Equity, Equity, Debt! No wait, BAD DEBT!

Yet again, a taxpayer loses for not properly and contemporaneously documenting his intentions.1 Here is  another lesson on the importance of properly documenting loans (i.e. don’t just “book” as loans but have written loan documents contemporaneous with the advance).

Mr. Burke made a number of advances to a business operated by his friend.  Although the friends discussed loans, Mr. Burke classified them as loans, the corporation’s books showed them to be loans, they were not made pro rata by the shareholders, and a promissory note was later prepared (years later). The Tax Court disagreed with Mr. Burke’s treatment.

Some advances were made at the same time as stock was issued to Mr. Burke, there was no set maturity or stated interest, and Mr. Burke admitted he expected to be paid out of profits.  Advances were made from 1995-2010.  A promissory note was first prepared in 2010 after seeking advice of tax attorneys.  Ultimately, the Tax Court found these factors more persuasive and denied Mr. Burke’s loss deduction.

Also, although seeking the advice of competent tax attorneys, Mr. Burke did not avoid penalties. The Court found Mr. Burke’s reliance on the advice was not reasonable to avoid penalties stating that Mr. Burke did not rely on the advice in good faith.  The Court found too many red flags in the plan that a sophisticated businessman should have noticed.

Footnotes

  1. Burke v. Comm’r, TC Memo 2018-18.