Bad Debt Deduction Denied Where There Was No Legal Obligation to Pay Debt.

(Parker Tax Publishing November 23, 2013)

An engineer and his wife could not take a business bad debt deduction for a payment made by the husband's limited liability company (LLC) to satisfy the debt of a second company that he owned because the couple failed to show that the LLC was legally obligated to satisfy the debt. Herrera v. Comm'r, 2013 PTC 352 (5th Cir).

In 1978, Juan Herrera, a mechanical and metallurgical engineer, formed an engineering consulting company, Met-Tech, Inc. (MTI), with a colleague, Steve Stafford. MTI began to perform steel fabrication work in addition to the consulting business. Subsequently, Juan and Steve spun off the consulting business to a newly formed LLC, Herrera, Stafford & Associates (HSA), and continued their steel fabrication through MTI. In 2007, Juan became the sole shareholder of MTI and owned most of HSA. When MTI's steel fabrication business became unprofitable and required a cash infusion in 2004, MTI and HSA jointly executed a promissory note for a line of credit from Wells Fargo. Although both companies were obligors on the note, MTI received all the funds. In 2005, the line of credit was renewed and increased; however, only MTI was designated as the borrower. Juan personally guaranteed the note. When MTI did not meet its loan obligations, HSA obtained a loan solely in its name and used the proceeds to pay MTI's debt to Wells Fargo.

On its 2007 tax return, HSA claimed a business bad debt deduction for the payment of its purported loan to MTI. The deduction flowed through to Juan's individual tax return, which he jointly filed with his wife. The IRS disallowed the deduction and issued a notice of deficiency. The Tax Court held that the bad debt deductions were not allowable for three reasons: (1) the transfers that HSA made to or on behalf of MTI did not constitute a bona fide debt; (2) the Herreras failed to show that the alleged debt became worthless in the tax year for which the deductions were claimed; and (3) if there was a bona fide debt, it was deductible only as a short-term capital loss. The couple appealed to the Fifth Circuit.

Under Code Sec. 166, taxpayers can deduct from their gross income a business debt that becomes worthless within the tax year. Reg. Sec.1.166-9(a) provides that generally, where a taxpayer guarantees a loan in the course of his or her trade or business and subsequently must make payments to fulfill that guaranty, he or she may deduct those payments. A guaranty payment qualifies for a bad debt deduction only if there was an enforceable legal duty upon the taxpayer to make the payment. Voluntary payments do not qualify.

OBSERVATION: To be deductible as a bad debt, the debt at issue must be a bona fide debt. A bona fide debt is a debt that arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money.

Juan argued that HSA merely substituted its own note for MTIs note, and HSA's payments were in economic substance payments of MTI's debt.

The Fifth Circuit affirmed the Tax Court and held that the business bad debt deduction was properly disallowed since the payment of MTI's loan was not a bona fide debt. The court noted that when Wells Fargo renewed and increased the line of credit, only MTI was designated as the borrower on the note. Juan personally guaranteed the renewed line of credit. However, he did not do so on behalf of HSA. Further, the couple cited no authority that under their circumstances, HSA's payment of MTI's debt was anything other than voluntary. The court concluded that, although HSA's payments were effectively payments of MTI's debt, the couple did not establish that HSA was legally obligated to pay MTI's debt.

For a discussion of the rules for taking a bad debt deduction, see Parker Tax ¶98,405. (Staff Editor Parker Tax Publishing)

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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