Company Owed $92 Million in Taxes After Making Bad Loans to Founder’s Son and Attempting to Write them Off

A business made loans to the son of its founder and never required the loans to be repaid. The business later attempted to write off the loans as bad debts or as ordinary and necessary business expenses. The IRS pursued the business, seeking $92 million in back taxes. The company petitioned the tax court, but after a trial the court upheld the agency’s determination, finding that the debts could not be written off because the company and the founder’s son lacked a bonafide creditor-debtor relationship. The company appealed and the appellate panel affirmed, finding that the company routinely deferred payment or renewed promissory notes without any receipt of payments and that it did not expect to be repaid unless various other events occurred. The panel determined that the company had not shown that it presented sufficient existence of a bonafide relationship to the tax court and it, therefore, affirmed the decision of the lower court.

Ron Van Den Heuvel’s father founded VHC in 1985 to provide services to the paper manufacturing industry. Ron and his four brothers all worked for VHC or its subsidiaries in some capacity, but Ron found particular success. Ron started at two of VHC’s subsidiaries, directed a number of its other companies, and launched his own companies separate from VHC. Between 1997 and 2013, VHC advanced $111 million to Ron and his companies. The payments fulfilled several purposes, including paying debts owed by both Ron and his companies. Ron and his companies would come to owe VHC $132 million, with interest, by 2013, but would only repay $39 million.

In 2004, VHC began writing off its payments to Ron as “bad debts,” ultimately writing off $95 million by 2013. After an audit, the IRS issued a notice of deficiency to VHC rejecting $92 million of the write-offs. VHC petitioned the tax court, and after a ten-day bench trial, the tax court upheld the agency’s deficiency finding. The court determined that Ron’s debts could not be written off because VHC and Ron lacked a bonafide debtor-creditor relationship. VHC then appealed.

The appellate panel began by citing Cole v. Comm’r, stating that when the Commissioner of Internal Revenue makes a deficiency assessment, the court places the burden on the taxpayer to prove that the assessment was erroneous. The panel stated that the burden is shifted to the Commissioner only if the taxpayer can demonstrate that a deficiency assessment lacks a rational foundation or is arbitrary and excessive.

The panel then stated that a bonafide debt is one that arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money and that the regulations specifically exclude any gift or contribution to capital as qualifying as a bonafide debt.

The panel then determined that the tax court reached the correct conclusion under either standard for determining whether a debtor-creditor relationship existed between Ron and VHC. The panel noted that VHC routinely deferred payment or renewed promissory notes without any receipt of payments and that it did not expect to be repaid unless various other events occurred, such as Ron securing additional investments or projects. The panel determined that VHC had not shown that it presented sufficient evidence to the tax court or that the tax court made grave errors in its evaluation of the evidence. The panel concluded that VHC’s payments to Ron were not “bad debts” qualifying for a deduction.

Finally, the panel turned to VHC’s second argument, that it could deduct its payments to Ron as ordinary and necessary business expenses under I.R.C. § 162. The panel stated that VHC’s argument was based on the fact that one of its creditors threatened to terminate VHC’s line of credit if it did not guarantee the debts owed to the creditor by Ron. The panel rejected this argument. The panel stated that the tax court had identified that VHC’s records were riddled with inconsistencies, and that documentary evidence VHC provided either did not support or outright contradicted its spreadsheet purporting to list the deductible expenditures. The panel then stated that, even if VHC had substantiated its expenses, it agreed with the tax court that VHC’s payments to Ron did not qualify as ordinary and necessary business expenses. The panel, therefore, affirmed the decision of the tax court.

You can read the court’s full decision here.

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