Taxpayer Failed to Show in Business of Loaning Money or That Debts Totally Worthless

Fred Cooper lent money to various individuals, including specifically Wolper Construction, Inc. a real estate development business.  In the case of Cooper v. Commissioner, TC Memo 2015-191 the Tax Court had to decide if Mr. Cooper could take a deduction for a bad debt in either 2008 or 2009.

IRC §166 governs the deduction of bad debts for taxpayers.  Differing rules apply depending on whether the debt in question is a business bad debt or is not one.  Generally business bad debts represent ordinary losses and a deduction can be claimed on a debt that becomes partially worthless.  A nonbusiness bad debt is deductible as a short term capital loss and for entities other than corporations per Reg. §1.166-5(a)(2), only deductible in the year in which the debt becomes wholly worthless.

Mr. Perry lent money to people referred to him by his friends, and those he loaned to included his secretary, his accountant and two business associates, as well as Wolper Construction, Inc.  His lending “due diligence” was a bit informal, as the Court pointed out:

Mr. Cooper did almost none of the due diligence that would be customary in a lending business. He did not conduct credit checks or verify collateral through title searches, and he did not collect information through any loan applications before extending loans. He testified that he would "loan to individuals based on their character and whether or not I believe that they have the ability and the willingness to repay. I really follow this motto. You can't make an immoral man moral with a contract or the vice vers[a] is also true."

Wolper Construction, like many other real estate operations, ran into financial difficulties during the middle of last decade.  In April of 2007 when the corporation’s $925,000 loan came due Wolper failed to pay, but Mr. Cooper indicated he wasn’t terribly concerned at that point, believing the company would eventually pay.

Wolper filed for Chapter 11 bankruptcy in June 2008, listing assets of $62,480,203 and liabilities of $34,571,185. A later listing of assets and liabilities showed similarly significant net equity in the business.  Mr. Cooper did not file a claim in the bankruptcy proceeding.

In 2009 a bank filed a creditor’s claim of over $42 million and moved that the proceeding be converted to a Chapter 7 filing, arguing that a mechanic’s lien listed as an asset in the bankruptcy was gross overvalued and various liabilities should be added to those listed.  The proceeding was converted to a Chapter 7 proceeding and in 2010 the mechanic’s lien was sold.  While it had initially been valued at over $36,500,000 it was finally sold for $116,000.

Mr. Cooper at this point filed an amended return, claiming a bad debt deduction in 2008 as a business loan.  In the alternative he argued that if it wasn’t deductible in 2008 it was deductible in 2009.

The Tax Court found initially that the loan did not qualify as a business loan.  Mr. Cooper was not found to be in the business of lending.  The Court noted that he only made 12 loans over a six-year period from 2005 to 2010, he lent money only to friends and acquaintances, he failed to conduct his lending “business” in accordance with the normal formalities associated with lending, he did not publicly hold himself out as lending money and he did not keep adequate business records. Thus, if there was a bad debt in any of the years in question it would be a nonbusiness bad debt.

But the Court found that Mr. Cooper had failed to show that the debt was completely worthless in either 2008 or 2009.  One big problem was that Mr. Cooper continued to report the debt as an asset on both a loan application and a personal financial statement he prepared in 2009, valuing the loan to the company at over $1,000,000 in each case.  As well, he failed to report the return as worthless on his original 2008 return, prepared in October of 2009.

He only first acted as if the debt was worthless in 2010 when he filed an amended return.  While Wolper filed bankruptcy in 2008, that filing by itself did not show the loan was worthless.  In fact, the filings with the bankruptcy showed a positive net worth of tens of millions of dollars.  Only when it was established that the mechanic’s lien was only worth a small fraction of its listed value did it become clear that the organization was insolvent.

Thus the Court found he failed to demonstrate the loan was entirely worthless by the end of either 2008 or 2009.