In a recent Tax Court memorandum, Anaheim Arena Management, LLC v Commissioner, T.C. Memo. 2025-68, the court delved into the complex issue of whether intercompany advances constituted bona fide debt for tax purposes, thereby determining the validity of a significant bad-debt deduction and the applicability of an accuracy-related penalty. This case offers critical insights for tax professionals navigating the often-ambiguous line between debt and equity, particularly in related-party transactions and intricate management agreements.

Factual Overview

The case centered on Anaheim Arena Management, LLC (AAM), a limited liability company treated as a partnership for federal income tax purposes. AAM was one of five Samueli entities owned by Henry Samueli and his family.

On December 16, 2003, AAM entered into a facility management agreement with the City of Anaheim (City), granting AAM the exclusive license to manage the Honda Center, a sports-and-entertainment arena. Key provisions of this agreement dictated how funds were handled and expenses paid. All funds received by AAM related to the Honda Center’s operations, including proceeds from "Operating Loans" and "Debt Service Loans," were property of the City, even though held and controlled by AAM in designated bank accounts (Operating Account, Third-Party Funds Account, Insurance and Condemnation Account, and Reserve Account).

The management agreement established a waterfall provision for the payment of expenses and other amounts from the Honda Center’s gross revenues and other proceeds. This priority included:

First: Operating Expenses.
Second: Contingent Waiver and Consent Fee.
Third and Fourth: Amounts for LILO Claims.
Fifth: Annual Budget items not otherwise described.
Sixth: Principal and interest on "Other Debt" (which included AAM’s Cap Ex Loans).
Seventh: 2003 Facility Financing Debt Service.
Eighth: Interest and principal repayment of "Operating Loans".
Ninth: Principal and interest on "Debt Service Loans".
Tenth: Amounts due to the letter of credit issuer.
Eleventh: Respective shares of "Adjusted Net Revenues" to Manager (AAM), Owner (City), and County of Orange. AAM was entitled to 100% of residual profits up to $12,000,000 and 75% of residual profits above $12,000,000.

Crucially, the management agreement mandated that if cash on hand was insufficient to pay Operating Expenses or Debt Service, AAM was required to "make, or cause an Affiliate or a third party lending institution to make, Operating Loans for such purposes" or "Debt Service Loans". These loans, if made by AAM or its affiliates, were to bear interest at Prime plus 1%. The agreement also specified that the City’s obligation to make any payment was a special obligation payable only from Gross Revenues available and not from any other funds, nor was the City’s full faith and credit pledged.

While managing the Honda Center, AAM frequently made advances to cover funding shortfalls. These advances were categorized into three types:

Operating Loans: Used to pay operating expenses, interest, or principal on other Operating Loans, or other section 5.2(b) payments, excluding Debt Service.
Debt Service Loans: Used to pay Debt Service.
Capital Expenditure Loans (Cap Ex Loans): Advances to fund capital expenditures for the Honda Center, which were defined as "Other Debt" in the management agreement.

AAM documented these advances with promissory notes, naming "AAM" as the lender and "the Honda Center" as the borrower. However, the Honda Center is a physical asset, not a distinct legal entity capable of borrowing money or being sued. Timothy Ryan, AAM’s CEO, signed the notes on behalf of "the Honda Center" but was not authorized to bind the City. Therefore, AAM’s ability to enforce repayment was solely under the terms of the management agreement, where the City was the actual recipient of the advances. The notes generally stated an interest rate of prime plus 1%. Operating Loans and Debt Service Loans had a stated maturity of one year from the note’s date but were treated as a revolving line of credit with no actual maturity date in practice, as AAM would carry over balances to new notes. Cap Ex Loans had varying maturity dates, generally tied to the asset’s life.

Despite the notes’ terms, AAM frequently did not receive principal payments on time, often waiving them and carrying over balances. For example, AAM received all Cap Ex Loan interest through December 31, 2015, but no principal payments after March 31, 2014, due to waivers and pauses in the repayment schedule. Operating Loans missed timely interest payments before December 31, 2006, and few principal payments were received after June 30, 2013. No principal payments were ever received for Debt Service Loans.

In March 2015, Bill Foltz, the new CFO of the Samueli entities, concluded that AAM’s advances would likely never be repaid. He, along with David Murphy (tax director) and Michael Schulman (AAM officer), consulted Dan Bolar and Christopher Bellew, CPAs at Bolar Hirsch & Jennings (BHJ), to determine the correct tax treatment. Bellew, considering the advances to be debt, drafted a memo recommending a bad-debt deduction for tax year 2015, focusing mainly on the worthlessness issue. Schulman, having final authority, relied on this memo to claim a $51,465,228 bad-debt deduction on AAM’s 2015 tax return.

Taxpayer’s Requested Relief

The Internal Revenue Service (IRS) audited AAM’s 2015 return and issued a Notice of Final Partnership Administrative Adjustment (FPAA). The FPAA disallowed the entire $51,465,228 bad-debt deduction, stating, "Because there was no valid enforceable obligation to pay a fixed or determinable sum of money, your bad debt deduction was disallowed". Additionally, the IRS determined a Section 6662(a) accuracy-related penalty due to a substantial understatement of income tax and/or negligence or disregard of rules or regulations.

H&S Investments I, LP, a member of AAM, filed a petition with the Tax Court under Section 6226(b) disputing the FPAA. H&S Investments sought to sustain the bad-debt deduction and argue for the non-applicability of the accuracy-related penalty.

Court’s Analysis of the Law

The Tax Court first established its jurisdiction over the TEFRA partnership-level proceeding, confirming that H&S Investments’ petition, filed on day 95, was timely even if it might have been the tax matters partner, because it also qualified as a notice partner.

Regarding the bad-debt deduction, the court noted that Section 166(a)(1) permits a deduction for "debt which becomes worthless within the taxable year". The IRS’s disallowance was based solely on the argument that the advances were not "debt," meaning the "worthlessness" of the advances was not an issue for trial. A bona fide debt is defined as one arising from a "debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money".

The Ninth Circuit, to which this case would be appealable, uses an eleven-factor test to determine if an advance constitutes debt for federal income tax purposes:

Names given to the certificates evidencing indebtedness.
Presence or absence of a maturity date.
Source of the payments.
Right to enforce the payment of principal and interest.
Participation and management by the putative lender.
Status equal to or inferior to other creditors.
Intent of the parties.
"Thin" or adequate capitalization.
Identity of interest between creditor and stockholder.
Payment of interest only out of "dividend" money.
Ability to obtain loans from outside lenders on substantially similar terms.

No single factor is determinative; the ultimate inquiry focuses on the economic substance of the transaction, not its form. The burden of proof for the bad-debt deduction was on H&S Investments.

For the accuracy-related penalty, Section 6662(a) applies to underpayments attributable to a substantial understatement of income tax or negligence/disregard of rules and regulations. While the understatement amount is calculated at the partner level, the applicability of the penalty and partnership-level defenses are determined at the partnership level. A key defense is reasonable cause and good faith under Section 6664(c)(1). This defense requires evaluating all pertinent facts and circumstances, with the most important factor being the taxpayer’s effort to assess their proper tax liability. Good faith reliance on the advice of an independent, competent professional can establish reasonable cause, provided:

The adviser was a competent professional with sufficient expertise.
The taxpayer provided necessary and accurate information.
The taxpayer actually relied in good faith on the adviser’s judgment.

Finally, the court considered the supervisory approval requirement under Section 6751(b)(1), which mandates written supervisory approval for initial penalty determinations. The burden of proving non-compliance with this section rested on H&S Investments.

Application of the Law to the Facts

Disallowance of the Bad-Debt Deduction (Debt vs. Equity)

Applying the eleven factors, the court systematically concluded that AAM’s advances did not constitute debt:

Names: While promissory notes were titled "SUBORDINATED PROMISSORY NOTE" and referred to "Borrower" (Honda Center) and "Lender" (AAM), the Honda Center is not a legal entity. The management agreement, which truly governed the advances, described AAM’s role as a manager with rights to residual profits, suggesting the advances were part of its contractual duties, not mere loans. This factor did not indicate debt.
Maturity Date: Although notes specified maturity dates, AAM had the sole discretion to extend them and regularly did so, treating Operating and Debt Service Loans as a revolving line of credit. Repayment was contingent on Honda Center revenues, and AAM’s expected return included a share of residual profits, which had no maturity date. This factor did not indicate debt.
Source of Payments: Repayment of advances and residual profits was expressly limited to revenues generated by the Honda Center’s business activities. This limitation significantly increased the uncertainty of repayment. This factor did not indicate debt.
Right to Enforce Repayment: The notes were not self-standing legal obligations. AAM’s ability to receive payment was solely contingent on sufficient Honda Center revenues, with no recourse if revenues were insufficient. This factor did not indicate debt.
Participation and Management: The advances were integral to AAM’s performance of its management duties. Failure to make advances would have risked losing its exclusive management rights and the associated residual profits. This factor did not indicate debt.
Status Equal to or Inferior to Other Creditors: While AAM argued its advances had higher priority than some other stated obligations (e.g., 2003 Facility Financing Debt Service), the court found those other obligations were also contingent on Honda Center revenues and thus not "regular creditors". Crucially, AAM’s overall investment return included a share of residual profits (11th priority), making its position inferior to most creditors. The low interest rate (prime + 1%) also indicated the advances were tied to AAM’s management obligations and profit sharing, rather than traditional lending. This factor did not indicate debt.
Intent of the Parties: The "parties" were AAM and the City, and the management agreement, their primary expression of intent, did not support the advances being true debt obligations. While Deloitte’s financial statements and City references used the term "loans," these did not override the economic substance dictated by the agreement. This factor did not indicate debt.
"Thin" or Adequate Capitalization: The history of payments showed that Honda Center revenues were frequently insufficient to fully repay principal on Cap Ex, Operating, or Debt Service Loans, and rarely sufficient to trigger AAM’s share of residual profits. This demonstrated the Honda Center’s inadequate capitalization to support the advances as debt. This factor indicated the advances were not debt.
Identity of Interest: AAM, despite not owning the Honda Center building, had an "equity-like stake" in the Honda Center’s operational profits through its right to residual profits (100% up to $12M, 75% thereafter). This showed AAM’s commitment to the business’s risk, similar to an equity investor. This factor did not indicate debt.
Payment of Interest Only Out of "Dividend" Money: Both the stated interest and the residual profit share were contingent on the Honda Center generating sufficient revenues, similar to dividends. This factor did not indicate debt.
Ability to Obtain Loans from Outside Lenders: The court found that a third-party lender would not have made these advances on substantially similar terms (prime + 1%). AAM made the advances at a low rate because it was contractually obligated to maintain the Honda Center and make up shortfalls, with the expectation of a share of residual profits. This factor did not indicate debt.

Based on this comprehensive analysis, the court concluded that none of the 11 factors indicated the advances were debt.

Applicability of Accuracy-Related Penalty

The court first addressed the Section 6751(b)(1) supervisory approval requirement. It found that regardless of whether Senior Counsel Coy or Revenue Agent Swann made the "initial determination" to assert the penalty, their respective immediate supervisors (Associate Area Counsel Famularo and Acting Group Manager Houston) provided timely written approval before assessment. The court dismissed H&S Investments’ arguments that RA Swann’s earlier reports (without penalty assertion) constituted the "initial determination" or that there was insufficient evidence of his role or his supervisor’s status. Thus, the IRS satisfied Section 6751(b)(1).

Next, the court considered AAM’s defense of reasonable cause and good faith reliance on professional advice. The court found that Michael Schulman, who had final authority to claim the deduction, reasonably relied on the advice of CPAs Dan Bolar and Christopher Bellew. Bolar and Bellew were deemed competent professionals with sufficient expertise, and AAM provided them with necessary and accurate information regarding the advances and the Honda Center’s financial situation. Although Bellew’s memo primarily focused on the "worthlessness" of the advances, Bellew credibly testified that his analysis included the determination that the advances were, in fact, debt. The court found that Schulman, Bolar, and Bellew genuinely believed the primary legal question for the deduction was worthlessness, and that Bolar and Bellew implicitly concluded the advances were debt as part of their advice. Therefore, Schulman’s decision to claim the bad-debt deduction was made in good faith reliance on professional judgment.

Conclusion

The Tax Court ruled in favor of the Commissioner regarding the disallowance of the bad-debt deduction, holding that AAM’s advances were not bona fide debt for tax purposes. This determination stemmed from a thorough application of the Ninth Circuit’s eleven-factor test, with the court finding that the economic substance of the advances pointed away from a true debtor-creditor relationship due to the contractual obligations, profit-sharing arrangement, and contingent repayment structure within the management agreement.

However, the court also ruled in favor of AAM regarding the accuracy-related penalty, concluding that AAM had reasonable cause and acted in good faith in claiming the deduction. This was primarily due to Schulman’s reasonable reliance on the advice of experienced and competent tax professionals, Bolar and Bellew, who, despite focusing on worthlessness, had implicitly determined that the advances qualified as debt under Section 166. This outcome highlights the importance of comprehensive professional advice and thorough documentation of such reliance, even when the underlying tax position is ultimately not sustained.

Prepared with assistance from NotebookLM.