Have a Business Purpose When Lending To Family and Friends

In Scheurer, TC Memo. 2017-36 the Tax Court found that a taxpayer was not entitled to a business bad debt deduction for funds he advanced to a business operated by a friend. The taxpayer attempted to claim a bad-debt deduction for "loans." Given the true nature of the lender and debtor's relationship as one of many factors to be considered, the Tax Court refused to find that the loans were bona fide.  

Background

The taxpayer, who apparently worked as a financial adviser, purported to have loaned a close personal friend money to keep his robocall operation afloat. The taxpayer was aware of the friend’s poor credit rating which prevented him from obtaining a commercial loan. The taxpayer also purported to have entered into a partnership with the friend to provide merchant processing services for his business.

The financial situation of the friend’s business worsened over time, and the taxpayer and his partnership ended their involvement with the operation. On his return for that tax year, the taxpayer claimed a business bad debt deduction attributable to funds he had allegedly advanced to his friend’s business that went unpaid. Apparently, he did not report any income, expenses, or other pass-through items on his return for the merchant-processing operation.  Only after being notified of a deficiency did the taxpayer attempt to claim a loss attributable to prepaid expenses made by his partnership.

Tax Court’s analysis

The Tax Court held that the taxpayer was not able to substantiate the advanced payments being received by the company or show facts that would indicate that there was a reasonable expectation of repayment. The court could not find any evidence to support that the taxpayer’s alleged loans were debts created or acquired in connection with either the trade or business of lending money, or, alternatively, that of a financial adviser.

In addition, the partnership’s voluntary payment to taxpayer’s friend’s business was not a valid partnership expense that could give rise to a net partnership loss that could flow through to the taxpayer. The court found that the partnership’s expenses were not paid to further the partnership’s business but rather to assist the taxpayer’s friend’s business -- a personal expense. 

The court ended up re-characterizing the payments as either capital contributions or as gifts.

References: CCH's December 2017 Federal Tax Weekly