Third Circuit Affirms Tax Court; $10 Million in Transfers Were Equity Investments, Not Debt

(Parker Tax Publishing February 2018)

The Third Circuit affirmed a Tax Court decision that a taxpayer's transfers of over $10 million from a wholly owned business to other companies in which he had an equity interest were equity investments, not loans, because the transfers bore no indicia of debt. The Third Circuit also rejected the taxpayer's treatment of the debt as worthless because no evidence was presented regarding the financial condition of the transferee companies and the taxpayer continued to transfer money to them after the year at issue. Sensenig v. Comm'r, 2018 PTC 16 (3d Cir. 2018).

John Sensenig is a CPA with years of experience preparing tax returns for himself and for businesses in which he has an equity interest. Sensenig has also engaged in business transactions totaling many millions of dollars. In 2005, Sensenig transferred $10.7 million through his wholly owned business, Conestoga Log Cabins Leasing, Inc. (CLCL), to three other companies in which he had an equity interest. Sensenig characterized the transfers as loans and deducted the full amount as wholly worthless debt in 2005. The deduction left Sensenig without income and thus without tax liability for that year.

The IRS determined that the transactions were not loans but equity investments. It disallowed the worthless debt deduction and determined that Sensenig owed approximately $1.5 million in taxes. A notice of deficiency was issued requiring payment of that amount plus a penalty of around $300,000. Sensenig petitioned the Tax Court. The Tax Court sustained the IRS's determination of the deficiency and the penalty. It agreed that the transfers were equity investments because, although Sensenig had identified a handful of the transactions as loans in his CLCL journal entries, the transactions bore no other indicia of debt. The Tax Court found that the transfers were not made pursuant to any written agreements providing for repayment of the principal or payment of interest, Sensenig never demanded repayment, and the transfers were designed to benefit Sensenig's equity interests in the companies. The Tax Court also concluded that even if the transfers were loans, they were not deductible as wholly worthless in 2005 because Sensenig produced no evidence regarding the financial conditions of the transferee companies and continued to transfer money to them after 2005.

Sensenig appeal to the Third Circuit. He pointed out that the transfers were accounted for in book entries by both the lender and the borrowing entities, that interest was calculated and booked, and that borrowing and repayments were also consistently booked over the years as loans and not as equity. Sensenig argued that he used book entries instead of promissory notes and that there was no law requiring a certain form of recordkeeping to prove a loan. Sensenig further contended that, as a Mennonite, he obtained the funds in question from a pool of Mennonite and Amish clients and that those clients orally instructed him to forward the funds as loans rather than as equity investments so that the funds would not be commingled with those of nonbelievers.

The Third Circuit affirmed the Tax Court's decision. Addressing the issues Sensenig raised on appeal, the court found that Sensenig cited no evidence of the purported book entries recording the transfers as loans. Sensenig's argument that he was not required to use promissory notes was rejected; as the Tax Court noted, aside from a handful of journal entries, there were no other objective indicia of loans and the economic realities of the transactions suggested that they were intended as equity investments. The Third Circuit determined that the Tax Court had applied the proper framework and that Sensenig had raised nothing to call its decision into question.

Finally, the Third Circuit found that Sensenig provided no evidence that the transfers were structured as loans at the instruction of his Mennonite and Amish clients. The Third Circuit reasoned that this argument undercut Sensenig's position. It noted that other transactions between Sensenig and his Mennonite and Amish clients were structured as loans and evidenced by notes providing for an interest rate. The transactions at issue, by contrast, were not. The Third Circuit concluded that even if Sensenig subjectively intended for the transactions at issue to be loans, he introduced no evidence regarding the intent of the transferee companies, and the evidence as a whole overwhelmingly suggested that the transactions were equity investments.

For a discussion of the characterization of a corporate instrument as stock or debt, see Parker Tax ¶45,310. For a discussion of the deduction for a worthless debt, see Parker Tax ¶ 98,410.

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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