A Loan Should Look Like a Loan

September 2, 2014

A business owner who advanced funds to a new employee was not entitled to deduct as a business bad debt either the funds that he knowingly advanced or the funds that the employee misappropriated from the business, the Tax Court determined recently.

Ronald Dickinson was a self-employed consultant. He hired Terry DuPont, a former employee, to work for him again in a new consulting business. Dickinson was aware that DuPont had financial obligations to his former spouse and to his children, and was experiencing financial problems as a result.

Dickinson sent DuPont a letter stating, essentially, that he would informally lend him money until DuPont was generating his own commissions. Ultimately, Dickinson wrote several checks to DuPont.

There was no promissory note or similar document evidencing the loans or stating that DuPont was obligated to repay. Dickinson neither charged interest nor provided a fixed repayment schedule, and DuPont did not offer any collateral.

After DuPont started working for Dickinson, he withdrew funds that he was not authorized to withdraw from one or more bank accounts over which he and Dickinson had signatory authority. DuPont also deposited certain funds that he was not authorized to deposit into one or more of his own bank accounts.

Dickinson later filed a complaint against DuPont in the state court alleging that DuPont had requested, and Dickinson had advanced to DuPont, funds totaling approximately $33,000 as loans that DuPont was obligated to repay. In his answer and counterclaim, DuPont admitted that Dickinson “did on occasion write checks payable” to DuPont but disputed the amount. DuPont also admitted that the funds were advanced at his request and constituted loans that he was obligated to repay.

The lawsuit was ultimately dismissed by the state court.

Dickinson claimed a business bad debt deduction of $32,550. He attached a letter to the return with his description of what had occurred. The IRS disallowed the deduction because Dickinson failed to show “that any amount was incurred for a bona fide debt which became worthless during the year.”

The Tax Court agreed with the IRS that Dickinson failed to prove that the arrangement constituted a bona fide loan, noting among other things the absence of any objective characteristics of a loan, such as interest or a debt instrument. The court also found that Dickinson did not have a reasonable expectation of recovering any portion of the funds at the time they were advanced because of DuPont’s known financial problems (Ronald R. and Shirley F. Dickenson v. Commissioner, TC Memo 2014-136, July 10, 2014).