Facts: Elmer Beans is the sole shareholder of Beans Real Estate, Inc., a C corporation. Beans Real Estate is the general partner of the Constabulary Limited Partnership, which constructed and is attempting to operate an upscale shopping center. Beans Real Estate was formed for the sole purpose of participating in this project. Norman Leer is also a limited partner in the partnership, owning a 25% interest in partnership profits and losses. * Constabulary has encountered difficult times, and is in need of $1 million to carry it through what will hopefully be temporary troubles. Norman believes in the perfect and is willing to lend the necessary funds, but he also is aware of the real risk that his loan will not be, or may only partially be, repaid. * Norman is concerned about the tax effects of any loss that might arise from the full or partial nonpayment of the loan and has approached his tax adviser for assistance in structuring the loan. Norman believes he has two alternatives. He could contribute or loan the money to Beans Real Estate, Inc., which would, in turn, loan the money to the partnership. Alternatively, Norman could loan the $1 million directly to the partnership. Issue: How should Norman structure the loan?
Sec. 166 allows taxpayers a deduction for debts that become worthless during the tax year. For noncorporate taxpayers, however, this allowance is qualified; losses attributable to nonbusiness bad debts are treated as resulting from the sale or exchange of capital assets held for not more than one year (i.e., short-term capital losses). As such, they are not fully deductible.
“Nonbusiness debts” are defined as debts other than debts “created or acquired in connection with a trade or business of the taxpayer” or “the worthlessness of which is incurred in the taxpayer’s trade or business.”
Partner Loans as Business Debts
The character of a bad debt loss attributable to a partner’s loan to a partnership appears to be governed by Butler, 36 TC 1097 (1962). Butler involved a creditor who was a limited partner of the debtor partnership. The Tax Court held that the partner’s loan to the partnership was deductible as a business bad debt. It based its decision on the aggregate theory of partnership taxation, attributing the partnership’s business to its partners, including limited partners. Under this reasoning, a loan made in furtherance of the partnership’s business is also made in furtherance of the partner’s business. The IRS acquiesced in the Butler decision.
Butler involved tax years prior to the enactment of the Internal Revenue Code of 1954. The 1954 Code may be relevant because it included a new provision — Sec. 707 — that explicitly stated that loans between a partner and a partnership are to be treated as loans between unrelated persons.
Two years after the Tax Court decided Butler, the Supreme Court decided Whipple, 373 US 293 (1963), involving the deductibility of a loss on a loan to a controlled corporation. The Court held that, even though the taxpayer devoted all his time to his several corporate enterprises, he had not established a “business” distinct from that of a shareholder attempting to increase his return on investments. As a result, the indebtedness was not a business debt (for which the bad debt loss would have been fully deductible). Instead, it was a nonbusiness debt, for which only a short-term capital loss was allowed. Later cases have indicated that an individual’s loan to a corporation is treated as a business debt only in certain limited circumstances, for example, if the loan arises as part of the business of lending money, or as part of the business of developing, promoting and selling corporate enterprises.
The effect of Whipple on the Butler decision was initially unclear, especially in light of the enactment of Sec. 707. However, in 1965, the Tax Court reaffirmed Butler in Stanchfield, TC Memo 1965-305. In Stanchfield, the taxpayer advanced cash to a construction company owned by his son-in-law. The court concluded that the taxpayer and his son-in-law had formed a general partnership and the advances were capital contributions. The taxpayer, however, had also guaranteed debt of the “partnership,” which he was later called on to pay.
In discussing the tax treatment of the payment on the guarantee, the Stanchfield court considered the loss on the guarantee to be a bad debt loss. Then, citing Butler, it held that the loss was a business bad debt because the taxpayer was a partner in the partnership. The court distinguished Whipple on the grounds that Whipple dealt with a shareholder-creditor and a corporate debtor, while the taxpayer in Stanchfield was a creditor of the partnership of which he was a partner.
Notwithstanding Stanchfield, it is questionable whether Butler continues to be reliable precedent. Under Sec. 707, a partnership’s business might not be attributed to the partner. If the partnership’s business is not attributed to the partner, the Whipple Court’s reasoning would appear to be applicable in the partnership setting, causing the debt to be characterized as a nonbusiness debt.
Notwithstanding these questions, the Service has not withdrawn or limited its acquiescence in Butler. Moreover, Butler has been applied by the Tax Court in a post-1954 Code setting. As a consequence, tax advisers should be entitled to continue relying on Butler, at least for the time being.
If Norman loans the money directly to Constabulary and the debt becomes uncollectible, he should be entitled to rely on the Butler decision and the IRS’s acquiescence to claim a business bad debt loss. As a result, his bad debt loss should be an ordinary loss, rather than a short-term capital loss. On the other hand, if he advances the funds to Beans Real Estate, which in turn advances the funds to the partnership, absent unusual circumstances (that do not appear to be present in this case), any bad debt loss realized by Norman would be a nonbusiness bad debt, giving rise to a capital loss. Because capital losses generally provide less tax benefit than ordinary losses, the tax adviser should advise Norman to loan the money directly to the partnership.
Norman should lend the money directly to Constabulary. This allows Norman to recognize an ordinary loss on the loan should it become worthless. Of course, if the corporation was an ongoing enterprise, its tax situation would have to be considered in determining the best structure. If the corporation could use the loss and would be able to repay Norman, another structure might be more advantageous.
Constabulary might also consider borrowing the money from a third-party lender, with Norman guaranteeing repayment of the loan. If the partnership later defaulted on the loan, and Norman was called on to pay on his guarantee, he would still be able to deduct his payment as an ordinary loss.
In the case of a loss on a payment pursuant to a guarantee agreement made after Dec. 31, 1975, Regs. Sec. 1.166-9(a) and (e)(2) provide that a taxpayer’s payment on the guarantee is treated as a debt, with the debt becoming worthless in the tax year in which the payment is made.
In the case of guarantee agreements, however, additional rules may limit a taxpayer’s ability to treat the payment as a worthless debt. Regs. Sec. 1. 166-9(d) provides that a payment on a guarantee agreement is treated as a worthless debt only if (1) the agreement was entered into in the course of either the taxpayer’s trade or business or a transaction for profit; (2) there was an enforceable legal duty on the part of the taxpayer to make the payment (except that legal action need not have been brought against the taxpayer); and (3) the agreement was entered into before the obligation became worthless.
Regs. Sec. 1.166-9(e)(1) further provides that the payment and satisfaction of a taxpayer’s agreement to act as a guarantor produces a worthless debt only if the taxpayer demonstrates that “reasonable consideration was received for entering into the agreement.” For this purpose, “reasonable consideration” is not limited to direct consideration, such as a payment to the partner.
If these requirements are met, the payment on the guarantee will produce a bad debt loss. For noncorporate taxpayers, the deductibility again depends on whether the debt has a business or nonbusiness character. In the case of a payment on a guarantee, this characterization is governed by the same rules that govern the character of direct indebtedness.