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Lack of Formal Loan Agreement Precludes Bad Debt Deduction.
(Parker Tax Publishing December 2013)

Advances made by an electrical contractor to another company and to a long-time employee were not bona fide debts because no genuine debtor-creditor relationship existed between the contractor and the borrowers; thus, no bad debt deductions were allowed. DF Systems, Incorporated, 2013 PTC 385 (5th Cir. 12/10/13).

DF Systems was an electrical contracting company owned and operated by Larry and Gladys Dorman. In 2000, DF Systems received a request from one of its customers for a contracting job to be performed by minority contractors. To fulfill the request, a second company, E.L. Construction, Inc. was formed by the Dorman's daughter, Lori Schroder. The board of directors for DF Systems voted to advance funds to E.L. Construction for the purpose of getting the company started and to pursue minority contracts. The board meeting minutes did not establish (1) the amount of money to be advanced, (2) an interest rate, (3) a repayment schedule, or (4) any security for the advance. DF Systems did not enter into a written loan agreement or take any equity interest in E.L. Construction.

In an unrelated transaction, in 2005, DF Systems advanced funds to a long-time employee who had become ill. Although the funds were recognized at a board of directors meeting, there was no indication that the funds were intended to be a loan. On its 2006 federal income tax return, DF Systems claimed a bad debt deduction for over $56,000 in payments to E.L. Construction and approximately $25,000 in payments to the long-time employee. After an audit, the IRS disallowed the bad debt deductions and determined a deficiency of over $30,000. The Tax Court affirmed the IRS determination and DF Systems appealed.

Code Sec. 166 states that 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 amount of money. Reg. Sec. 1.166-1(c) provides that, to determine the existence of a bona fide debt, the following non-exclusive factors must be considered: (1) the names given to evidence the debt; (2) the presence or absence of a fixed maturity date; (3) the source of the payments; (4) the right to enforce payment of principal and interest; (5) participation in management as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the intent of the parties; (8) adequate capitalization; (9) identity of interest between creditor and stockholder; (10) source of interest payments; (11) ability of corporation to obtain loans from outside lending corporations; (12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to pay on the due date.

OBSERVATION: The parties' intention that a transaction is a loan depends on whether the advances were made with a reasonable expectation that they would be repaid. The existence of a bona fide debt is a factual inquiry that is determined by the facts and circumstances of a particular case.

The IRS contended that DF Systems failed to show that (1) the funds arose from a true debtor-creditor relationship, (2) the debt was based on a legally enforceable obligation, (3) the amounts became worthless during the tax year, and (4) the company took reasonable steps to collect the debts. DF Systems argued that the Tax Court focused too narrowly on the form of the transaction and disregarded evidence of the parties' intent. The Tax Court agreed with the IRS and DF Systems appealed.

The Fifth Circuit affirmed the Tax Court's holding that neither of the two monetary transfers were bona fide loans as DF Systems showed no objective evidence that it had entered into a genuine debtor-creditor relationship with either borrower. The court noted that, although not determinative, the absence of a formal loan agreement was relevant. Regarding the advances to E.L. Construction, recurring payments and non-corresponding credits from other companies under DF Systems account for E.L. Construction indicated that DF Systems was paying E.L. Construction's expenses and collecting its revenues instead of showing E.L. Construction was making repayments of the loan, the court said. Similarly, with respect to the payments to the long-time employee, there was no fixed sum of money to be repaid, repayment schedule, interest rate, or collateral for the loan.

Thus, in looking at the circumstances of the transaction, the court concluded that DF Systems failed to substantiate that it had a debtor-creditor relationship with either borrower to establish the existence of a bona fide debt.

For a discussion of the general rules for a bad debt deduction, see Parker Tax ΒΆ98,401. (Staff Editor Parker Tax Publishing)

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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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