Taxpayer's Detailed Records Proved Loans Were Bona Fide

(Parker Tax Publishing November 2016)

The Tax Court determined that a taxpayer had properly excluded from income amounts he characterized as loans. The court found the taxpayer's testimony and records were sufficiently credible and detailed to prove the existence of bona fide loans, and noted the IRS could not offer any evidence otherwise. Stanley v. Comm'r, T.C. Memo. 2016-196.

Background

Clifton Stanley owned and operated Stanley & Associates, a sole proprietorship engaged in the insurance business, where he worked as an insurance agent selling annuities and providing retirement advice to clients. He also invested in real estate. In 2010 and 2011 (the years at issue), Stanley received funds from clients and friends, which he treated as loans, and made periodic payments to some of those clients and friends (and in some cases returned the amounts provided). Generally, Stanley used the loan proceeds to expand Stanley & Associates, invest in real estate, cover some personal and business expenses, and occasionally to repay other loans that became due. He did not link any particular loan proceeds with any particular activities. He intended to repay the lenders from his real estate investment income and his insurance business.

Stanley issued promissory notes to lenders for 22 loans during the years at issue. All but one of the promissory notes were unsecured. Repayment periods ranged from 6 to 24 months, and interest rates ranged from 7 percent to 25 percent. Some of the interest payments were made in accordance with the terms of the corresponding promissory note while other interest payments were untimely. Stanley recorded the amounts of interest paid on some of the corresponding promissory notes. For other payments the only record was the check itself.

When the loans became due, some were paid in full while others were renewed. With respect to the loans that were renewed, the repayment period of each loan was extended and interest continued to accrue. Stanley indicated in writing on most (but not all) of the promissory notes whether the loans were paid in full or were renewed. In some cases, loans were renewed without any documentation of the renewal; the only indication of renewal was that Stanley paid interest or in some cases made a partial loan repayment.

On his 2010 and 2011 income tax returns, Stanley did not include in income the proceeds from the loans. Following an audit of these returns, and after performing a bank deposits analysis, the IRS determined that the excluded amounts were income, not bona fide loans, and adjusted Stanley's income for 2010 and 2011.

Analysis

Courts consider various factors in determining whether a transaction is a bona fide loan, such as:

(1) the ability of the borrower to repay;

(2) the existence or nonexistence of a debt instrument;

(3) security, interest, a fixed repayment date, and a repayment schedule;

(4) how the parties' records and conduct reflect the transaction;

(5) whether the borrower had made repayments;

(6) whether the lender had demanded repayment;

(7) the likelihood that the loan was disguised compensation for services; and

(8) the testimony of the purported borrower and lender.

These factors are non-exclusive and provide a general basis on which courts analyze a transaction.

The Tax Court determined that the amounts Stanley had excluded from his returns were proceeds from bona fide loans, and thus weren't required to be included in his income.

The court stated that Stanley credibly testified that the lenders provided him funds because he offered an attractive return on their investment and that he intended to repay the outstanding loans in full and intended to pay any interest that had accumulated. While Stanley did not have a specific plan for repayment, the court said, he intended to use the proceeds from his insurance business and his real estate investments. The court noted that the IRS offered no evidence to contradict his testimony save the fact that certain loans had been renewed.

In addition, the court stated, Stanley's records, although not complete, generally supported loan characterization. The record before the court contained 22 promissory notes between Mr. Stanley and the lenders for 2010 and 2011. The promissory notes included: the amount and date of the loan; the lender's name and address; the interest rate; the length of the loan period; the due date of interest payments and the unpaid principal; and the signatures of the parties.

The court concluded that Stanley's actions also supported loan characterization. The court noted he paid the interest for the corresponding promissory notes, made repayments on some of the loans while other loans were renewed, and indicated the loan status on some of the corresponding promissory notes (whether paid off or renewed and the amount of interest paid).

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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