Or, If It Doesn’t Look Like a Loan, It Isn’t

The takeaway from John C. and Margaret T. Ramig, 2011 T.C. Mem. 147, filed 6/27/11, is that, if you make a loan to a business in which you have an ownership interest, the more it looks like a loan, the better chance you have for a business bad debt deduction.

John was a lawyer turned shoe salesman. He started an on-line C Corporation shoe store in the early dot.com days, but it soon lost its footing and never made money. John made four purported loans, the remaining unpaid balance of which aggregated $29,600, to the business, none of which was ever repaid. What sinks John’s business bad debt deduction is that John never treated the loans as loans, even paying business creditors before taking any payment on the loans.

Judge Morrison lists the factors Ninth Circuit (where an appeal would lie) would consider in determining that the monies paid, 2011 T.C. Mem. 147, at p. 18. These are (i) the labels on the documents evidencing the (supposed) indebtedness, (ii) the presence or absence of a maturity date, (iii) the source of payment, (iv) the right of the (supposed) lender to enforce payment, (v) the lender’s right to participate in management, (vi) the lender’s right to collect compared to the regular corporate creditors, (vii) the parties’ intent, (viii) the adequacy of the (supposed) borrower’s capitalization, (ix) whether stockholders’ advances to the corporation are in the same proportion as their equity ownership in the corporation, (x) the payment of interest out of only “dividend money”, and (xi) the borrower’s ability to obtain loans from outside lenders.

Though there were notes from the C Corp to John, John signed only one of the four both as lender and as officer of the borrower. The other three were unsigned. Though there were maturity dates stated in the notes, the parties ignored them. Interest was never paid, and John testified he expected to be repaid if the C Corp could raise further capital from investors (which it never did). John clearly paid trade creditors ahead of the noteholder (himself).

Thin capitalization is neutral, as neither John nor IRS introduced evidence on that point.  But the outside financing availability factor weighs against John, as the C Corp clearly was unable to generate sufficient revenue to pay an arms’-length lender, and John never introduced evidence to show the C Corp could borrow from other sources. Although John’s advances were not proportional to his ownership interest, Judge Morrison gives this little weight, as he does whether John increased his right to participate in management, as no evidence was introduced on that point.

As for enforceability, it is questionable whether one can enforce an unsigned promissory note.

Bottom line–John was an equity investor, not a creditor.

My footnote-  Judge Morrison noted that John raised no other possible tax treatment with respect to the unpaid advances. How about capital loss, long or short term as the case might have been? John never asked, so Judge Morrison did not tell.