<img src="//bat.bing.com/action/0?ti=5189112&amp;Ver=2" height="0" width="0" style="display:none; visibility: hidden;">

    The Lawletter Blog

    TAX:  Retroactive Documentation of “Bona Fide Loans”

    Posted by Lee P. Dunham on Tue, Mar 5, 2024 @ 13:03 PM

    The Lawletter Vol. 49 No. 1

    Lee Dunham—Senior Attorney

                 Closely related people or entities often make loans, including promissory notes, to each other without the formalities that usually accompany business transactions between strangers. Later—sometimes years later—such transfers can become problematic if the IRS seeks to treat the transfer as a distribution or gift for tax purposes. Is the parties’ failure to execute a promissory note contemporaneously with the loan fatal to treatment of the transaction as a loan? Can the parties retroactively document the loan with a newly executed promissory note?

              “The question of whether a taxpayer has entered into a bona fide creditor-debtor relationship pervades Federal tax litigation.” Dynamo Holdings Ltd. P'ship v. Comm’r, Nos. 2685-11, 8393-12, 2018 Tax Ct. Memo LEXIS 60, at *47 (May 7, 2018). For tax purposes, the answer turns on intent: “[t]he parties must have actually intended to establish a debtor-creditor relationship,” i.e., “at the time the advances were made there [must have been] ‘an unconditional obligation on the part of the transferee to repay the money, and an unconditional intention on the part of the transferor to secure repayment.’” Id. at *47–48, citing Calloway v. Comm’r, 135 T.C. 26, 37 (2010), Ellinger v. United States, 470 F.3d 1325, 1333 (11th Cir. 2006), and Haag v. Comm’r, 88 T.C. 604, 616 (1987), aff'd without published opinion, 855 F.2d 855 (8th Cir. 1988).

            The question of whether a “valid debtor-creditor relationship” was created in a transaction is analyzed under the same rules no matter what kinds of related persons or entities were involved. See, e.g., Est. of Lockett v. Comm’r, Nos. 8922-09, 8940-09, 2012 Tax Ct. Memo LEXIS 120, at *20 (Apr. 25, 2012) (considering whether transfers from Arizona family LLP to family members were bona fide loans); Dynamo Holdings, 2018 Tax Ct. Memo LEXIS 60, at *47 (applying same principles to transfers from a corporation to a related limited partnership), Kelly v. Comm’r, Nos. 6225-16, 16847-16, 2021 Tax Ct. Memo LEXIS 109, at *60 (June 28, 2021) (same from a corporation to a related LLC); Welch v. Comm'r, 204 F.3d 1228, 1230 (9th Cir. 2000) (same from one individual to another).

            Retroactively proving intent can be a difficult matter when the transferor and transferee are related parties. Special scrutiny is applied to “intrafamily transfers and transactions between entities in the same corporate family or with shared ownership.” Dynamo Holdings, 2018 Tax Ct. Memo LEXIS 60, at *47 (citing examples). “Transfers between family members are presumed to be gifts.” Id., citing Perry v. Comm’r, 92 T.C. 470, 481 (1989), Barr v. Comm’r, No. 17491-97, 1999 Tax Ct. Memo LEXIS 85, at *7 (Feb. 8, 1999), and Vinikoor v. Comm’r, Tax Ct. Dkt. No. 15567-94, 1998 Tax Ct. Memo LEXIS 153, at *10 (Apr. 27, 1998). However, “[t]his presumption can be rebutted by ‘an affirmative showing that there existed a real expectation of repayment and intent to enforce the collection of the indebtedness.’” Id., quoting Vinikoor, 1998 Tax Ct. Memo LEXIS 153, at *10.

              When analyzing transfers between related parties, while “it is useful to compare the transactions at issue to arm's-length transactions and normal business practices,” the “business realities of related parties” are also taken into consideration. Dynamo Holdings, 2018 Tax Ct. Memo LEXIS 60, at *47–48 (citations omitted). For example, security and other creditor protections have been deemed less important in a related-party context. Id.

               The various circuits have formulated balancing tests for weighing various factors to determine whether a transfer reflects a bona fide debt. In the Eleventh Circuit, where there is no question of whether the transfers reflected debt or equity, in determining whether the transfer was part of a bona fide loan, the question of whether there was a promissory note is only one of multiple factors that are considered, which include whether:

    (1) There was a promissory note or other evidence of indebtedness,

    (2) interest was charged,

    (3) there was security or collateral,

    (4) there was a fixed maturity date,

    (5) a demand for repayment was made,

    (6) any actual repayment was made,

    (7) the transferee had the ability to repay,

    (8) any records maintained by the transferor and/or the transferee reflected the transaction as a loan, and

    (9) the manner in which the transaction was reported for Federal tax is consistent with a loan.

    Dynamo Holdings, 2018 Tax Ct. Memo LEXIS 60, at *49–50.

              A slightly different, thirteen-factor test is considered in a debt-versus-equity determination. Id. at *48, citing Ellinger, 470 F.3d at 1333–1334. Not all of the factors are equal, nor are they merely countedthey are simply issues to consider in analyzing the totality of the pertinent facts. Id.

               A promissory note created ex post facto can serve as “evidence of indebtedness,” although it is not as strong as that of a promissory note executed contemporaneously with the loan. In Dynamo Holdings, the transactions in question took place between 2005 and 2007, but the parties did not execute formal promissory notes evidencing the prior advances until later in 2007. Despite the absence of other indicia of a debt, the court held that bona fide loans nonetheless existed between the parties where, in addition to retroactively creating the promissory notes, the debtor and creditor had maintained records that reflected the advances as debt in their general ledgers. Id.

                A promissory note or other debt instrument is not essential to a finding of a valid debt, particularly in the case of related entities. “It is quite clear that a valid debt may exist between parties even where no formal debt instrument exists.” Est. of Holland v. Comm'r, 73 T.C.M. (CCH) 3236 (T.C. 1997), distinguished by Tech. Advice Memorandum, IRS Tech. Adv. Mem. 200341002 (Oct. 10, 2003), citing Litton Bus. Sys., Inc. v. Comm’r, 61 T.C. 367, 377 (1973); Schering-Plough Corp. v. United States, 651 F. Supp. 2d 219, 249 (D.N.J. 2009), aff'd sub nom. Merck & Co. v. United States, 652 F.3d 475 (3d Cir. 2011) (presence of customary loan documentation is not a prerequisite to a bona fide loan, but only one consideration under a totality analysis); Merck & Co., 652 F.3d at 481 (“The Court has never regarded the simple expedient of drawing up papers as controlling for tax purposes when the objective economic realities are to the contrary.” (quoting Frank Lyon Co. v. United States, 435 U.S. 561, 573, 98 S. Ct. 1291, 1298 (1978))). “This is particularly true in the case of related parties since formal debt paraphernalia of this type in a closeknit family are not necessary to insure repayment as the case may be between unrelated entities.” Est. of Holland; but see Jones v. Comm'r, 74 T.C.M. (CCH) 473 (T.C. 1997), aff'd sub nom. Jones v. Comr. of IRS, 177 F.3d 983 (11th Cir. 1999) (absence of either formal loan documents or other evidence such as corporate minutes to substantiate the claim that the transaction constituted a loan was a significant fact that weighed against the petitioner).

              Where, however, promissory notes exist that are lacking in standard conditions normally found in such documents, they are given less weight as evidence of a bona fide loan. See Vinikoor, 1998 Tax Ct. Memo LEXIS 153 (while the parties executed loan documents, they lacked an amortization schedule, minimum payment, and were due “only when I call it,” and were therefore afforded less weight in the court’s analysis).

              In short, where parties failed to document a loan with a promissory note at the time of the transaction, doing so later won’t “save the day” in the absence of any other documentation that the transaction was a bona fide loan. It may, however, provide additional evidence that, on balance with other factors, will ensure appropriate tax treatment of the transfer.

    Topics: IRS, debtor-creditor relationship

    New Call-to-action
    Free Hour of Legal Research  for New Clients

    Subscribe to the Lawletter

    Seven ways outsourcing your legal research can empower your practice

    Latest Posts