The 7th Circuit Court of Appeals recently affirmed the decision of the US Tax Court in VHC, Inc. v. Comm’r of Internal Revenue, 2020 WL 4529930, at *3 (7th Cir. Aug. 6, 2020), which held that business “loans” from a family business to a son of the family were not really loans and thus did not qualify for bad debt deductions for the family business when the loans were not repaid.
In an audit, the IRS found that over $100 million in “loans” to the business owners’ son were not truly loans. The 7th Circuit looked to see if there was an enforceable obligation between the son and the corporation. In finding that there was not an enforceable obligation, the court noted that it viewed intrafamily transfers with particular suspicion.[1] The Court looked at the intent of the parties and found an investor relationship, rather than a creditor/debtor relationship, notwithstanding the existence of promissory notes, because the promissory notes were regularly redone and extended and there was no expectation of payment without the son meeting with business successes, such as additional investors.
The court further found that the payments to the son were not ordinary and necessary business expenses and thus not subject to deduction under IRC § 162. The business failed to substantiate records and demonstrate that payments made to third parties (to creditors of the son) were an expense of the company.
Practice Points: The parties to an intrafamily loan must scrupulously document the nature of the loan and treat the terms like unrelated, arm’s length parties. If arm’s length parties would not have unending loan extensions and side agreements that the loan would be repaid only if additional capital were raised, like in VHC, then the family business and the family member should not have such loose and unbusiness-like terms. I urge businesses to talk to legal counsel to make sure intrafamily loans are correctly entered into and documented in company records in order to avoid the issues faced in VHC in not being able to deduct the payments as bad debt or ordinary and necessary business expenses.
Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal and state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
[1] VHC, Inc. v. Comm’r of Internal Revenue, 2020 WL 4529930, at *2 (7th Cir. Aug. 6, 2020)