Friday, October 28, 2016

Give This Taxpayer An "A" For Creativity; An "F" In Application of Tax Law

William Delaney, EA
Westwood, MA
Dear Readers---you can’t make up this stuff!  Here are the facts in Hatcher v. Comm., T.C. Memo 2016-188 (10/6/2016).

Taxpayer Mary B. Hatcher was employed for ten years by Blockbuster Corp., including three years as Senior Vice President and Treasurer.  Her responsibilities included tax matters.  She possessed an undergraduate business degree and an MBA in corporate finance.  After her employment ended, in 2010, she continued with Blockbuster as a 1099-MISC consultant.

While still single (she married in 2010), she made a series of loans to her boyfriend, Brad Carpenter.  She advanced $75,000 in March 2004, and obtained a promissory note to be repaid “based on mutually agreed company performance, beginning 1 year following distribution or licensing agreement” of a comic strip which Carpenter hoped to develop and syndicate.  In April of the same year, she advanced $50,000 which Carpenter used to purchase a Hummer vehicle, apparently with Hatcher’s approval.  Hatcher continued to advance funds, and by October of 2005 (when they had stopped dating) the total was $430,500.

The 2004 promissory note was superseded by one issued June 1, 2006, which stated that the purpose of the loans was “to fund Carpenter’s personal expenses and the development of his comic strip.”  The note was due on December 31, 2007.  Carpenter did not pay the note.  In February 2008 and April 2010 the past-due note was amended.  The second amendment required monthly installment payments of $1,000 (no mention of interest although the past-due note carried a 5% rate of interest).  Payments totaling $7,000 were made between March and October 2010; then, the payments stopped.  No interest was attributed to the repayments.

Mary believed that no further payments would be made, especially since Carpenter had e-mailed to her on December 17, 2010 that “I have no money.”  Hatcher sent to Carpenter a formal notice of default and, on February 15, 2012 she obtained a court awarded judgment for damages of $573,175 (principal - $430,500; interest - $142,675) and attorney fees of $50,000.

In an effort to collect, Hatcher, via discovery, alleged that he was receiving $7,500 per month of disability income plus unexplained bank deposits.  This occurred in 2012, so the Court noted that “As of December 31, 2010, the Carpenter note had not become completely worthless.

So far, a not uncommon fact pattern.  Love blinds one to the other persons faults, and may cause you to do things which you would normally not do, such as lend large sums of money while failing to check on the background and credit worthiness of the borrower.  The Court made note of this, and of Hatcher’s extensive financial background, when arriving at its determination.

It appears that Hatcher thought about a bad debt deduction on her 2010 personal income tax return and may have concluded that this defaulted obligation should not be classified as a personal bad debt (with the limitation on how much could be deducted each year); she wanted a business bad debt deduction which would wipe out her jointly filed 2010 income plus create an NOL which would carryback to 2008 (a year in which she had significant income).  Ah, so how to tax plan for the desired result, thought this business major with an MBA!  I’ve got it…

Hatcher formed an LLC, MBH Partners LLC (apparently a single member LLC because it filed a Schedule C) and, almost immediately, contributed the Carpenter note to the LLC.  At the end of 2010, the LLC held the note and nothing else.  It had not engaged in lending or other trade or business activities; it had no customers, although it was formed to provide advisory and consulting services.

Now it gets better (giving rise to my “F” for tax law).  Hatcher prepared a joint 1040 for 2010.  Two Schedules C were filed.  The first reported Hatcher’s 1099-MISC income from Blockbuster.  The second reported for the LLC---no income; a bad debt deduction of $600,847 (principal - $430,500; interest - $170,347).  Note that an additional $27.672 had accrued in interest since the judgment date in 2012.  This bad debt deduction offset the couple’s joint income and also created an NOL to carryback to 2008, where it resulted in a refund claim of $105,353!

There are a few problems with this, as the Court noted.  First, the Hatchers were cash basis taxpayers.  No interest income from this note had ever been reported on a federal income tax return.  That’s understandable, since no interest was ever paid.  Therefore, Hatcher was not allowed a bad debt deduction (of any kind) for income which had not been reported and taxed.  (“F” for tax law).  Score one for the IRS.

Next, to the issue of a business bad debt.  The Court struggled to find any business connection to the note and the LLC, especially since the LLC had not even carried on any tradeor business.  “Mary’s (i.e. Hatcher) principal purpose for contributing the Carpenter note to MGH (the LLC) was to enhance the appearance that the note was business-related” noted the Court.  The Judge was not buying the business bad debt.

“Although petitioners assert that the Carpenter loan was a business debt, they have not identified any trade or business with which it could be associated.  Mary was not engaged in the trade or business of lending money…”  “Nor was any loss on the Carpenter note ‘incurred in the taxpayer’s trade or business,’ namely…as a Blockbuster employee.”  “The Carpenter note clearly was not ‘acquired…in connection with’ any trade or business carried on by MGH.”

Finally, as to when this became a personal bad debt (i.e. the year in which a limited deduction may be taken).  “On the record before us, we conclude that the Carpenter note was not wholly worthless as of December 31, 2010.”   “…petitioner’s subsequent actions show that they had not abandoned reasonable hope of recovery” (in 2010).
“In February 2011 petitioners commenced litigation against Mr. Carpenter to enforce repayment…they secured a $573,175 judgment the next year.” (in 2012)  “…it is implausible that they would have kept throwing good money after bad if they genuinely believed the Carpenter note had become wholly worthless two years previously.”  During that two year period the Hatchers apparently had incurred $50,000 in attorney fees, which were a separate part of the uncollected judgment.

The Court imposed an accuracy related penalty [Sec. 6662(a)] of $21,147 for the 2008 carryback year and a $20,185 accuracy related penalty for the 2010 year. Plus, they were assessed significant income tax for both years.  The loss year was disallowed; the net operating loss carryback to 2008 was disallowed.

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