For most closely-held businesses, and especially for those that are newly-formed, the infusion of capital is of paramount concern because it may be needed to fund start-up costs, operations and, eventually, expansion. In some cases, the capital may be obtained from investors in exchange for an equity interest in the business; in others, the capital may take the form of a loan. Either way, the parties to the financing transaction must agree as to the nature of their relationship or transaction, they must be aware of its potential income tax consequences, and they must structure and memorialize the transaction accordingly.

A recent decision of the Tax Court described an unusual set of circumstances in which an individual taxpayer borrowed funds that he then transferred to his start-up business.snoopyirscartoon

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Taxpayer cofounded Business in 1996. As cofounder, Taxpayer served in various roles, including president, chief executive officer, and director.

At about the same time, Corp was in desperate need of an experienced executive to manage its operations. Corp was impressed with Taxpayer and began courting him as a candidate for Corp’s executive position in late 1997.

Taxpayer met with Corp to discuss the executive position. Taxpayer explained that he intended to stay in Business because, as the cofounder, he owed a duty to its financial well-being and to its employees.

Unusual Arrangement

Despite Taxpayer’s initial hesitancy to join Corp, Corp did not stop pursuing him. In January 1998, in order to induce Taxpayer to join Corp, Corp made him an offer that included a salary, employee benefits, and a loan of $X (the Loan). The parties understood that, if Taxpayer accepted the offer, he would lend the $X to Business in order to support its operations. Corp required that the Loan be made to Taxpayer—and not to Business—because Corp did not want to have any financial dealings with Business’s board of directors.

Taxpayer met with Business’s directors to advise them of Corp’s proposal. Taxpayer also advised them that, in addition to providing the loan for Business, Corp was interested in contracting with Business for operations and technical support services. Up until this date, Business had sought and obtained equity investors but nevertheless still needed additional funds to continue and grow its operations. Business ‘s directors approved Corp’s arrangement, and Taxpayer accepted Corp’s offer.

Taxpayer and Corp executed an employment agreement in May 1998. The agreement allowed Taxpayer to continue to serve as a director and CEO of Business. Additionally, the agreement stated that the Loan would become due if Taxpayer’s employment with Corp was ever terminated.

In September 2000, Corp sold its interest in the Loan to its parent company (“Parent”).

As agreed in the employment agreement, after Taxpayer received the Loan, he lent $X to Business. Additionally, shortly after Taxpayer began his employment with Corp, Business began to receive sizable contracts from Corp. By the end of 1999 Business’s contractual arrangements with Corp generated approximately 60% of Business’s revenue.

However, in late 2000 it became apparent that Taxpayer was needed to manage Business full time because of its rapid growth. Consequently, in May 2001—with Corp’s approval—Taxpayer resigned his position with Corp. Taxpayer’s resignation from Corp triggered his repayment obligations as to the Loan under the employment agreement. Corp and Parent did not demand repayment of the Loan at that time, nor did Taxpayer receive a Form 1099-C, Cancellation of Debt, from Corp or Parent discharging the Loan. The “terms” of the Loan were not amended.

Taxpayer Runs Into Trouble

In 2001, Corp received significant government financing, with which it began to hire its own operations and technical staff, thereby reducing its reliance on Business. As a consequence, Business’s performance suffered, forcing Taxpayer to reduce expenses, cut salaries, and lay off employees.

In February 2002, Business filed a petition with the Bankruptcy Court. In July 2009, the Court entered its final decree ending the bankruptcy and Business was dissolved.

In February 2005, Taxpayer went back to work for Corp.

The IRS Audit

In October 2008, Taxpayer filed a Federal income tax return for 2007. In 2010, in connection with an audit of Corp’s return, the IRS commenced an audit of Taxpayer’s return for 2007. (Please note that the examination of the return of the unrelated lender led to the audit of the borrower’s return. You never know. You need to be prepared.)

In 2011, Corp met with Taxpayer and notified him that the Loan was still due and owing. Taxpayer then arranged to begin making payments on the Loan via payroll deductions from his Corp paycheck.

In March 2013, the IRS sent Taxpayer a notice of deficiency for 2007 determining that Taxpayer had failed to report cancellation of debt (“COD”) income as to the Loan. Taxpayer filed a petition with the Tax Court appealing the IRS’ determination.

Cancellation of Debt

The Code defines the term “gross income” broadly to mean all income from whatever source derived, including income from discharge of indebtedness. Whether a debt has been discharged depends on the substance of the transaction. As always, mere formalisms arranged by the parties are not binding in the application of the tax laws.

The moment it becomes clear that a debt will never have to be paid, that debt must be viewed as having been discharged. The test for determining that moment requires a practical assessment of the facts and circumstances relating to the likelihood of payment and often turns on the subjective intent of the creditor. Any identifiable event that fixes the loss with certainty may be taken into consideration.

The IRS argued that Taxpayer realized COD income in 2007 from forgiveness of the Loan. In support of that position, the IRS relies on Corp’s and Parent’s failure to take collection action after the Loan became due and before the period of limitations for collection expired (the period of limitations for collection of the Loan expired in 2007). Such inaction, the IRS argued, manifested the intention of Corp or Parent to forgive the Loan.

Taxpayer argued that the Loan was not discharged in 2007 because it was still outstanding and was being repaid.

Credible Testimony

Taxpayer and Corp’s president testified regarding the Loan. “Having observed their appearances and demeanors at trial,” the Court  found “their testimonies on this issue to be honest, forthright, and credible.” Corp’s president testified that Parent considered the Loan outstanding and that he was confident that Taxpayer would repay it. Additionally, Taxpayer testified that he was specifically told by the president that the Loan was still due and owing. Taxpayer further testified that he was currently repaying the Loan via payroll deductions from his paycheck. Furthermore, Taxpayer correctly pointed out that if the Loan had been forgiven, Parent would have a strong incentive to report the loan as discharged so that Parent could benefit from a bad debt deduction. Yet Taxpayer testified that he did not receive a Form 1099-C from Parent discharging the Loan.

Addressing the IRS’s statute of limitations argument, the court stated that although, under some circumstances, the expiration of a State limitations period can serve as an identifiable event, it is not conclusive as to when a debt has been discharged. This is because the expiration of the period of limitations generally does not cancel an underlying debt obligation but simply provides an affirmative defense for the debtor in an action by the creditor.

Because Parent and Corp never treated the Loan as canceled or otherwise forgiven, and in light of the fact that Corp’s president credibly testified that the Loan was still outstanding, the Court concluded that Taxpayer had no COD income in 2007 with respect to the Loan because it was still outstanding and was being repaid.

Consistent Treatment

The foregoing highlights the importance, from a tax perspective, of how the parties to a transaction each view the transaction. Both the Taxpayer and Corp acted consistently in their treatment of the Loan. They both understood the nature of the financial arrangement into which they entered: it was a loan to be repaid.

Although the Court’s opinion did not go into much detail, it appears that the Loan was not evidenced by a separate note (rather, it was part of the employment agreement). No mention was made of its bearing a reasonable rate of interest, of interest being paid (or even imputed for tax purposes), or of the Loan’s being secured. It also appears to have been a term loan, although the term was fixed only in reference to the Taxpayer’s period of employment, and not as a set number of years.  Additionally, the Loan does not seem to have been serviced prior to the IRS audit.


Against these facts, the intention and subsequent actions of the parties, as well as their credibility, was all-important. Without such factors, the Court could easily have found that there was COD income in 2007. Indeed, but for the fact that the 1998 tax year was long closed, the IRS would have argued and the Court would, I believe, have treated the Loan as compensation to the Taxpayer.

I wouldn’t want to rely upon these factors, alone. Give me something that is objectively determinable and contemporaneous with the transaction at issue, something that is consistent with what the transaction purports to be. If it’s supposed to be a loan, treat it like a loan.