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Individual's Personal Loans to Failed Company Qualified for Bad Debt Deduction

(Parker Tax Publishing August 2017)

The Tax Court held that the owner of a commercial lending business who made personal loans to a laundry business and recovered nothing on the loans was entitled to a bad debt deduction. In ruling that the individual was in the trade or business of lending, the court noted that the individual had, during a 14 year period, personally made at least 66 loans exceeding $24 million, which it found was more than sufficient when compared to the benchmark set in other cases. Owens v. Comm'r, T.C. Memo. 2017-157.


William Owens owns a majority interest in Owens Financial Group, Inc. (OFG), a commercial mortgage broker. Owens has been the president of OFG for more than 20 years. OFG specializes in short term bridge loans to investors looking for quick financing on purchases of income-producing property. Owens also makes loans from his personal assets and has done so since at least 1986. The personal loans were typically made to borrowers too risky for OFG. Owens funded these personal loans from his trust or from a family limited partnership (FLP) he managed. Owens had made over 200 personal loans since 1979, including at least 89 from 1999 through 2013. Owens did not keep a separate office for his personal lending business. Personal lending was done out of the OFG office and OFG staff handled all correspondence, documentation, and legal issues arising from his personal lending. OFG also managed loan servicing throughout a loan's duration.

In 2002, Owens began a series of loan transactions with David Lohrey, the owner of the largest commercial laundry in San Francisco. Lohrey's largest customer, Marriott, bought 50 percent of Lohrey's laundry in order to form Marriott Services, a company that would bundle laundry with other hotel services. Marriott later bought out Lohrey's interest and leased a commercial laundry facility in Gilroy, CA from Lohrey. Later in 2002, Marriott Services was sold to Sodexo. Lohrey bought back the business from Sodexo in 2003 and opened Lohrey Enterprises, d/b/a West Coast Linen. Lohrey began to fall behind on his payments and the bank foreclosed on the Gilroy property. Lohrey Investments then filed for chapter 11 bankruptcy. After a buyout was negotiated, Lohrey needed funding to pay off the new loan and to purchase equipment. Lohrey's bank decided that he was too much of a risk for a loan and referred him to OFG.


Owens determined that OFG could lend Lohrey Investments $7.5 million -- not enough to pay off the bank loan. Owens then personally advanced additional funds. He had appraisals of Lohrey Investments' equipment prepared and obtained the bank's appraisals of the Gilroy property. In 2003, Owens personally loaned Lohrey Investments $2.75 million, funded by Owens Trust and the FLP. The loan had a 15 percent interest rate, required monthly payments and had a September 2005 maturity date. It was secured by the Gilroy property and, unlike the OFG loan, gave Owens the right to participate in the income of the business over a certain threshold.

When Lohrey Investments fell behind on its payments, Owens agreed to defer repayment of his personal loans, in part to allow Lohrey to continue paying back OFG. In December 2005, Owens entered into an operating agreement with Lohrey himself, making Owens Trust a member of Lohrey Investments and Owens the tax matters partner. The operating agreement allocated to Owens 30 percent of both the profits and capital and 99 percent of the losses. However, Owens's tax filings for 2006 and 2007 reported him as having a 99 percent share in the profits, losses and capital of Lohrey Investments. Owens reported a net rental real estate loss of approximately $4 million for 2006 and $2.8 million for 2007.

In 2005, Lohrey needed additional money but OFG and Owens were tapped out, so Owens recommended Vestin Mortgage, Inc., which agreed to a loan as long as Owens subordinated his own loans to Vestin. Owens thought the additional money would help stabilize the business; he was hopeful because Lohrey was negotiating a large deal with Kaiser Industries. In June 2006, Vestin loaned $16 million to Lohrey Investments, secured by the Gilroy property and the equipment within it. Lohrey fully repaid OFG but not Owens's personal loan. Lohrey also bought more laundry equipment.


Lohrey Investments became delinquent on the Vestin loan. West Coast Linen filed for chapter 11 bankruptcy in August 2008, which Lohrey intended as a delay tactic until he could install a better client billing system. Overnight, the bankruptcy trustee padlocked the gate to the Gilroy property, leaving several large hospital and hotel customers without clean linens. In November 2008, the bankruptcy was converted to a chapter 7 liquidation. At that time, although the company was unable to operate, it listed its assets as exceeding its liabilities. However, Owens ultimately recovered nothing. Lohrey Investments filed for chapter 11 in January 2009, which was also converted to a chapter 7 proceeding; David Lohrey also filed for personal bankruptcy. Owens recovered nothing in either the Lohrey Investments or David Lohrey proceedings.

Tax Returns

Owens's CPA advised him that he was entitled to a bad debt deduction for his losses on the loans to Lohrey Investments. Owens claimed a $9.5 million bad debt loss expense on his 2008 return and a net operating loss carryforward for 2009 and 2010. He also amended his returns for 2003-2005 to claim a carryback for those years. The IRS issued a notice of deficiency denying the deduction, carrybacks and carryforwards. The total of the claimed deficiencies was over $3 million. According to the IRS, Owens's lending activity was not a trade or business and even if it was, the loans were more equity than debt. Owens argued that he qualified for the deduction because he had been in the business of making personal loans on a continual and regular basis for years, that the loans were bona fide debts, and that they became wholly worthless in 2008 when West Coast Linen filed for bankruptcy and the trustee padlocked the Gilroy facility.


The Tax Court held that Owens was entitled to a bad debt deduction in 2008. According to the Tax Court, Owens was in the trade or business of lending money during the years at issue because his moneylending activity was continuous, regular, and had the primary purpose of earning income or making a profit. The court found that between 1999 and 2013, Owens personally (alone, or acting as trustee of Owens Trust) made at least 66 loans exceeding $24 million, which it found was more than sufficient when compared to the benchmark set in other cases. In the court's view, the fact that OFG staff kept records of the loans did not count against Owens. To the contrary, the recordkeeping showed that Owens was treating his personal lending as a continual and regular activity, according to the court. Further, given the number of loans Owens made, the court found that his personal lending was a regular activity. The fact that Owens continued to lend money to Lohrey and subordinated his loans to other creditors did not, in the court's view, mean that Owens was not acting with a profit motive. The court found that under the circumstances, Owens's decision to continue advancing money to Lohrey was a reasonable business decision.

Next, the Tax Court applied a multifactor test under Ninth Circuit precedent and found that, under the facts and circumstances, the loans created bona fide debts. Weighing in Owens's favor was the fact that he used promissory notes with maturity dates. Although the maturity dates were not enforced, the court found it was reasonable for Owens to give Lohrey time to improve his financial situation. Also favorable to Owens was that he did not make repayment legally contingent on the success of Lohrey's business; rather, Owens's right to enforce payment regardless of Lohrey's success showed the existence of a bona fide debt, according to the court. The court found that although the subordinate status of Owens's loans implied an equity interest, it was not unreasonable under the circumstances for Owens to accommodate other lenders in order to see a return on his advances.

The Tax Court also held that Lohrey Investments' debt to Owens became worthless in 2008 because Owens had no hope of recovery as of 2008 when West Coast Linen filed for bankruptcy and the trustee padlocked the Gilroy facility. At that point, there was little hope for a comeback because Lohrey had lost his primary client and his reputation was irreparably damaged, according to the court. Further, when Lohrey told Owens in 2008 that Lohrey Investments was going to file for bankruptcy, Owens knew that Lohrey Investments would not be able to repay its debt and that in a battle over collateral, Owens would lose to Vestin. According to the court, the fact that Lohrey still subjectively believed his company to be solvent in 2008 was less important than Owens's belief that the value of the property was very small relative to the debt. That Owens ultimately recovered nothing was evidence of Owens's reasonableness in believing the loans to be worthless in 2008, in the court's view.

For a discussion of the general rules for a bad debt deduction, see Parker Tax ¶98,401.

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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