199911003
Nonbusiness Debt
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224
NOVEMBER 18, 1998
Office Symbols: CC:DOM:FS:IT&A
Case Number:
UILC #: 166.04-00
Number: 199911003
Release Date: 3/19/1999
MEMORANDUM FOR:
District Counsel,
ATTN: Lisa N. Primavera; Jenny A. Moon
FROM:
Deborah A. Butler
Assistant Chief Counsel (Field Service)
SUBJECT:
Internal Revenue Service National Office Field Service Advice
This Field Service Advice responds to your memorandum dated September
1, 1998. Field Service Advice is not binding on Examination or Appeals and is not
a final case determination. This document is not to be cited as precedent.
LEGEND:
A =
Year 1 =
ISSUE(S):
1. How do a business and investment motives differ, and what factors
do courts use in distinguishing between these motives? What
was the dominant motive of A in the present case?
2. What indicia have courts set forth in identifying taxpayers in the
trade or business of money lending? Does A meet these
indicia?
3. Has the purchase of notes been held by courts to be within the
scope of the trade or business of money lending? Was A’s
purchase of the note in connection with the money
lending business?
2
CONCLUSIONS: 1.
A’s dominant motive in making loans and
purchasing notes was to make a profit. This is evidenced
through A’s continuous and regular conduct over
a number of years, the acquisition of a written obligation
with fixed terms from an unrelated party and the prompt
enforcement of its rights under the obligation.
Such conduct is consistent with a business person, rather
than an investor. A therefore meets the requirements for
a trade or business.
2.
A satisfies the guidelines set forth by courts for
identifying persons engaged in the money lending
business. Several facts lead to this conclusion. A has
loaned money and purchased notes for many years, A
is known in the community as a lender and
purchaser of notes and has been approached by
borrowers and sellers of notes. In addition, A was in no
way related to borrower or to the seller of the note, and
took action to enforce its rights under the note.
3. The purchase of the note falls within the scope of the
money lending business. A’s purchase of the note was
proximately related to his money lending business. It was
A’s practice to purchase notes in the ordinary course of
its business for many years.
FACTS:
We rely upon the statement of facts contained in your memorandum of
September 1, 1998. A has been in the money-lending business for many years. A
has made loans and purchased extant obligations from other lenders. A is known
by the community to be a money lender, and is regularly approached by prospective
borrowers and sellers of debt obligations. In year 1, an individual who had heard of
A’s past money lending activities sold to A a note secured by a second deed of
trust. After failing to receive payment from the borrower and to recoup the loss
from a foreclosure sale of the first deed of trust, A deducted the note as a business
bad debt.
LAW AND ANALYSIS
3
Section 166(a) and Treas. Reg. § 1.166-1(a) provide that a deduction may be
taken for any bona fide debt which becomes worthless in the taxable year. A bona
fide debt arises from a debtor-creditor relationship based on a valid and
enforceable obligation to pay a fixed or determinable sum. Treas. Reg. § 1.166-
1(c).
Section 166(d)(2), in defining a nonbusiness bad debt, distinguishes between
a business and nonbusiness bad debt. A business bad debt is one which is
created, acquired or incurred in connection with a taxpayer’s trade or business.
I.R.C. § 166(d)(2). A nonbusiness bad debt is any other type of debt. Id.
Whereas a business bad debt is deductible in full, a nonbusiness bad debt is
deductible only as a short-term capital loss. I.R.C. § 166(a)(1), (d). Prior to the
passage of the Revenue Bill of 1942, there was no distinction between the tax
consequences of declaring a business and nonbusiness bad debt.
Treas. Reg. § 1.166-5(b) states that distinguishing between a business and a
nonbusiness bad debt is a factual question. The regulations set forth a two-
pronged test for determining whether a taxpayer is entitled to a bad debt deduction.
First, the taxpayer must be engaged in a trade or business; and second, the debt
must be proximately related to that trade or business. Treas. Reg. § 1.166-5(b). In
United States v. Generes, the Supreme Court held that a proximate relationship
between the debt and the trade or business exists if the dominant motive for the
loan is related to the taxpayer’s business. United States v. Generes, 405 U.S. 93,
103, reh’g denied, 405 U.S. 1033 (1972). The requirement of a dominant motive is
designed to prevent taxpayers from using unrelated or weakly related business
interests as a vehicle to obtain more favorable tax consequences. Id. at 104.
Each bad debt deduction should be examined independently to ascertain the true
nature of the transaction from which the deduction stemmed to determine whether it
was created or incurred in the taxpayer’s trade or business, as well as whether a
proximate relationship exists between the debt and the trade or business. Whipple
v. Commissioner, 373 U.S. 193, 202, reh’g denied, 374 U.S. 858 (1963); Sitterding
v. Commissioner, 20 T.C. 130, 135 (1953).
Although you have stated that it has been established that A was in the trade
or business of money lending, you have raised several questions, which shall be
addressed below, about the application of the legal principles stated above in the
context of a taxpayer engaged in the money lending business. These questions
are: what does it mean to be in the money lending business, what is the distinction
between an investment motive and a business motive, what factors do courts use in
distinguishing between these two motives and whether the purchase of an existing
note is within the scope of the money lending business.
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1. How do business and investment motives differ, and what factors do courts use
in distinguishing between these two motives? What was the dominant motive of A in
the present case?
As stated above, the question of whether a bad debt is proximately related to
a trade or business involves an inquiry into the dominant motive which the taxpayer
had for making the loan. The taxpayer’s dominant motive is identified by examining
the objective facts surrounding the business transaction, which, as you stated in
your memorandum, is a matter of judgment in each case. Kelson v. U.S., 503 F.2d
1291, 1294 (10th Cir. 1974). Although investors and persons engaged in a trade or
business share common goals, such as the desire to make a profit, there are
characteristics unique to business persons and investors which courts have used to
distinguish between taxpayers entitled to a business versus a nonbusiness bad
debt deduction.
A taxpayer is engaged in a trade or business where his activities are
conducted in good faith, with continuity and regularity, and for the purpose of
making a profit or income. Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987);
Ferguson v. Commissioner, 16 T.C. 1248, 1257 (1951) (trade or business
necessitates expending of substantial amount of time and effort, and maintaining
books and an office). Whether a person is engaged in a trade or business is a
factual inquiry. Higgins v. Commissioner, 312 U.S. 212, 217, reh’g denied, 312
U.S. 714 (1941). Although investors and persons engaged in a trade or business
are both motivated by profit, every profit-making activity cannot be characterized as
a trade or business. Bettinger v. Commissioner, T.C. Memo. 1970-18, 29 T.C.M.
52, 56. This interpretation of trade or business is also present in the legislative
history of section 166. The Committee Reports for the Revenue Act of 1942
distinguish between losses incurred in a trade or business, and those derived from
any profit-making transaction, including those not connected with a business. H.R.
Ways and Means Committee Rep., No. 2333, 77th Cong., 1st Sess. 76 (1942) 1942-
2 C.B. 573. Although a taxpayer may possess a profit motive for his lending
activities, such activities may fail to constitute a trade or business if they were not
engaged in with such frequency as to rise to the level of a business. Magee v.
Commissioner, T.C. Memo. 1993-305, 66 T.C.M. 105, 112. In Hoogerworf v.
Commissioner, the Court held that the taxpayer’s lending activities did not fit into
the category of a trade or business, which was “narrowly defined” as requiring “the
expenditure of a substantial amount of time and effort”, since his activities were
neither consistent nor regular. Hoogerworf v. Commissioner, T.C. Memo. 1976-
185, 35 T.C.M. 810, 813.
There are several factors which courts have employed to decide whether a
taxpayer’s money lending activities are sufficiently extensive to constitute a trade or
business. These include the number of loans made by taxpayer over the years, the
amount of time spent on money lending activities, the maintenance of an office for
purposes of engaging solely in the money lending business, the maintenance of
5
books and records detailing taxpayer’s money lending activity, whether taxpayer
held himself out to the public to be in the money lending business, whether the
taxpayer advertised his loan services, whether taxpayer had a reputation in the
community for making loans, the amount of income the taxpayer derived from his
money lending activities, and whether the taxpayer indicated that he was in the
money lending business on his or her tax return. U.S. v. Henderson, 375 F.2d 36,
41 (5th Cir.), cert. denied, 346 U.S. 816 (1953). Moreover, the amount of a loan is
not a determinative factor in assessing whether a taxpayer’s activities constitute a
trade or business. Deely v. Commissioner, 73 T.C. 1081, 1096 (1980), acq. 1981-2
C.B. 1 (taxpayer who made isolated loans for large amounts of money did not
establish that he was in the money lending business). These factors are discussed
in greater detail in the response to your next question regarding what constitutes
the trade or business of money lending.
In differentiating between business and investment motivations, the Supreme
Court, in Whipple v. Commissioner, contrasted dividend income or increased value
of a stock which is derived from the successful operation of an entity in which
monies are invested, with income derived from the efforts of the taxpayer in running
his own business. Whipple, 373 U.S. at 202. A taxpayer must show that his goal
was to achieve more than the return of an investor through his own activities. Id.
In Maytag v. U.S., the Court made a similar distinction in stating that
one is not engaged in a business simply because he has invested
money in it for the purpose of making a profit, and if he lends money
to
it . . . to protect his investment, and loses the money, he has not lost
the money in the business in which he is engaged.
Maytag v. U.S., 289 F.2d 647, 650 (Cl. Ct. 1961), disapproved on other gds.,
Whipple v. Commissioner, 373 U.S. 193 (1963), reh’g denied, Whipple v.
Commissioner, 374 U.S. 858 (1963). A loan may thus be made for investment
motives when a taxpayer’s goal is to increase or protect the value of his stock in the
debtor company or to protect his existing investment in a company. See Kelly v.
Patterson, 331 F.2d 753 (5th Cir. 1964); Jones v. Commissioner, T.C. Memo. 1997-
368; Weber v. Commissioner, T.C. Memo 1994-341. Therefore, a taxpayer seeking
a business bad debt deduction must show that the activity from which the loss was
derived was separate from the amount taxpayer would have received as a return on
his investment in a company. Bettinger, 29 T.C.M. at 56.
You point out in your memorandum, citing the court’s discussion in
Henderson, that since investing is a motive for those engaged in the business of
money lending, there is no real distinction between business and investment
motives. As a trade or business is not established by every person who engages in
profit-making activities, not every investor is engaged in the money lending
6
business. The extent to which taxpayer devotes himself to money lending activities,
and conducts a business according to the factors mentioned above, define the
distinction between business and investment motives. The Henderson court
highlighted several factors, such as the absence of loan terms, the non-payment of
principal or interest and lack of security, which led it to conclude that the taxpayer’s
actions did not resemble those of a taxpayer engaged in the money lending
business. Henderson, 375 F.2d at 41, 42. The court emphasized the taxpayer’s
passive role in Henderson, in that she chose not to secure her rights to interest or
repayment, and any return she would receive would depend solely upon the
success of the corporation. Id. The court relied upon these factors in denying the
taxpayer a bad debt deduction.
Even though a taxpayer’s personal investment activities may be extensive
and occasionally involve loans of large amounts of money, courts have consistently
held that these activities do not rise to the level of a trade or business of money
lending. Higgins, 312 U.S. at 218. In Smith v. Commissioner, a business bad debt
deduction was disallowed where although taxpayer managed, invested and made
loans to a number of corporations, he did not regularly engage in money lending.
Smith v. Commissioner, 203 F.2d 310, 312 (2nd Cir.), cert. denied, 346 U.S. 816
(1953). Similarly, the Court in Estate of Bounds v. Commissioner, noted that the
taxpayer made loans for investment purposes, and distinguished between a
taxpayer engaged in a trade or business, and an investor by observing the level
and degree of lending activities. Estate of Bounds v. Commissioner, T.C. Memo.
1983-526, 46 T.C.M. 1210, 1213. In Eberhart v. Commissioner, the Court held that
taxpayer presented insufficient evidence that he was in the money lending business
by merely making isolated loans, maintaining records of his loans and reporting
interest income. Eberhart v. Commissioner, T.C. Memo. 1977-155, 36 T.C.M. 660,
663. The Court held that these factors were insufficient to establish a business of
money lending, and furthermore, that it would be natural for an investor to engage
in these activities. Id. See also Ferguson v. Commissioner, 253 F.2d 403, 406 (4th
Cir. 1958) (extensive personal investment activities cannot establish trade or
business of money lending); Campbell v. Walker, 208 F.2d 457, 461 (2nd Cir. 1953)
(denial of deduction where bad debt loss occurred in course of taxpayer’s personal
investment); Deely v. Commissioner, 73 T.C. at 1093 (taxpayer’s management of
own investments can never constitute a trade or business); Marks v. Commissioner,
T.C. Memo. 1983-574, 41 T.C.M. 1408, 1411 (single loan to company insufficient to
show that taxpayers were in the money lending business); Mayo v. Commissioner,
T.C. Memo. 1957-9, 16 T.C.M. 49, 56 (taxpayer involved in investing and money
lending to a number of businesses was not found to be engaged in a trade or
business where activities lacked continuity and frequency). Thus, a taxpayer must
show a frequent and continuous pattern of lending activities to prove that he is in
the money lending business.
7
Another distinction between business and investment motives can be found
by focusing on the type of benefit or return which the taxpayer expected from the
loan, and how the taxpayer would have benefitted from loan had it not become
worthless. If the source of a taxpayer’s return is dependent largely or solely on the
future profits of the corporation to which the loans were made, this is another
indication that the taxpayer was engaged in investment activities, rather than in the
business of lending money. Hudson v. Commissioner, 31 T.C. 574, 583 (1958);
Bettinger v. Commissioner, 29 T.C.M. at 58. Where a taxpayer advanced monies
to several corporations, and the return on the monies he invested was derived
largely from sale of his stock in the corporation, the Court held that the taxpayer
was an investor, and not in the business of lending money. Post v. Commissioner,
T.C. Memo. 1979-419, 39 T.C.M. 311, 335. If the loan produced an increase in the
value of the stock and capital gains upon its sale, this is indicative of a nonbusiness
motive. Osterbauer v. Commissioner, T.C. Memo. 1995-490, 70 T.C.M. 988, 991.
If, on the other hand, the result is to increase a taxpayer’s income, the motives are
more likely to be business related. Id. Moreover, the success or failure of the
loans must have some direct effect on the business of the taxpayer to be
considered a business bad debt. Hunsaker v. Commissioner, 615 F.2d 1253, 1256
(9th Cir. 1980). Accord Lundgren v. Commissioner, 376 F.2d 623, 629 (9th Cir.
1967) (anticipated benefit to taxpayer’s business must be real and direct); Williams
v U.S., 12 AFTR2d 6157, 6160 (M.D. Fla. 1957) (to determine whether loans were
proximately related to business, one factor to examine is whether taxpayer
expected a direct, and not remote or speculative, benefit from them).
Examining the degree of risk and speculation which a taxpayer is willing to
accept relating to the monies lent is another way in which business and investment
motives may be distinguished. In discussing the difference between a creditor and
a stockholder, the Court, in Gilbert v. Commissioner, stated that a stockholder is
more willing to hazard a risk with his contributions, whereas a lender seeks a
definite obligation with set terms. Gilbert v. Commissioner, 248 F.2d 399, 406,
appeal after remand, 262 F.2d 512 (2nd Cir.), cert. denied, 359 U.S. 1002 (1959). In
Hunsaker v. Commissioner, a taxpayer made unsecured loans to his father’s
business. Hunsaker v. Commissioner, 615 F.2d at 1258. In deciding that the
debts, which eventually became worthless, were nonbusiness in nature, one factor
the court noted was that at the time the loans were made, the borrower was
“seriously undercapitalized” and “experiencing cash flow problems”, which made the
likelihood of attaining a profit a “mere expectation of a future benefit.” Id. See also
Bettinger, 29 T.C.M. at 57 (taxpayer’s continued advancement of funds despite
borrower’s weak condition was one factor that negated finding of money lending
business).
In the present case, A’s dominant motive for making loans and purchasing
notes was to make a profit. There are several facts which support this position,
namely A’s continuous and regular conduct of making loans and purchasing extant
8
obligations over a number of years and the acquisition of a secured obligation
evidenced by a written note with fixed terms. Moreover, you stated that A was in no
way related to any of the parties involved with the note, including the seller and the
borrower. A’s prompt enforcement of his rights under the obligation upon
nonpayment is yet another factor which weighs in favor of business motives.
Viewed as a whole, such conduct is more consistent with that of a business person
than an investor.
2. What are the indicia of the trade or business of money lending? Does A meet
these indicia?
Courts have allowed bad debt deductions for lenders who are engaged in the
trade or business of lending money. Although this question is highly fact sensitive,
courts have set forth a number of guidelines by which this determination may be
made. First, a standard commonly employed by courts is the frequency and time
which a taxpayer has devoted to money lending activities in proportion to his other
activities. The “exceptional situation standard,” mentioned in your memorandum,
provides that a bad debt deduction will be allowed only when the taxpayer’s money
lending activities are so extensive as to constitute a trade or business. Berwind v.
Commissioner, 20 T.C. 808, 815, aff’d, 211 F.2d 575 (3rd Cir. 1954).
Courts’ interpretations of whether a taxpayer’s activities are extensive
enough to place him in the money lending business have been guided by many
factors. These include the number of loans made by taxpayer over the years,
(Eberhart v. Commissioner, 36 T.C.M. at 663); the amount of time spent on money
lending activities (Rankin v. Commissioner, No. 58,385 (T.C. Memo. 1953)); the
maintenance of an office for purposes of engaging solely in the money lending
business (Fuller v. Commissioner, 21 T.C. 407, 412 (1953); Carraway v.
Commissioner, T.C. Memo. 1994-295, 67 T.C.M. 3139, 3139-5); the maintenance
of books and records detailing taxpayer’s money lending activity (Ferguson v.
Commissioner, 16 T.C. at 1251), whether taxpayer held himself out to the public to
be in the money lending business (Gross v. Commissioner, 401 F.2d 600, 603 (9th
Cir. 1968); Kushel v. Commissioner, 15 T.C. 958, 960 (1950)); whether the
taxpayer advertised his loan services (McCracken v. Commissioner, T.C. Memo.
1984-293, 48 T.C.M. 248, 251, 252); whether taxpayer had a reputation in the
community for making loans (Carpenter v. Erickson, 255 F.Supp. 613, 615 (D. Or.
1966); the amount of income the taxpayer derived from his money lending activities
(Rollins v. Commissioner, 32 T.C. 604, 614 (1959), aff’d, 276 F.2d 368 (4th Cir.
1960); Scrivani v. Commissioner, T.C. Memo. 1992-467, 64 T.C.M. 523, 528); and
whether the taxpayer indicated that he was in the money lending business on his or
her tax return (Deely v. Commissioner, 73 T.C. at 1087; Zivnuska v. Commissioner,
9
33 T.C. 226, 239 (1959); Carraway v. Commissioner, T.C. Memo. 1994-295, 67
T.C.M. 3139, 3139-5). Courts have not required that all these factors be present
for a taxpayer to be in the money lending business, but have examined each case
on its own to assess the scope and nature of taxpayer’s overall lending activities.
U.S. v. Henderson, 375 F.2d at 41.
In several where courts found taxpayers to be in the business of money
lending, and thus entitled to a business bad debt deduction, courts carefully
scrutinized the above factors to determine whether taxpayers’ activities were so
extensive as to constitute a trade or business. In Carpenter v. Erickson, the Court
held that the taxpayer was in the money lending business where taxpayer financed
and guaranteed loans for seven entities and persons for a six year period, was
known in his community as a money lender, and had no relationship with the
individuals or ownership interest in the entities with whom he dealt. Carpenter v.
Erickson, 255 F.Supp. at 614. Similarly, in Serot v. Commissioner, the Tax Court
cited fifty-five loans totaling $1,200,000 made within a period of ten years,
voluminous records memorializing these loans, reputation in his community as a
money lender, devotion of forty to fifty hours per week to lending activities and
absence of relationship to borrowers as sufficient evidence to establish taxpayer’s
business as a money lender. Serot v. Commissioner, T.C. Memo. 1994-532, 68
T.C.M. 1015, 1022, 1023. The Court reached this conclusion despite the fact that
the taxpayer’s records were somewhat disorganized and not completely accurate
and the failure of taxpayer to advertise. In Cushman v. United States, the Court
found taxpayer’s money lending activities extensive enough to constitute a business
where twenty-one loans were made over eight years, taxpayer maintained an office
at home and employed a full-time secretary. Cushman v. United States, 148
F.Supp. 880, 884, 886 (D. Ariz. 1956). See also Ruppel v. Commissioner, T.C.
Memo. 1987-248, 53 T.C.M. 829, 833, 834 (taxpayer made one hundred and
twenty-four loans with seventy-six entities over ten years, was known in community
as money lender, had no interest in borrowers’ companies, and kept books and
records); McCracken v. Commissioner, 48 T.C.M. at 252 (loans to twelve borrowers
totaling $620,000 over course of fifteen years, twenty-year reputation as money
lenders, maintenance of separate bank account, books and records, lack of
relationship to borrowers indicated existence of loan business); Jessup v.
Commissioner, T.C. Memo. 1977-289, 36 T.C.M. 1145, 1151 (taxpayer held to be in
money lending business despite fact that he did not maintain office, advertise or
devote more than twenty-five hours per week to loan activities); Minkoff v.
Commissioner, T.C. Memo. 1956-269, 15 T.C.M. 1404, 1408, 1409 (substantial
number of loans and amounts of money loaned placed taxpayer in money lending
business); Estate of Cone v. Commissioner, T.C. Memo. 1954-56, 13 T.C.M. 512,
513 (money lending business established where numerous interest bearing loans
memorialized by notes over a period of fifteen to twenty years were made).
10
Another way in which courts have examined whether a taxpayer is in the
money lending business is through a review of the terms and conditions of the loan
from which the deduction is derived, as well as other loans which the taxpayer has
made. In reviewing the terms and conditions of a loan, the courts have considered
whether the loan was interest bearing, whether the terms of the loan were written,
whether the loans were made with any expectation of repayment by the lender and
borrower, the debtor’s ability to obtain money from other creditors, the degree of
speculation involved and whether the creditor made any efforts to enforce the loans
upon non-payment. Scriptomatic v. United States, 555 F.2d 364, 367 (3rd Cir.
1977). If the taxpayer fails to establish basic terms of interest, maturity or security,
then courts are not likely to view his activities as constituting a money lending
business. See generally Sekulow v. Commissioner, T.C. Memo. 1980-564, 41
T.C.M. 582, 584, 585. It is important to note that one of the problems which
spurred the amendment creating the distinction in tax consequences between
business and nonbusiness deductions was the abuse of the bad debt deduction by
persons who loaned money even though they not expect to be repaid. H.R. Ways
and Means Committee Rep. No. 2333, 77th Cong., 2d Sess. 45 (1942) 1942-2 C.B.
408, 409.
These factors relate more generally to whether monies advanced by a
taxpayer constitute a loan, to which section 166 applies, or a capital contribution.
As stated in the regulations, a bona fide debt arises from a debtor-creditor
relationship based on a valid and enforceable obligation to pay a fixed or
determinable sum. Treas. Reg. § 1.166-1(c). A capital contribution differs from a
loan in that it is an investment placed at the risk of the success or failure of the
business. See Recklitis v. Commissioner, 91 T.C. 874 (1988); Hudson v.
Commissioner, 31 T.C. 574 (1958); Stark v. Commissioner, T.C. Memo. 1982-639.
The issue of whether an advancement is debt or equity is a factual determination
which focuses on several factors such as the parties’ intent, the relationship
between the creditors and shareholders, ability of borrower to obtain a loan from
others, the amount of risk involved in the loan and whether there are formal terms
such as an interest rate, an obligation to repay and a fixed maturity date. Fin Hay
Realty Co. v. United States, 398 F.2d 694, 696 (3rd Cir. 1968). Where a taxpayer
claimed that his monetary advances to a corporation were business bad debts
incurred in taxpayer’s money lending business, the court held that the advances
were not loans, but capital contributions, since the advances were made to an
insolvent corporation, and there was no written evidence of a significant amount of
the monies he advanced. Zivnuska v. Commissioner, 33 T.C. 226, 235-237 (1959),
acq., 1960-2 C.B. 7. In Krause v. Commissioner, taxpayer argued that monies
advanced to a corporation constituted business bad debts in conjunction with his
money lending business. The Court held that the monies advanced were not loans,
but capital contributions, as their repayment was dependent solely upon the earning
of future profits. Krause v. Commissioner, T.C. Memo. 1967-68, 26 T.C.M. 358,
359, 360.
11
Numerous courts have held that where no written indicia of a loan exists,
such as an obligation to repay, a date for repayment, security for the loan, or the
applicable rate of interest due, the advances constitute capital contributions, rather
than loans. In Gross v. Commissioner, the Court held that taxpayer was not in the
money lending business where his advancements were not evidenced by a note,
terms of interest, dates for repayment or security. Gross v. Commissioner, 401
F.2d 600, 601, 602 (9th Cir. 1968). In Bettinger v. Commissioner, a taxpayer who
claimed that he was in the business of lending money was denied a business bad
debt deduction where he took no action to collect interest or enforce his notes and
loaned money to entities in poor financial condition, to whom other lenders would
not make loans. Bettinger v. Commissioner, 29 T.C.M. at 56, 57. The Court held
that taxpayer’s actions were inconsistent with a those of a person in the business of
lending money. Id. at 57. Accord U.S. v. Henderson, 375 F.2d at 41, 42 (evidence
that taxpayer took no action to enforce repayment, charged no interest and agreed
to accept a share of profits from company, if received, indicated that monies
advanced were not loans); Farkas v. Commissioner, T.C. Memo.1985-488, 50
T.C.M. 1085, 1092 (noting that an important distinguishing factor between debt and
capital contribution is a provision for interest payments); Cochran v. Commissioner,
T.C. Memo. 1955-66, 14 T.C.M. 206, 208 (continued advances to corporation
operating at a loss showed intent to place advances at risk of business and recover
investment only if company was profitable and thus constituted capital
contributions). See also Recklitis v. Commissioner, 91 T.C. at 901, 905
(commenting that it is “extremely improbable that prudent creditor would lend
money interest free, unsecured, and for an unspecified . . . time to an entity [in]
questionable financial condition”); Estate of Byers v. Commissioner, 57 T.C. 568,
578 (1972), aff’d, 472 F.2d 590 (6th Cir. 1973) (lending activity found not to
constitute business, as activity was casual and spontaneous); Estate of Pachella v.
Commissioner, 37 T.C. 347, 351, aff’d, 310 F.2d 815 (3rd Cir. 1962) (absence of
repayment date or interest rate to be paid indicated that contributions were not
loans); Rollins v. Commissioner, 32 T.C. 604, 614 (1959), aff’d, 276 F.2d 368 (4th
Cir. 1960) (vague records of advancements, absence of interest payments,
collateral and maturity date, and reliance on success of corporation for repayment
negated finding of business bad debt); Carraway v. Commissioner, 67 T.C.M. at
3139-5 (loans based on “handshakes,” and occasional allowance of services as
payment, lacked formality associated with money lending business); Steury v.
Commissioner, T.C. Memo. 1985-416, 50 T.C.M. 744, 749 (where no formal
repayment scheme existed, and there was no likelihood that funds would be loaned
by outside creditor, court held that advances were capital contributions).
A third and related way in which courts determine if a taxpayer is in the
business of money lending is by examining the scope of his or her money lending
activity. This entails an inquiry into whether the majority of taxpayer’s loans are
made to businesses in which taxpayer had an interest, or to persons in some way
12
related to the taxpayer. As the Supreme Court noted in Burnet v. Clark, where a
substantial number of advancements are made to an entity in which a taxpayer has
an interest, and the advancements possess the characteristics of informality and
lack of security described above, they are often held to be capital contributions
whose motivations often stem from the taxpayer’s desire to protect his investment.
Burnet v. Clark, 287 U.S. 410, 413, 414 (1932). In Post v. Commissioner, the Court
rejected the taxpayer’s argument that he was in the money lending business, noting
that most of his advancements were made to his wholly owned corporation, and
lacked terms of repayment. Post v. Commissioner, T.C. Memo. 1979-419, 39
T.C.M. 311, 335. The Court rejected a similar argument in Rollins v.
Commissioner, where taxpayer had served as director, officer and general counsel
in the group of corporations to which the majority of his advancements were made.
Rollins v. Commissioner, 32 T.C. at 614, 615. This fact, along with the absence of
interest payments, repayment dates and reliance on profits of company for future
repayment, led the court to conclude that the advances were capital contributions,
and not business debts. Id. In Palmer v. Commissioner, the scope of taxpayer’s
lending activity was held to be too narrow to constitute a trade or business of
financing corporations, since his lending activity was limited to the company in
which he held stock. Palmer v. Commissioner, 17 T.C. 702, 704 (1951). The
Court, in Lohman v. U.S., determined that the taxpayer was not in the loan
business, where the only “loans” he made were to a company in which he held
stock and, moreover, where he did not receive full reimbursement. Lohman v. U.S.,
10 AFTR2d 6151, 6152 (N.D. Okla. 1962). The Court characterized these
payments as capital contributions. Id. at 6152. Accord Carraway v. Commissioner,
T.C. Memo. 1994-295; Lee v. Commissioner, T.C. Memo. 1986-294; Bush v.
Commissioner, T.C. Memo. 1968-039; Beeman v. Commissioner, T.C. Memo.
1961-86; Bradley v. Commissioner, T.C. Memo. 1956-189; Funke v.
Commissioner, T.C. Memo. 1955-156.
Similarly, where the scope of a taxpayer’s lending activity consists primarily
of loans to relatives or personal friends, courts have not allowed a business bad
debt deduction, as the loans were not made in connection with any trade or
business of the taxpayer.
the Henderson case involved a loan
between relatives with no written terms, no efforts to collect interest or principal and
repayment only in the event that the business became successful. United States v.
Henderson, 375 F.2d at 42. See also Doneff v. Commissioner, T.C. Memo. 1991-
253; Jessup v. Commissioner, T.C. Memo. 1977-289; Eberhart v. Commissioner,
T.C. Memo. 1977-155; Mangrum v. Commissioner, T.C. Memo. 1960-136; Mayo v.
Commissioner, T.C. Memo. 1957-9.
A’s business as a money lender is supported by the following facts: A has
loaned money and purchased notes for many years, A has a reputation in the
community as a lender and purchaser of notes, and has been approached by
borrowers and sellers of notes. You have presented no evidence that A was in any
13
way related to the borrowers or to the seller of the note. Furthermore, A took action
to enforce its rights under the note, evidencing an expectation of repayment. There
are no facts in your memorandum which would indicate that A acquired the note for
investment purposes outside of his money lending business, or are inconsistent
with an individual engaged in the money lending business.
3. Has the purchase of notes been held by courts to be within the scope of the
trade or business of money lending? Was the taxpayer’s purchase of the note
proximately related to his money lending business?
The purchase of notes by an individual falls within the scope of the money
lending business. The Code and Treasury Regulations contemplate worthless debt
deductions derived not only from loans originated by a taxpayer, but also from a
taxpayer’s acquisition of existing loans. In defining a business bad debt, the Code
and Regulations state that the debt must be either created or acquired in the
course of a taxpayer’s trade or business. I.R.C. § 166(d)(2); Treas. Reg. § 1.166-
5(b)(1) (emphasis added). An example furnished in the regulations, in which an
obligation is sold by its original owner to a third party purchaser, illustrates this
point. Treas. Reg. § 1.166-5(d), ex. 2. In order for the acquired debt to be a
business debt, it must have been acquired in connection with the purchaser’s trade
or business, and, at the time the debt becomes worthless, the purchaser must be
“engaged in a trade or business incident to the conduct of which a loss from the
worthlessness of such claims is a proximate result.” Id. The legislative history for
section 166 also contains references to the acquisition of debt by a taxpayer, which
evidences an intent to include within the statute’s scope not only loans created by
the taxpayer, but also existing loans which a taxpayer acquires. H.R. Ways and
Means Committee Rep. No. 2333, 77th Cong., 2d Sess. 76 (1942),1942-2 C.B. 431.
In Kasachkoff v. Commissioner, the Court held that a petitioner who was in
the business of acquiring large numbers of secured trust notes from their holders
was engaged in a business, and was thus entitled to bad debt deductions on those
notes which had become worthless. Kasachkoff v. Commissioner, T.C. Memo.
1960-252, 19 T.C.M. 1393. The Court noted the volume and continuity of
petitioner’s business, the large amount of time spent on this activity, and the fact
that the activity was a major source of his income, in holding that petitioner was in
14
the business of buying and selling secured second and third trust notes.
Kasachkoff, 19 T.C.M. at 1395.
Similarly, in Hutton v. Commissioner, petitioner sought a bad business debt
deduction relating to his money lending activities. Hutton v. Commissioner, T.C.
Memo. 1976-006, 35 T.C.M. 16. One portion of his money lending activities
consisted of acquiring existing notes, an activity in which taxpayer had regularly
continuously engaged for a period of years. Id. at 20. The Court held that
petitioner’s acquisition of notes was part of his business of lending money. Id.
In the instant case, A’s purchase of the note was proximately related to A’s
money lending business, and the loss which A suffered occurred during the time in
which it was engaged in that business. The facts of the present case resemble
those of Kasachkoff and Hutton, in that A has been in the practice of originating
loans and purchasing existing obligations from lenders in the ordinary course of
his business for many years, and is known by the community as a money lender
and note purchaser. A was not related to the seller of the note or the borrower.
It is not evident from the facts that the taxpayer purchased this particular note for
any other reason than to make a profit. Thus, the note is proximately related to
A’s business.
CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS:
DEBORAH A. BUTLER
15
Assistant Chief Counsel (Field Service)
THOMAS D. MOFFITT
By: THOMAS D. MOFFITT
Senior Technician Reviewer
Income Tax and Accounting Branch
Field Service Division