In the case of Owens v. Commissioner, TC Memo 2017-157, the issue to be decided involved a $9.5 million bad deduction claimed as a business bad debt an individual who took the position he was in the trade or business of lending money.  The IRS argued that he wasn’t in the business of lending money, that the debts in question were not actually debts and, even if they were, the loan did not become worthless in the year he claimed the loss.

As the Tax Court summarized the matter:

Owens argues that he has been in the business of making personal loans on a continual and regular basis for years. He also argues that the loans he made to Lohrey Investments created bona fide debts and that those debts then became wholly worthless in 2008 when West Coast Linen filed for bankruptcy after the trustee padlocked the building in Gilroy. The Commissioner doesn’t think that Owens’s lending activity amounted to a trade or business and even if it did, the Lohrey loans were more equity than debt. Even if they were debts, they didn’t become worthless in the 2008 tax year.

As the Tax Court points that, the issues are those that involve Section 166 which allows a deduction for bona fide debt that becomes worthless during a year.[1]

The first issue the Court had to decide was whether Mr. Owens had incurred the debt in the course of a trade or business.  If not, any bad debt would be a short-term capital loss.[2]  That would limit any deduction for a single year to $3,000 in excess of any net capital gains incurred in the year—and the loss would not lead to a net operating loss deduction.

Mr. Owens claimed he was in the trade or business of lending money and that this loan was made as part of that business.  The Tax Court, citing the cases of Cooper v. Commissioner, T.C. Memo. 2015-191; Scallen v. Commissioner, 2002 WL 31684676, at *9, outlined the following non-exhaustive list of items to be considered in determining if a taxpayer is in the trade or business of lending money:

• the total number of loans made;
• the time period over which the loans were made;
• the adequacy and nature of the taxpayer’s records;
• whether the loan activities were kept separate and apart from the taxpayer’s other activities;
• whether the taxpayer sought out the lending business;
• the amount of time and effort expended in the lending activity; and
• the relationship between the taxpayer and his debtors.

One complicating factor was that Mr. Owens was involved with a corporation (Owens Financial Group, referred to in the case as OFG) which also made loans—so the question became whether Mr. Owens himself had a money lending activity. 

The first test looks at the number of such loans made by Mr. Owens personally.  The Tax Court noted that he did have a significant number of personal loans:

We find that Owens’s personal lending activities were continuous and regular by themselves.8 It is clear from the record that from 1999 through 2013 Owens personally (alone, or acting as trustee of Owens Trust) made at least 66 loans (including the Lohrey loans) to a multitude of borrowers, easily exceeding $24 million. These figures are more than sufficient when compared to the benchmark we’ve set in other cases. Compare Serot v. Commissioner, T.C. Memo. 1994-532 (55 loans over 10 years totaling approximately $1.2 million shows business), aff’d, 74 F.3d 1227 (3d Cir. 1995), Ruppel v. Commissioner, T.C. Memo. 1987-248, 53 T.C.M. (CCH) 829 (1987) (27 loans over 4 years totaling just under $1.4 million shows business), and Jessup v. Commissioner, T.C. Memo. 1977-289 (31 loans over 10 years ranging from $315,000 to $2.7 million each year shows business), with Cooper v. Commissioner, T.C. Memo. 2015-191 (12 loans over 6 years not a business).

From 2003 through 2008 — the most crucial years in this case — Owens made approximately 33 loans totaling over $21 million, including $17 million in Lohrey loans. This period was not unusual — money had been Owens’s stock in trade since the first days of his career, and lending had long since become his vocation. We are convinced that, over the years, he had fallen into the understandable and prudent habit of lending money raised from the public through OFG to more secured and better risks; the riskier-but-still-promising loans he took on for himself.

The IRS complained that OFG staff kept the records for the loans in question, but the Tax Court found that rather than working against Mr. Owens, this was a fact in his favor, noting:

OFG treated documentation related to Owens’s lending the same as it did its own: It kept a file for each loan that included the underwriting documentation, legal documentation, and any security agreements. OFG kept additional documentation when a borrower was in default, including correspondence, notices, and forbearance agreements. OFG also kept records of existing loans reflecting the balances, summary of payments, and due dates.

Should any of this count against Owens? We don’t think so. Remember that the question we’re asking is whether his personal lending was a trade or business. The answer to this question is more probably “yes” the more his personal-lending activity looks like the activity of a traditional lender — in contrast, say, to the activity of someone who writes a personal check to his brother-in-law and then bugs him about repaying it every so often. That Owens kept good records of his loans in exactly the same way OFG kept records on its loans very much suggests that Owens was treating his personal lending as a continual and regular activity.

The IRS was also upset that Mr. Owens didn’t present a detailed accounting of how much time he spent on the activity, a factor that is often fatal is certain contexts (such as proving qualification as a real estate professional under IRC §469).  But in this area, the Court was not nearly as troubled by lack of detailed records, noting:

Owens testified that he generally spent an average of 50 hours at work each week and did not distinguish the time he spent on lending from his personal funds from the time he spent on lending from OFG’s funds. We recognize this as an officially approved factor-to-be-considered but also find that the toilsome drudgery of measuring out one’s days in six-minute increments is rarely found among our more entrepreneurial countrymen — they are more inclined to focus on getting the chore in front of them done as efficiently as possible than on keeping detailed time sheets. And on the facts of this case, we find, as we have in similar cases, that Owens had no need to bill specific hours on his personal lending while managing OFG. See Jessup v. Commissioner, T.C. Memo. 1977-289. Just look at the number of loans Owens made and how much money he tied up in them — unless motivated by some hidden whimsy or charitable purpose, he spent a sufficient amount of time on them.

The IRS argued that Mr. Owens, since he did not advertise his ability to make personal loans, did not seek out the loans in a way that would indicate he was in the business of lending money.  The Tax Court, while agreeing he did not advertise, did not agree this meant he didn’t seek out the loans:

The Commissioner argues, and we do not disagree, that Owens did not advertise his availability to make personal loans. But we also find that he didn’t need to any more than the taxpayers in Serot, Ruppel, and Jessup. He had a reputation in the community as a lender and was very well respected. It was clear from the credible testimony of his competition and colleagues that it was his personal reputation that brought borrowers to both OFG and him personally. It wasn’t unusual for borrowers to call OFG and ask for Owens directly. We believe the testimony that the professional relationships Owens developed with his borrowers also made it possible for him to continue lending to them.

Having failed to convince the Court so far that Mr. Owens was not in the trade or business of making loans, the IRS now turned to the particular loans and argued that Mr. Owen’s actions with regard to the particular loans indicated they were not made in a businesslike fashion since he subordinated his rights to that of another lender after the borrower was already in deep financial distress.  But the Tax Court found his actions were that of a prudent businessman noting:

But we’ve already found that given his options, Owens did act reasonably. We’re being consistent here: In Ruppel the taxpayer continued to lend money to a borrower over time because he saw it as the only way to fully recoup his investment. It’s easy in hindsight to argue that a lender who kept lending more money to a borrower who ultimately failed was unreasonable. But we try to look at things as the lender saw them at the time, and here we find that Owens’s advancing more and more money to a growing and capital-intensive business was reasonable under the circumstances. It turned out to be a bad business decision, but it was a business decision and not charity or lunacy or something else.

Even if Mr. Owens was in the trade or business of lending money, his loss would be capital if there was no bona fide debt and what he held was an equity interest.  As the Tax Court notes, the line between debt and equity is often “blurry” and each case should be considered based on its own facts.

The IRS argues that the notes, while they may have had stated maturity dates, did not really have any maturity dates since Mr. Owens did not enforce them.  But the Court found that Mr. Owens actions in not enforcing those dates were reasonable actions for a lender in this case, noting:

The Commissioner argues, however, that this factor should still weigh against Owens because the dates were not enforced, but Owens credibly testified that he wanted to work with Lohrey and allow him time to improve his financial situation. In Bishop v. Commissioner, T.C. Memo. 2013-98, at *15, we had a similar situation: The taxpayer did not exercise the acceleration clause under the note when the debtor stopped making payments because he thought that by giving the debtor a chance to recover from the real-estate crisis, the debtor would be able to resume payments. We found this explanation reasonable then, and we find it reasonable now. This factor will weigh in favor of Owens.

The IRS argued that the only possible source of repayment of the debt was earnings, and that a participation in earnings is what makes something equity—so these interests should be treated as equity, not debt.  But the Court did not agree, noting:

The Commissioner argues that because Lohrey Investments would be able to repay its debt to Owens only if Lohrey was able to improve West Coast Linen’s financial status, repayment was dependent on earnings. But this isn’t how we use this factor. If it were, there could only be investments in, and no lending to, distressed borrowers. This just isn’t the rule. We recognize that there are types of debt that look very similar to equity and types of equity that look very similar to debt, but Owens was not close to this line here. His advance of money to Lohrey Investments did have the goal of enabling that business to become profitable enough to repay its lenders, but the repayment of those advances was not legally contingent on success. See Flint Indus., Inc. v. Commissioner, T.C. Memo. 2001-276, 2001 WL 1195725, at *12 (“When circumstances make it impossible to estimate when an advance will be repaid because repayment is contingent upon future profits or repayment is subject to a condition precedent, or where a condition may terminate or suspend the obligation to repay, an equity investment is indicated.” (quoting Affiliated Research, Inc. v. United States, 173 Ct. Cl. 338 [ (1965))). As a practical matter, Owens’s ability to be repaid would be harmed if Lohrey Investments and West Coast Linen failed, but as a legal matter Owens’s advances were secured by a deed of trust on the Gilroy property, and Lohrey Investments was obliged to pay back the advances plus interest. This may be distressed debt, but it is debt nonetheless.

Mr. Owens had received an ownership interest in the entity at one point during this transaction after it was clear the borrower was in financial trouble.  The IRS argued that the fact he obtained this interest at a point where the business was in a crisis converted his prior advances to equity and that the same treatment would apply to any subsequent advances.  But the Court noted that the operating agreement specifically provided that Mr. Owen’s loans will not be treated as a capital contribution and the granting of the interest was not in close proximity to advances—his interest was received more than a year after his last previous advance, and he did not loan more funds to the entity for two more years.  The Tax Court found that there was not a sufficient direct correlation between the grant of the interest and the advances to covert the loans to equity.

Equity holders get paid after creditors, so the fact that Mr. Owens subordinated his debt to that of a new lender might indicate he was an equity holder rather than a creditor.  The Tax Court, while noting that the subordination factor does favor the IRS view, finds it’s not a determinative factor, nothing that “[w]ithout additional financing from Vestin, Owens would not have seen a return.”

But the IRS argues this subordination raises another issue—didn’t it indicate that the borrower was unable to obtain loans from outside lending institutions and, therefore, Mr. Owens advance was not in the nature of a loan.  But the Court found that the IRS wasn’t applying this factor correctly in this case, noting:

The Commissioner mistakenly hinges his argument on Owens’s subordination to Vestin, arguing again that this is not how a reasonable creditor behaves. What this factor requires us to look at, however, is whether at the time Owens made advances to Lohrey Investments, Lohrey Investments could have obtained financing from a different source on the same terms. See, e.g., Provost v. Commissioner, T.C. Memo. 2000-177. When Lohrey initially approached OFG it was because other lenders considered financing Lohrey Investments too risky. Yet, OFG — certainly a [*39] legitimate lender — did provide financing. Owens provided more. Later, Lohrey Investments was able to obtain still more debt financing from other sources: There was Vestin, for one, as well as lenders like Podium, Wells Fargo Bank, and Tri-State. These facts bolster a finding that the advances were bona fide debt.

The Court also looked at whether the borrower was so thinly capitalized that the “loans” had to be equity, finding:

But more cases say that thin capitalization is a strong indication of equity only if (1) the debt to equity ratio was initially high, (2) the parties realized that it would likely go higher, and (3) substantial portions of these funds were used for the purchase of capital assets and for meeting expenses needed to commence operations. Am. Offshore, Inc. v. Commissioner, 97 T.C. at 604. When Owens made his first loans to Lohrey Investments, they were adequately secured. Subsequent loans might not have been, but those were meant to protect Owens’s initial advances, and we don’t find they thereby became an equity investment. We also find based on credible testimony that neither Owens nor Lohrey had any reason to believe Lohrey Investments would eventually take on so much additional debt. Both Owens and Lohrey gave credible testimony regarding their optimism about the market — and the Great Recession caught many off guard. We do acknowledge that it is not clear from the record what Lohrey Investments used Owens’s initial advances for. We know that at least part of Owens’s initial advance was used to pay off another loan. But Lohrey did use subsequent advances to hire additional employees and purchase additional equipment and vehicles to meet the requirements of the highly anticipated Kaiser contract.

All that remained for the taxpayer is to show that the debt became worthless in 2008.  The IRS argued that it was not yet worthless in 2008 since the borrower believed in 2008 that his equipment and property were worth more than the outstanding loans.  But the IRS offered no evidence that the borrower’s belief was a correct belief.  As the Court noted:

We can think of no reason why we would give Lohrey’s subjective belief at the time more merit than the facts and circumstances surrounding Owens’s belief that the value of the property was “very small relative to the debt.” In fact, we can take into consideration subsequent events to prove the reasonableness of this belief. Am. Offshore, Inc. v. Commissioner, 97 T.C. at 597. And Owens indeed did not recover in the bankruptcies: Lohrey Investments’ liabilities towered over what the Gilroy Property, water rights, and equipment sold for. Owens recovered nothing.

One factor that could have proved a problem for Mr. Owens was the fact that he had filed a proof of claim in the borrower’s bankruptcy.  The Court noted that filing a claim “may indicate that a taxpayer had some hope for recovery” the Court was “reluctant to determine the outcome of this case based on Owens’s steps to secure his place in the order of distribution.”  As a practical matter, the Court is saying that this could very well have been an impediment to the deduction, but the Court was willing to overlook this problem based on the other facts that the taxpayer had brought forward.

In the end, the Tax Court allowed Mr. Owens a full deduction for the bad debt in 2008 and allowed him to treat it as a business bad debt, leading to a significant net operating loss.

[1] Reg. §1.166-1(c)

[2] IRC §166(d)