Cease-and-Desist Order Not Sufficient Evidence for Bad Debt Deduction

Cease-and-Desist Order Not Sufficient Evidence for Bad Debt Deduction

Cease-and-Desist Order Not Sufficient Evidence for Bad Debt Deduction

In Sensenig v. Commissioner,T.C. Memo. 2017-1, the court considers whether an investment fund is entitled to a bad debt deduction for cash-hungry start-up companies the fund had invested in when securities regulators barred the investment fund from raising money needed to sustain the start-up companies. The court considers whether the receipt of a cease-and-desist order from the state regulator is a triggering event that establishes that the start-up companies were worthless in the year the order was received.

The Facts & Procedural History

The facts and procedural history are as follows:

  • The taxpayer operated a business that raised money to invest in start-up companies.
  • In return for the money his business invested, the taxpayer would acquire an equity interest in the start-up companies and he acquired financial control over each of the companies by becoming a director, a bank account signatory, the chief financial officer, and the tax return preparer.
  • The taxpayer had raised $50 million from third parties to invest in these start-up companies.
  • The taxpayer’s business invested in 15-20 start-up companies.
  • The Pennsylvania Securities Commission (“PSC”) determined that the practice of issuing demand notes to investors in return for receipt of borrowed funds constituted the sale of unregistered securities.
  • In June of 2005, the PSC issued the taxpayer an order to cease and desist the offering and sale of unregistered securities.
  • In January 2006 the PSC accepted the taxpayer’s offer of settlement and rescinded the summary order to cease and desist.
  • The taxpayer and his fund were permanently barred from offering or selling securities in Pennsylvania unless he received a valid registration statement.
  • The taxpayer took steps to try to register with the U.S. Securities and Exchange Commission, but it proved too costly and he abandoned the effort.
  • The taxpayer claimed a $10,695,581 bad debt loss on his 2005 tax return for three of these start-up companies.
  • The IRS audited the taxpayer’s return and disallowed the loss.

 

Debt vs. Capital Contribution

The court started by considering whether the monies advanced to the start-up companies were even a debt. The court considered the factors that indicate whether an advance is a loan or a capital investment:

(1) the intent of the parties;
(2) the identity between creditors and shareholders;
(3) the extent of participation in management by the holder of the instrument;
(4) the ability of the corporation to obtain funds from outside sources;
(5) the thinness of the capital structure in relation to debt;
(6) the risk involved;
(7) the formal indicia of the arrangement;
(8) the relative position of the obligees as to other creditors regarding the payment of interest and principal;
(9) the voting power of the holder of the instrument;
(10) the provision of a fixed rate of interest;
(11) a contingency on the obligation to repay;
(12) the source of the interest payments;
(13) the presence or absence of a fixed maturity date;
(14) a provision for redemption by the corporation;
(15) a provision for redemption at the option of the holder; and
(16) the timing of the advance with reference to the organization of the corporation.

Weighing these factors, the court concluded that the money advanced by the investment fund were capital investments. This precluded from taking a bad debt deduction.

Whether the Cease-and-Desist Order Establishes Worthlessness

The court then assumes that the advances were debt, to consider whether the loans were worthless if the advances were debt.

The taxpayer argued that the securities regulators shut down his investment activity with the June 2005 cease-and-desist order and he lacked additional funds with which he could keep the companies going. According to the taxpayer, it was obvious that the companies were therefore doomed and that the loans from the investment funds to them became worthless.

The court noted that the receipt of the cease-and-desist order was significant, but that this fact alone was not sufficient to establish that the debt was worthless. The court asked the taxpayer to provide evidence of the companies finances as of 2005. The taxpayer failed to do this, which resulted in the court concluding that the debt was not worthless.

It should be noted that the taxpayer could also be entitled to take a deduction for worthless securities for its investment in the start-up companies. It does not seem that this worthless securities deduction would have been available in 2005 either, as the start-up companies were still operating in 2005.

The Takeaway

Bad debt and worthless securities deductions are often timing issues. The question is what year is the deduction allowable. For investment funds, the takeaway from this case is that the receipt of a cease-and-desist order from a state regulator alone is not a sufficient triggering even to establish worthlessness. The taxpayer also needs to show financial records to prove that the start-up companies were worthless in the same year that the cease-and-desist order was received.

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