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The Court of Appeals for the Ninth Circuit, affirming the Tax Court in an unpublished opinion, has concluded that a chief executive officer (CEO), who was also a board member and minority shareholder, couldn’t take a bad debt deductions for advances he made to his corporation and other payments he made on the company’s behalf.

Background. A noncorporate taxpayer’s bad debt may be either a business or nonbusiness bad debt. A bona fide business bad debt may be deducted during the tax year in which it becomes worthless.  A business bad debt must arise from a bona fide debt—i.e., one from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable amount of money.  By contrast, a nonbusiness bad debt is not deductible and is treated as a short-term capital loss.  A nonbusiness debt is any debt other than: (1) a debt created or acquired in connection with the trade or business of the taxpayer; or (2) a debt, the loss from the worthlessness of which is incurred in the taxpayer’s trade or business.

The Ninth Circuit has used the following factors in determining whether advances to a corporation give rise to a bona fide debt, as opposed to an equity investment:

(1) the labels on the documents evidencing the (supposed) indebtedness;
(2) the presence or absence of a maturity date;
(3) the source of payment;
(4) the right of the (supposed) lender to enforce payment;
(5) the lender’s right to participate in management;
(6) the lender’s right to collect compared to the regular corporate creditors;
(7) the parties’ intent;
(8) the adequacy of the (supposed) borrower’s capitalization;
(9) whether stockholders’ advances to the corporation are in the same proportion as their equity ownership in the corporation;
(10) the payment of interest out of only dividend money; and
(11) the borrower’s ability to obtain loans from outside lenders. 

Facts. John Ramig, an attorney and entrepreneur, with several others formed shoeS4Work, a business that used the internet to sell safety footwear. Ramig was the CEO, a board member, and a minority shareholder. A “Key Employee Agreement” governed his work as CEO, providing a $150,000 annual salary and placing a $50,000 limit on whatever expenses or obligations he might incur on shoeS4Work’s behalf.

In 2001 and 2002, Ramig made seven advances, purported to be loans, to shoeS4Work. Records showed seven promissory notes corresponding to each of the loans, and eight checks documented the payment of the proceeds of the supposed loans. Each note called for 12% interest and gave a date on which the note was immediately due and collectible. Only two of the seven notes were signed. Ramig signed those two notes as shoeS4Work’s president and CEO.

Ramig stated that he made the seven loans in anticipation of being able to raise the capital to repay himself at some point in the future. He also stated that shoeS4Work repaid the first three notes, which totaled $57,000, but failed to repay the last four notes, which totaled $29,600. Besides Ramig’s testimony that the first three loans were repaid, there was no evidence of repayment.

Ramig also paid $11,274 of shoeS4Work’s operating expenses with his credit card, including postage, office supplies, and some inventory purchases. He claimed that the payments were loans to shoeS4Work and that similar past advances had been repaid. However, no documents substantiated that shoeS4Work had either agreed to repay the amount or had repaid similar amounts in the past.

In addition, Ramig claimed that he made $2,500 of car payments to General Motors Acceptance Corporation on shoeS4Work’s behalf, and, as shoeS4Work’s guarantor, $2,500 of equipment leasing payments to Puget Sound Leasing.

ShoeS4Work stopped operations in August 2002. Soon afterward, it liquidated most of its tangible assets and used the proceeds to pay suppliers. It did not pay Ramig.

On audit, IRS challenged Ramig’s claim that he was entitled to bad debt deductions for the unpaid principal on the promissory notes, the expenses paid on his credit card, and the car and leasing payments he made on the company’s behalf.

Tax Court’s decision. The Tax Court concluded that Ramig wasn’t entitled to bad debt deductions for the unrepaid loans and other advances he purportedly made to or on behalf of shoeS4Work.

Evaluating all the facts and circumstances, the Tax Court concluded that the advances were equity investments, not loans. Because of shoeS4Work’s failure to find more investors and its declining financial condition, the Court reasoned that it was unlikely that shoeS4Work could have borrowed the money from an outside lender. The parties to the “loans” appeared to expect repayment only if the shoeS4Work was financially able to do so, and shoeS4Work was on a downward track, showing steady losses from operations along with steadily declining inventory and assets.

Further, the parties’ treatment of the advances suggested an equity investment. Ramig didn’t demand timely repayment and treated his claim as subordinate to the rights of other creditors that were paid first. Ramig gave no evidence that shoeS4Work ever paid interest or that he ever requested interest payments. The fixed maturity dates on the notes were ignored by both parties. He never tried to enforce the notes, and since three of the four notes were unsigned, their enforceability was in question.

In evaluating the credit card debt, the Tax Court concluded that Ramig and shoeS4Work didn’t have a bona fide debtor-creditor relationship. Although Ramig claimed shoeS4Work repaid similar past advances, he failed—aside from his own testimony—to show either past repayments or similar past advances.

Finally, the claims that Ramig made additional payments toward shoeS4Work’s debt to an auto company and as guarantor on its equipment leases failed for lack of proof that the auto company payment was even made or that payment to the equipment leasing entity was in fact pursuant to some guaranty agreement.

Appellate decision. The Ninth Circuit’s majority opinion concluded that it wasn’t clearly erroneous for the Tax Court to determine that the $29,600 in advances wasn’t a bona fide debt. An examination of the factors in A.R. Lantz Co. favored a conclusion that the advances were equity rather than debt. Perhaps most importantly, the financial condition of the company was such that repayment couldn’t be expected from the company’s earnings. Since lending wasn’t available from an outside source, repayment was dependent on the company raising more capital. That weighed against a characterization of Ramig’s advances as bona fide business loans.

The Ninth Circuit also found that it wasn’t clearly erroneous to determine that the $11,274 credit card charges wasn’t debt. Though Ramig may have expected repayment, he knew that repayment was uncertain and depended on the company raising more capital.

Finally, the Court concluded that it wasn’t clearly erroneous for the Tax Court to determine that the $2,500 payments to Puget Sound Leasing weren’t debt. While Ramig purportedly made the payments as a guarantor for shoeS4Work, he failed to produce any documentary evidence substantiating such an agreement.