Ninth Circuit Affirms Tax Court; Advances to a Corporation Were Equity, Not Debt

(Parker Tax Publishing November 2024)

The Ninth Circuit affirmed the Tax Court and held that taxpayers were not entitled to take a bad debt deduction under Code Sec. 166(a) for advances they made to their floundering corporation because a unanimous consent agreement converted all of the company's debt to equity and removed all notes payable to the taxpayers from its balance sheet. The Ninth Circuit rejected the taxpayers' argument that the unanimous consent agreement did not apply and found that the Tax Court correctly weighed the factors set forth in Hardman v. U.S., F.2d 1409 (9th Cir. 1987), and found that the substance of the advances to be the shareholders providing their corporation with the cash necessary to stay afloat. Keeton v. Comm'r, 2024 PTC 390 (9th Cir. 2024).

Background

Arland and Ima Jean Keeton and another couple, Robert and Lorene Riemenschneider, formed Keeton-Riemenschneider, LLC (KRLLC), with each couple owning 50 percent of the LLC. The Keetons and the Riemenschneiders each owned 34.5 of Idaho Waste Systems, Inc. (IWS), a C corporation that operated a landfill near Boise. From 1994 to 2007, the Keetons and the Riemenschneiders funneled cash to IWS through KRLLC. IWS issued notes payable to KRLLC that provided an interest rate of 9 percent but specified no repayment schedule.

In 2012, all of the IWS shareholders signed a unanimous consent agreement converting their debt to equity, and IWS removed all notes payable to KRLLC from its balance sheet. IWS went into foreclosure in early 2018, and KRLLC recorded its outstanding balance due from IWS as a bad debt expense. The Keetons then reported their share of this bad debt expense as a loss on their 2017 and 2018 tax returns. The IRS disallowed the loss, stating that the advances from KRLLC to IWS were equity infusions, not loans, and applied accuracy-related penalties to the resulting deficiencies.

Code Sec. 166(a)(1) allows as an ordinary loss deduction any bona fide debt that becomes worthless within the tax year, except in the case of certain nonbusiness debts defined in Code Sec. 166(d). In Zimmerman v. U.S., 318 F.2d 611 (9th Cir. 1963), the Ninth Circuit held that a bona fide debt is a debt that arises from "a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."

In Hardman v. U.S., F.2d 1409 (9th Cir. 1987), the Ninth Circuit identified 11 factors as potentially relevant in determining whether a transfer to a corporation by a shareholder is a debt or a contribution of capital. The factors are: (1) the names given to the certificates evidencing purported debt; (2) the presence or absence of a maturity date; (3) the source of the payments, and in particular whether they are dependent upon earnings; (4) the right to enforce payment of principal and interest; (5) whether the advances increase participation in management; (6) whether the "lender" has a status equal or inferior to that of regular creditors; (7) objective indicators of the parties' intent; (8) whether the capital structure of the "borrower" is thin or adequate; (9) the extent to which the funds advanced are proportional to the shareholder's capital interest; (10) the extent to which interest payments come from "dividend" money; and (11) the ability of the "borrower" to obtain loans from outside lending institutions.

In Keeton v. Comm'r, T.C. Memo. 2023-35, the Tax Court found that the bad debt issue was "greatly simplified" by the unanimous consent agreement executed by the shareholders of IWS. The court found that under that agreement, there existed no debt from IWS that could have gone bad. The Keetons pointed out that KRLLC was not itself a shareholder of IWS, and accordingly argued that the unanimous consent agreement, while cancelling all shareholder loans, left the alleged loan from KRLLC intact. However, the Tax Court found that the business records of IWS unambiguously showed that the cancelled loans included the loans that the Keetons extended through KRLLC.

Although the Tax Court's conclusion based on the unanimous consent agreement supplied a sufficient basis for sustaining the IRS's disallowance of the Keetons' bad debt deduction, the court also considered whether a bona fide debt existed between IWS And KRLLC as of the end of 2011, immediately before the debt-to-equity conversion. The court did so by considering the Hardman factors, and concluded that the most relevant of those factors clearly pointed to characterization of KRLLC's advances as capital contributions rather than debt.

The Keetons appealed the Tax Court's decision to the Ninth Circuit.

Ninth Circuit's Analysis

The Ninth Circuit affirmed the Tax Court after finding that the Tax Court did not clearly err in concluding that KRLLC's advances to IWS were equity, not debt.

The Ninth Circuit agreed with the Tax Court that KRLLC was not a third-party creditor and that rather it was a vehicle through which the Keetons and the Riemenschneiders, as IWS shareholders, advanced funds to their floundering corporation. Despite the Keetons' testimony that they gave no money directly to IWS, and their belief that the unanimous consent agreement did not affect KRLLC's debts, the Ninth Circuit found that there was a sufficient basis for the Tax Court to find that the unanimous consent agreement converted all of KRLLC's debt into equity.

The Ninth Circuit further found that the Tax Court correctly weighed the Hardman factors because the IWS shareholders merely used a corporate formality to advance funds to their corporation. The Ninth Circuit agreed with the Tax Court that in substance, the advances were the two largest shareholders in IWS (the Keetons and the Riemenschneiders) providing their corporation with the cash necessary to stay afloat. In the view of the Ninth Circuit, the Hardman factors "overwhelmingly" supported an equity finding. To name a few: there was no fixed maturity date on KRLLC's purported loans; the repayments were not dependent upon earnings; KRLLC had no enforcement rights and it took a subordinate position to other creditors; IWS was thinly capitalized; and it had no ability to borrow from other sources.

In addition, the Ninth Circuit affirmed the Tax Court's finding that the Keetons did not have a reasonable cause defense to the accuracy-related penalties. The Keetons contended that they relied on the advice of their CPA, Jennifer Werner, and therefore had a reasonable cause and good faith defense under Code Sec. 6694(a)(3). However, the Ninth Circuit noted that taxpayers cannot rely on the advice of a professional when such advice was not based on knowledge of all the facts. Werner testified that she was unaware of the existence of the unanimous consent agreement and the fact that any note payable due to KRLLC was removed from IWS's books; she also testified that such information would have been relevant to her advice. Given that the Keetons did not provide Werner the unanimous consent agreement, as well as the Tax Court's finding that Keeton's belief that the agreement did not apply to KRLLC to be unambiguously refuted by the record, the Ninth Circuit concluded that the reasonable cause defense did not apply.

For a discussion of the bona fide debt requirement with respect to the bad debt deduction, see Parker Tax ¶98,405. For a discussion of the reasonable cause defense to accuracy-related penalties, see Parker Tax ¶262,127.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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