to undermine the importance of documentation. Documentation is certainly of the utmost importance, but when it comes to determining whether a payment is a bona fide debt, the old saying rings true…actions speaks louder than words. In order for loans to be respected as bona fide debt, the parties must treat such loans as true debt. Interest must be accrued and payments must be made in accordance with the terms of the documents and agreed payment schedules, debts should not be continuously renewed and/or consolidated, and credit cannot continue to be extended where payments are already in default. Certainly there are times where payments cannot be made and the debt will be renegotiated at arm’s length, but such should not be the norm, and often times when such happens, the borrower will be required to make additional assurances such as more collateral and personal or third party guarantees. Unfortunately for VHC, the norm for Ron’s loans was to defer and extend payments and renew notes without any renegotiations taking place.
Additionally, anytime a taxpayer is seeking a deduction, proper books, records, and documentation must be kept in order to substantiate the deduction. In the VHC case, the documents, records, and bookkeeping were sloppy at best. Some of the notes were signed, some were stamped, and some where unsigned. The terms of the notes did not match up with VHC bookkeeping in several instances. Not only did these facts harm VHC’s argument that the payments were true debt, but it also became an issue of substantiating the payments for purposes of the ordinary and necessary business expense deduction. The Court agreed with the Tax Court conclusion that VHC did not provide enough evidence to substantiate the payments for the Section 162 deduction.
Last, any time there are dealings with family members, they must be undertaken at arm’s length and in the same manner as such dealings would be done with a third party. Further, the tax considerations must be carefully thought through. A great discussion of these considerations and a few cases where they have come up can be found in one for our prior articles here. In almost every court case involving intrafamily dealings, it is noted that such dealings are subject to a higher level of scrutiny. It is always important to properly document and treat loans as debt, but even more so when such loans are to family members.
[1] VHC, Inc. v. Commissioner, 126 AFTR 2d 2020-XXX (7th Cir. 2020).
[2] Id.
[3] Id.
[4] INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992).
[5] Cole v. Commissioner, 637 F.3d 767 (7th Cir. 2011).
[6] Id.
[7]Buelow v. Commissioner, 970 F.2d 412 (7th Cir. 1992).
[8] § 166(a). All references to a Section or § are to a Section of the Internal Revenue Code unless otherwise noted.
[9] Frierdich v. Commissioner, 925 F.2d 180 (7th Cir. 1991)
[10] Van Anda’s Estate v. Commissioner, 12 T.C. 1158 (1949), aff’d per curiam, 192 F.2d 391 (2nd Cir. 1951).
[11] § 162(a).
[12] Lohrke v. Commissioner, 48 T.C. 679 (1967).
[13] Id.
[14] Commissioner v. Lincoln Savings & Loan Association, 403 U.S. 345 (1971)
