TAX ALERT | March 21, 2023
Authored by RSM US LLP
Executive summary: Keeton v. Comm’r and the importance of properly documenting debt
The Keeton decision is yet another reminder that taxpayers must properly document related party cash advances if they wish to treat the advances as debt for tax purposes. The IRS is willing to attack and disallow purported bad debt deductions stemming from advances not clearly and appropriately documented as debt. Undocumented advances and documentation not kept current are low hanging fruit for the IRS, and taxpayers should understand the risk that they take on when they fail to properly substantiate the amounts.
Unfortunately, taxpayers too often don’t focus on the tax status of these advances until the determination is critical, a deal issue, and often too late to properly document the desired position. This issue may be of particular importance in the current economic environment where more taxpayers are encountering financial distress.
Tax Court denies bad debt deduction; advances were equity and not debt
The taxpayers, a married couple, owned 50% of an LLC that operated a landfill business. The business was poorly capitalized and had minimal access to third-party debt and instead relied primarily on cash advances from related parties. The cash advances, which began in 1999 and were accounted for using QuickBooks spreadsheets, totaled $7.4 million by the end of 2007. To memorialize the cash advances (or a portion of them) as debt, the parties signed a one-page promissory in 2008, which required the landfill business to repay $3.2 million plus interest at a 9% annual rate. However, the promissory note did not contain a maturity date or repayment schedule. Furthermore, the amount stated in the promissory note was not reconcilable with the totals in the QuickBooks ledger. The company did not actually pay any interest. There was no collateral securing the purported debt; the promissory note merely stated that, upon a demand for repayment, the debt must be paid along with any collection and attorney’s fees incurred in the process.
Over the years, the business’s financial condition worsened. In order to obtain new third-party financing in advance of a third-party loan’s 2012 maturity date, the taxpayers decided to capitalize the cash advances to company equity in an attempt to strengthen its balance sheet. In January 2012, this transaction was memorialized in a written agreement, which provided that accrued interest of $5.7 million would be canceled and the remainder of the debt would be converted to paid in capital. The company’s balance sheet for 2012 reflected this change and did not include a note payable.
In 2017, after all attempts to refinance the third-party loan fell through, the creditor foreclosed on the landfill, which represented the bulk of the company’s assets. Notwithstanding the conversion of the purported debt into equity, the taxpayers claimed a bad debt deduction of $2.1 million on their 2017 tax return relating to the cash advances.
The Tax Court’s ruling
The court denied the bad deduction for two reasons: (i) the purported debt was never debt; it was equity from the start and (ii) even had it been debt, the 2012 agreement would have converted it from debt into equity, thus eliminating the future ability to take a bad debt deduction.
A bona fide debt is one that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Reg. section 1.166-1(c). Whether a purported loan is a bona fide debt is determined by the facts and circumstances of each case. Because this case would be appealable to the Ninth Circuit, the court followed that jurisdiction’s precedent for guidance. The Ninth Circuit utilizes eleven factors to determine whether an advance of funds gives rise to bona fide debt as opposed to an equity investment.
The court walked through each of the factors and determined that the cash advances were not bona fide debt. As part of its analysis, the court noted that: (i) the cash advances were not memorialized as debt until years after they were made, (ii) the promissory note did not have a maturity date, (iii) the company did not pay interest, (iv) the company did not provide collateral, (v) the purported debt-holders did not have a realistic means of enforcing the collection of the cash advances, (vi) the company was thinly capitalized when the advances were made and (vi) repayment of the cash advances was subordinated to other debts. The court also noted that there were inconsistencies between the total amounts of the advances listed in the QuickBooks entries and the amount listed on the promissory note. Furthermore, the court noted, one of the relevant parties was not even aware of the existence of the promissory note. Accordingly, the court ruled that the cash advances did not constitute a bona fide debt obligation even prior to the conversion of the purported debt into equity, and the taxpayers were therefore not entitled to a bad debt deduction.
The court stated further that even had the cash advances constituted debt and not equity, the 2012 conversion of the debt into equity would have eliminated any status as debt. That was an additional reason why the taxpayers were not entitled to a bad debt deduction.
The situation that arose in Keeton is not unusual between related entities. For example, in Burke v. Comm’r, the Tax Court in 2018 addressed a situation that contained many similarities to Keeton, as we discuss in this article, Tax Court denies bad debt deduction holding advances were equity. Keeton and Burke underscore a longstanding premise: A taxpayer that wishes to treat related party cash advances as debt for tax purposes should ensure that (i) the advances meet certain criteria and (ii) the advances are properly documented as debt.
Failure to properly document debt is low hanging fruit for the IRS and may result in the denial of debt treatment for tax purposes, which may result in the disallowance of bad debt deductions. Proper documentation shouldn’t wait until it becomes salient to the taxpayer but should instead be executed at the outset. We recommend that a taxpayer seeking to treat intercompany cash advances as debt consult with a tax professional contemporaneously.
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This article was written by Nick Gruidl, Joseph Wiener, Aman Tekbali and originally appeared on 2023-03-21.
2022 RSM US LLP. All rights reserved.
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