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Tax Court Upholds LLC's $2.9 Million Bad Debt Deduction
(Parker Tax Publishing February 2019)
The Tax Court held that a limited liability company (LLC) properly deducted a debt of approximately $2.9 million as worthless because the debt was a bona fide debt and became worthless in the year at issue. The court rejected the IRS's argument that debt was extinguished when it was contributed to the LLC in exchange for a member interest as the result of negotiations between the debtor and the lender, who had both a personal and a business relationship. 2590 Associates, LLC, et al v. Comm'r, T.C. Memo. 2019-3.
Background
Joseph Spinosa is a Louisiana real estate developer who owns multiple real estate ventures through numerous business entities. Mr. Spinosa organized two limited liability companies (LLCs), Perkins Rowe Associates I and II (referred to collectively as Perkins Rowe) to acquire and develop land for a shopping center (the Perkins Rowe property).
In 2006, Perkins Rowe was in discussion with KeyBank National Association for a construction loan to finance the development of the Perkins Rowe property. At that time, work had begun on the Perkins Rowe property and Perkins Rowe needed capital to continue the work before the construction loan was approved.
Spinosa obtained a loan from Nick Saban, his acquaintance and business associate. Saban lent Perkins Rowe $2 million in April 2006 in exchange for a note providing for 16 percent interest and an April 2007 maturity date (2006 note). Saban did not have an equity interest in Perkins Rowe, did not participate in its management, and had no member voting rights.
In July 2006, Perkins Rowe received a construction loan of $170 million from KeyBank. Spinosa intended to repay the Saban loan from the first disbursement of the construction loan. However, problems with contractors caused the project to fall behind schedule. In April 2007, Spinosa asked Saban to extend the due date on the Saban loan. Perkins Rowe gave Saban a second note (2007 note) for a principal amount of approximately $2.3 million, plus 16 percent interest with a June 2008 maturity date. At this point, Perkins Rowe had preleased approximately 70 to 80 percent of the development and had contracts for sale on around 80 condominium units in the development.
Contractor issues and cost overruns resulted in the need for additional capital and, in late 2007, Perkins Rowe sought a $15 million loan from KeyBank. KeyBank declined to make the loan, so Perkins Rowe obtained a loan from another lender in exchange for an interest in another of Spinosa's real estate projects unrelated to Perkins Rowe. Around this same time, Perkins Rowe and KeyBank discussed refinancing the construction loan. Despite obtaining an appraisal showing that Perkins Rowe had significant equity in the project, KeyBank rejected the refinancing. Spinosa also attempted to raise capital through the use of tax-exempt Gulf Opportunity Zone (GO Zone) bonds. Perkins Rowe was approved to issue $250 million in GO Zone bonds.
In June 2008, Saban asked Spinosa about a plan to repay the Saban loan. Spinosa offered Saban five options, four of which included the transfer of an ownership interest in a real estate project unrelated to Perkins Rowe; the fifth option was to extend the maturity date of the 2007 note and to lower the interest rate. Saban agreed to acquire an ownership interest in another property that Spinosa planned to develop which was owned by an LLC called 2590 Associates. There was no business relationship between Perkins Rowe and 2590 Associates, and the developments were unrelated. However, Spinosa managed both entities and they had some common ownership.
In 2008, Perkins Rowe I, which was 50 percent owned by Spinoza and 50 percent by another investor, executed a promissory note for approximately $2.9 million (2008 note) payable to Saban in August 2010. The 2008 note stated that it was given in substitution for the 2007 note. Saban transferred the note to 2590 Associates in exchange for a member interest, and 2590 Associates took physical possession of the note. The operating agreement was amended to reflect Saban's 15 percent allocation of the profit, gain and loss.
In late 2008, Perkins Rowe defaulted on the construction loan and KeyBank filed a foreclosure lawsuit. In 2011, a district court dismissed Perkins Rowe's affirmative defenses and counterclaims and entered summary judgment on KeyBank's right to foreclose. However, the final judgment was entered in 2012 due to issues unrelated the foreclosure. 2590 Associates did not attempt to collect on the 2008 note, which would have been futile. The GO Zone bonds were also terminated in 2011 due to Perkins Rowe's failure to place the bonds with investors.
2590 Associates filed a partnership tax return for 2011 claiming a worthless debt deduction of approximately $2.9 million for the 2008 note. The same year, Perkins Rowe recognized cancellation of indebtedness income of approximately $2.8 million in connection with the 2008 note. The IRS issued a final partnership administrative adjustment (FPAA) disallowing the worthless debt deduction. 2590 Associates challenged the FPAA in the Tax Court.
Analysis
Under Code Sec. 166(a), a taxpayer can deduct any debt which becomes worthless within the taxable year. Reg. Sec. 1.166-1(c) provides that the taxpayer must show:
(1) the deducted amount represents a bona fide debt;
(2) the debt became worthless during the year; and
(3) the debt was incurred in connection with a trade or business.
A bona fide debt is one that arises from a debtor-creditor relationship on the basis of a valid and enforceable obligation to pay a fixed or determinable sum of money. The Fifth Circuit considers 13 nonexclusive factors to determine whether a bona fide debt exists:
(1) the names given to the certificates evidencing the debt;
(2) a fixed maturity date;
(3) the source of repayment;
(4) a legally enforceable right of repayment;
(5) the creditor's right to participate in the debtor's management;
(6) the subordination of the obligation;
(7) the parties' intent;
(8) the debtor's capitalization and use of the funds;
(9) the identity of interest between creditor and stockholder;
(10) the payment of interest;
(11) the debtor's ability to obtain funds from outside lenders;
(12) the extent to which the advance was used to acquire capital assets; and
(13) the failure of the debtor to repay on the due date or seek postponement.
The real issue, according to the Fifth Circuit, is the extent to which the transaction complies with arm's length standards and normal business practice, and special scrutiny is applied to transactions between entities in the same corporate family or with shared ownership.
The IRS conceded that the debt between Saban and Perkins Rowe was bona fide. However, the IRS argued that the transfer of the 2008 note to 2590 Associates did not create a bona fide debtor-creditor relationship between Perkins Rowe and 2590 Associates. Rather, the IRS contended that Saban's receipt of the member interest in 2590 Associates satisfied the Saban loan. According to the IRS, Perkins Rowe and Saban entered into a contract to modify and extinguish the Saban loan through the transfer of an interest in 2590 Associates. The IRS argued that the parties to the Saban loan, including Spinosa by his own testimony, viewed Saban's receipt of an interest in 2590 Associates as satisfaction of Perkins Rowe's debt to Saban. In addition, the IRS said that there was no transfer of funds between Perkins Rowe and 2590 Associates that could create a debt.
The Tax Court rejected the IRS's arguments and concluded that 2590 Associates was entitled to a worthless debt deduction. The court found that Saban entered into a legitimate debt with Perkins Rowe and transferred the debt to 2590 Associates. Saban's transfer of the 2008 note to 2590 Associates, the court said, did not negate the legitimacy of the debt. The court noted that the transaction may not have been typical of a normal business relationship because of the personal relationship between Spinosa and Saban, but the court found that it was nevertheless a transfer of a legitimate debt. In the court's view, 2590 Associates made a business decision, influenced by personal relationships, to give Saban an ownership interest in exchange for the 2008 note. The court found that although the July 2008 memorandum expressed the intent to satisfy the debt to Saban, the transaction postponed the need for Perkins Rowe to repay the debt but did not discharge it. The court further found that each option offered to Saban in the July 2008 memorandum was a means to delay repayment rather than to cancel the debt.
The Tax Court also found that there was not identity of ownership between Perkins Rowe and 2590 Associates because, although the two entities had common management (Spinosa) and common, related owners, an unrelated investor owned 50 percent of Perkins Rowe I, which was the only named debtor on the 2008 note. Spinosa's partial ownership of Perkins Rowe I alone did not negate its finding that Saban transferred a legitimate debt to 2590 Associates, in the court's view. The Tax Court found that only two of the 13 factors weighed against a bona fide debt: the note's subordination to secured creditors and Perkins Rowe's failure to repay the debt and accrued interest.
Finally, the Tax Court found that the 2008 note became worthless in 2011. The court reasoned that it was in that year that the GO Zone bonds were terminated. In addition, Perkins Rowe's counterclaims and affirmative defenses in the foreclosure case were dismissed that year. With these events, the court concluded that it was reasonable to abandon hope of recovery on the 2008 note by the end of 2011.
For a discussion of the bad debt deduction, see Parker Tax ¶98,400.
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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