In March, the Tax Court held that a venture capitalist was entitled to claim a Code Section 166(a) business bad debt deduction for an amount that the taxpayer had forgiven on a loan made to a business acquaintance. The IRS argued that the taxpayer incorrectly reported his loss as a business bad debt deduction when it should have been reported as a non-business bad debt. Since the loss would have been accounted for differently, the IRS argued that the taxpayer had a tax deficiency and subsequently an accuracy-related penalty. The Court ultimately held that the taxpayer engaged in the loan as part of trade or business endeavor of managing venture capital funds and that his bad debt loss was related to a trade or business.
Internal Revenue Code §166 provides the general rule as to when business and non-business bad debts are deductible. Business bad debts are deductible as ordinary deductions if they are partially worthless or wholly worthless. If the loss is a non-business bad debt, the loss is deductible only as a short-term capital loss.
The Code defines the non-business bad debt as a bad debt that is other than a debt incurred, created or acquired in connection with a trade or business of the taxpayer. A non-business bad debt is far less favorable than a business bad debt because non-business bad debt capital losses may be deducted only if it offsets capital gains limited to a maximum of $3,000.
Taxpayer, Todd Dagres, was an employee of BMC and a Member-Manager of the General Partner LLCs, both of which managed venture capital funds. Dagres loaned $5 million to a business acquaintance, Schrader, in return for the opportunity to be the first to invest in any new companies.
Prior to the loan, Schrader was experiencing financial difficulty and exhausted his personal funds and money from family and friends. Schrader repaid part of the loan in 2002, but was unable to continue. To avoid forcing Schrader to file for bankruptcy, Dagres forgave the original loan and obtained a non-demand promissory note for $4 million. Schrader made some more payments on the restructured debt for a while before he notified Dagres that he would no longer be able to make any further payments on the note. Dagres executed a settlement in which he would accept $364,782 in securities from Schrader and forgave the remaining balance of the $4 million.
On his Form 1040 for 2003, Dagres claimed a business bad debt loss. He did not claim any business income because he claimed a $3,635,218 loss which was equivalent to the difference between the $4 million loan less the $364,782 securities received from Schrader.
The IRS contends that the loan was for an investing activity which under the Code, is not considered a trade or business venture. The IRS argued that investors who invest their own funds in public companies or in privately held companies earn investment returns. Since they are investing they are not conducting a trade or business. Thus the loss from the loan would be considered a non-business bad debt loss that would have been subject to the $3,000 limitation.
Tax Court Analysis:
The Tax Court sided with the taxpayer. The Court held that Dagres was actively part of a trade or business and when he made the loan to Schrader. He was acting in a matter that would enable him to gain preferential access to companies and deals that would assist him in using that information in venture capital activities. The Tax Court held that the loan was related to venture capital management activities that were a part of his career thus the loan was made in connection with his trade or business and was deductible as a business bad debt loss.