Seventh Circuit Affirms That Purported Loans Were Not Bona Fide Debt

(Parker Tax Publishing August 2020)

The Seventh Circuit upheld a Tax Court decision denying a bad debt deduction under Code Sec. 166(a) for cash payments a paper services company made to the son of the company's owner that were never repaid because there was no debtor-creditor relationship between the parties. The court also held that the company could not deduct the payments as ordinary and necessary business expenses under Code Sec. 162 because the company could not show that the payments were an ordinary arrangement in the paper services industry. VHC, Inc. v. Comm'r, 2020 PTC 235 (7th Cir. 2020).

Background

Ron Van Den Heuvel's father founded VHC, Inc., in 1985 to provide services to the paper manufacturing industry. Ron and his four brothers all worked for VHC or its subsidiaries in some capacity. Ron subsequently formed two of VHC's subsidiaries, directed a number of its other companies, and launched his own companies separate from VHC.

Between 1997 and 2013, VHC advanced $111 million to Ron and his companies. These payments took several forms and fulfilled several purposes, including paying debts owed by both Ron and his companies. Ron and his companies would come to owe VHC $132 million, including interest, by 2013 but would only ever repay $39 million. In 2002, Associated Bank, a creditor to both Ron and VHC, demanded that VHC guarantee all of Ron's debts to Associated - about $27 million - as a condition of preserving VHC's line of credit with Associated. VHC agreed and made similar arrangements a year later with two other banks.

Ron's companies struggled, and in 2004 VHC began writing off its payments to Ron as bad debts under Code Sec. 166(a), ultimately writing off $95 million by 2013. After an audit, the IRS issued a notice of deficiency to VHC, rejecting $92 million of these write-offs. VHC petitioned the Tax Court to review the deficiency determination. The Tax Court upheld the IRS's deficiency finding. Applying the 10-factor test for a debtor-creditor relationship laid out in In re Larson, 862 F.2d 112 (7th Cir. 1988), the Tax Court determined 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 rejected VHC's alternative arguments, including its contention that its payments to Ron were ordinary and necessary business expenses under Code Sec. 162(a) because of VHC's 2002 agreement with Associated. The Tax Court slightly reduced VHC's liability, however, concluding that the unpaid interest accrued on the payments to Ron was not taxable as income because the debts were not bona fide. VHC appealed the Tax Court's ruling to the Seventh Circuit.

On appeal, VHC argued that the only relevant factor was the intent of the parties, and that VHC demonstrated that it believed the advances to be debt for which it expected to be repaid by signing promissory notes and holding out to third parties that the advances were debts. VHC also contended that Associated Banka creditor of both Ron and VHCthreatened to terminate VHC's line of credit, forcing VHC into bankruptcy, if it did not float money to Ron to help him pay his own debts to Associated. VHC highlighted that the Tax Court's ruling in Lohrke v. Comm'r, 48 T.C. 679 (1967), that payments made by a taxpayer for the benefit of a third party may be deductible as ordinary and necessary business expenses if the taxpayer benefited from the payment. In addition, VHC argued that the Tax Court did not sufficiently reduce VHC's interest income, and that if the payments to Ron were not bona fide debts, then it should be allowed to reduce its taxable income in the amount of any interest that accrued on the payments.

Analysis

The Seventh Circuit held that VHC did not have debtor-creditor relationship with Ron and therefore was not entitled to deduct the payments to him as bad debts. The court held that even if VHC was correct that the parties' intent was the only relevant factor, VHC's appeal would still fail because VHC and Ron did not treat the payments as debt. The court noted that although many of the promissory notes had fixed maturity dates, VHC routinely deferred payment or renewed the notes without any receipt of payment. Further, the court found that VHC did not expect to be repaid unless various other events occurred, such as Ron securing additional investments and projects. In the view of the Seventh Circuit, this sort of relationship was that of an investor, not a creditor. Though VHC may have described the payments as debt, it did not treat them as part of an ordinary debtor-creditor relationship and therefore did not establish that the parties intended such a relationship.

The Seventh Circuit also rejected VHC's argument that the payments were deductible as ordinary and necessary business expenses. The court found that VHC failed to substantiate its expenses and that, even if it had, the requirement by Associated that VHC guarantee Ron's loans did not automatically make any related expenses ordinary and necessary. In the court's view, VHC failed to show that such payments ordinarily occur in the paper services industry. Rather, the court found that VHC and Associated entered into a seemingly unusual arrangement through which VHC's credit depended on its support of a third party, and the court concluded that VHC did not carry its burden of showing that its payments to support Ron under such an arrangement were ordinary in its industry.

With respect to VHC's claim for an additional interest income reduction, the court found that VHC had argued before the Tax Court only for a reduction of its taxable income by the amount of accrued interest for the period before 2007, the year when VHC decided that it did not expect repayment. The court said it would not search for error where the court below did exactly as VHC requested, and the court found no error in the Tax Court's determination that interest accruals stopped in 2007.

For a discussion of the bona fide debt requirement for a bad debt deduction, see Parker Tax ¶98,405. For a discussion of ordinary and necessary business expenses, see Parker Tax ¶ 90,110.

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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