Taxpayer Was Entitled to Business Bad Debt Deduction for Unrepaid Loan

(Parker Tax Publishing September 2019)

The Tax Court held that a real estate broker who made a personal loan to a furniture business and later recovered only a portion of the principal amount of the loan was entitled to take a business bad deduction under Code Sec. 166(a) for the unrecovered amount. The court found that the taxpayer was engaged in the trade or business of lending money because he personally made loans to a variety of borrowers on a regular basis, his lending activity was substantial, and he engaged in the activity with the intent of making a profit, and concluded that the debt became worthless in the year at issue. Bercy v. Comm'r, T.C. Memo. 2019-118 (2019).

Background

Charles Bercy, a licensed real estate broker in California, was the founder and president of the Argus Group (Argus). Argus was chiefly engaged in making mortgage loans secured by real estate, typically short-term speculative loans for residential construction. Argus lent at least $750 million since its founding in 1989. Bercy also owned Astin-Carr, a company that arranged real estate syndications and regularly supplied capital to Argus.

Apart from his activity in these companies, Bercy loaned substantial sums for his own account. Over the years, he made more than $25 million of personal loans. Whenever a plausible borrower approached him about a personal loan, Bercy investigated the proposed project, sought appraisals, and consulted his personal guidelines for gauging risks and rewards. Most, but not all, of the loans Bercy made for his own account were real estate related. He pegged the outstanding volume of his personal property loans in 2007 at about $1 million.

In early 2007, Bercy's acquaintance, Darryl Aken, approached Bercy with a proposal for a personal loan. Aken operated a furniture business in Los Angeles under the trade name Girari. Girari's high-end furniture, which it sold as well as rented, was popular among Los Angeles partygoers, and in 2007 Aken sought capital to expand his business to Las Vegas. He told Bercy that he was looking to borrow $200,000. Aken disclosed that Girari had $400,000 of pre-existing debt, including $100,000 owed to Richard Kern, an unrelated party whom Bercy believed to be a savvy investor.

Bercy investigated Girari and, impressed by Girari's business plan and Kern's business reputation, decided to lend money. Bercy did not want to lend the full $200,000 himself, so he asked another lender, Dennis Levitt, to go 50-50 with him. The parties executed a promissory note whereby Bercy and Levitt each lent $100,000 to Girari. The note bore interest at 11.25 percent and matured in one year. Aken personally guaranteed the note and Girari gave Bercy and Levitt equal security interests in its assets. The lenders did not, however, perfect their security interests.

Demand for Gerari's furniture dwindled during the 2007-2008 financial crisis and when the promissory note came due in 2008, Girari was unable to repay. As a real estate lender, Bercy had bigger problems at that point, so he declined to seek an immediate remedy for Girari's default. Instead, Bercy resolved to let Aken, who had expertise in the furniture industry, attempt to restructure Girari and find a way to repay the loan. In 2010, Aken concluded that selling Girari was the only option, but by early 2013 Girari had not been sold. In 2013, Levitt agreed to take $25,000 in seven installments in complete satisfaction of the $100,000 he was owed. Bercy and Girari's other lenders believed that they stood to recover more if they waited until Aken found a buyer. They accordingly acquiesced in Levitt's exit on these terms. By year end 2013, Girari had made total payments to Levitt of only $13,000.

In 2014, Girari sold its assets to Kool Party Rentals (Kool) for $235,000. Kool paid $30,000 in cash and executed a promissory note for the $205,000 balance. The note bore interest at 5 percent annually and required that principal be repaid in monthly installments of $3,500, plus interest. Girari used the $30,000 to refurbish the rental furniture that was to be delivered to Kool. The first $12,000 paid via monthly installments was allocated to Levitt to satisfy the balance of his $25,000 claim. The other creditors agreed that the balance of the note, or $193,000, would be paid 20 percent to Bercy, 20 percent to Kern, and 60 percent to other investors. Bercy's share of the principal was thus $38,600 (20 percent of $193,000). Bercy and the other lenders believed that Girari's and Aken's obligations to them, originally totaling $500,000, had been completely extinguished on their receipt during 2014 of interests in the Kool note. Kool fully discharged the $205,000 note in April 2017.

On their 2014 tax return Bercy and his wife claimed a business bad debt deduction of $65,000 under Code Sec. 166(a). They reported this loss on the Schedule C, Profit or Loss From Business, for Bercy's sole proprietorship activity. The Bercys' accountant calculated the $65,000 loss by valuing Bercy's interest in the Kool note at $35,000, applying a 9.4 percent discount to the $38,600 of principal that he was due. In a notice of deficiency, the IRS disallowed the claimed deduction because it had determined that Bercy failed to establish that the expense was ordinary and necessary to his business. The Bercys took their case to the Tax Court.

The IRS conceded that Bercy was engaged in the business of real estate lending but argued that making personal property loans was outside the scope of that business. The IRS also contended that Bercy's non-real estate lending activity was insufficiently robust to constitute a trade or business distinct from his business of real estate lending. The IRS asserted that the debt did not become worthless in 2014 because Bercy could have recovered more than his pro rata share of the Kool note. According to the IRS, Bercy's security interest in Girari's assets attached to the proceeds of the asset sale and gave him priority over the claims of the other creditors. Based on that premise, the IRS argued that Bercy was entitled to receive all of the proceeds from the Kool note until he was repaid in full.

Analysis

The Tax Court held that the Bercys were entitled to a bad debt deduction of $61,400, the difference between the original $100,000 loan and the $38,600 face value of Bercy's interest in the Kool note. The court found that Bercy made a bona fide loan to Girari in 2007, the loan constituted a business debt, and the debt became worthless in 2014.

The court concluded that Bercy was engaged in a trade or business of lending money distinct from his activities on behalf of Argus and Astin-Carr because he personally made loans to a variety of borrowers, solely for his own account, on a regular basis. The court found that his personal lending activity was substantial and that he engaged in this activity with the intent of making a profit. In addition, Bercy's behavior in connection with the Girari loan was consistent with his general business practices and the loan was proximately related to his trade or business of lending money. In the court's view, the IRS construed the term "trade or business" too narrowly. The court explained that when previously considering the status of loans as business debts under Code Sec. 166, the court has not segmented a taxpayer's lending business according to the nature of the loan or type of customer. Rather, the court explained, it has simply asked whether the taxpayer was in the business of lending money, separate and distinct from any other gainful employment.

Next, the court found that the debt became worthless in 2014 because the sale of Girardi's assets was an identifiable event that reasonably caused Bercy to abandon any hope of recovery beyond the amount to which he was entitled under the Kool note. The court rejected the IRS's argument that Bercy could have recovered more than his pro rata share of the Kool note. In the court's view, it was unclear what the source of that recovery could have been as Girari had sold all of its assets and Bercy's ability to sue on Aken's personal guarantee was uncertain under California law. The court also did not agree that Bercy had priority over Girari's other creditors. The court noted that Bercy agreed with the other creditors to accept pro rata shares of the Kool note in full payment of their respective claims against Girari, and it was difficult for the court to see how Bercy could have reneged on that agreement by asserting an unperfected security interest as a bar to their entitlements.

Finally, the court determined that the Bercys' bad debt deduction should be calculated without applying a discount rate. According to the court, the fact that the Girari note bore a higher interest rate than the Kool note was irrelevant and the interest rate that Girari agreed to pay was immaterial to the determination of the fair market value of Bercy's share of the Kool note.

For a discussion of claiming a business bad debt deduction, see Parker Tax ¶98,430.

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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