Editor's Note: With this column, Robert Fitzgerald ends his tenure as author of "Taxes in Your Practice." The Editorial Board of the Journal of The Missouri Bar, along with the Journal's staff, wishes to gratefully acknowledge Mr. Fitzgerald's years of service to the Journal, and thank him for his many contributions to the continued competence of members of The Missouri Bar.
Careful structuring of loan documentation is essential when the loan goes into default since for an individual taxpayer only business bad debts are treated as deductions against ordinary income while a nonbusiness bad debt is treated as a short-term capital loss subject to all of the limitations of such a loss, including the $3,000 per year limitation. In a recent 10th Circuit case, the court determined that a loss suffered by an attorney under a repurchase agreement for money he had loaned to his client corporation was not a business bad debt deduction, but rather a short-term capital loss.
In Litchfield v. Commissioner, 97-2 USTC 89, 157 (10th Cir. 1997), the facts were never in dispute. Litchfield was a partner in a law firm which was owed more than $250,000 in legal fees from a client. The client agreed with Litchfield to pay $100,000 of fees to the law firm through funds held in escrow by the firm. Litchfield then agreed to loan the client an additional $100,000 if the $100,000 was used to pay the law firm directly for legal fees previously incurred and the client agreed to issue stock to Litchfield with a repurchase agreement for the taxpayer exercisable on a given date more than a year later. The balance of the law firms receivable to the client was written off.
As part of the purported loan transaction from Litchfield to the corporation, the client did not deliver a promissory note to Litchfield but issued shares of stock in the corporation with a requirement that the corporation repurchase the shares within 120 days of the issuance of the stock or pay 12% interest on the $100,000 on demand. The taxpayer assigned the repurchase right contract (but no interest in the unwritten note) to his bank as collateral for the money that he had borrowed to loan to his client.
But Litchfields best laid plan went awry. The repurchase date was extended a number of times over a number of years because the client did not have the funds to acquire the stock. Some nominal interest was paid directly by the client corporation to the attorneys bank and a partial payment was made to the attorney by the client. In late 1985, the client filed for bankruptcy protection and the remaining shares were deemed worthless. The attorney filed a creditors claim in the bankruptcy proceeding and received 6¢ on the dollar for the $100,000 investment and repurchase agreement.
In 1985, the taxpayer attorney claimed a business bad debt deduction of $100,000. The Tax Court determined that the transaction represented a nondeductible, short-term capital investment and loss, subject to the $3,000 per year limitation. Litchfield appealed.
On appeal, the 10th Circuit determined that the transaction was not a bona fide loss. The debtor-creditor relationship that is required under § 166 of the Internal Revenue Code was not met since neither the stock certificates issued to Litchfield nor the repurchase agreement of the client corporation actually represented a bona fide debt for purposes of § 166 of the Code. The tax treatment accorded business bad debts and nonbusiness bad debts significantly differs. Litchfield was not able to show that his dominant motivation in making the $100,000 payment (loan) was business-related in order to obtain the more favorable tax treatment of a business bad debt. In a letter submitted as evidence by the IRS, the taxpayer attorney stated that the price of the clients stock on the original put date (120 days after the transaction) was 75¢ per share but he wished to delay the put date becaus the market price of the stock was expected to rise to $1.25 per share.
Comment
In May of 1982 our youngest daughter, Tara, was born. In that same month, my first article in the Journal appeared. Over the last 16 years, I have had the pleasure and honor of writing a number of columns that have proved to be insightful and beneficial to a number of members of the bar; at least, this is what my friends and acquaintances have told me! It is amazing to me that 16 years have passed so quickly and that, based upon the demographics recently given to me by members of the bar, nearly 40% of the current readers of this column were not even admitted to the bar in 1982. I thank my wife Vicki, my children, Matt, Joan, Leslie and Tara for giving me the time and the opportunity to write this column. Many times over the years my children have commented on why on a Saturday or Sunday afternoon I dragged them to the office to write this column while they drew pictures for me. I told them that writing this column was important to me, served the members of the bar and kept me updated on numerous issues associated with my corporate practice. I did not tell them that I adored their drawings and have kept many of them in my drawers. As they got older and headed for college, they each reminded me of our weekend conversations as they doodled and as I wrote. More than one time however, each of them have chided me because of the "age" of my picture in the Journal; hopefully, I have gracefully aged over the years, but according to my children, Dad was never that young looking. Next month my partner, Scott Vincent, will write his first article. I wish him well. He will bring a new and fresh style to this column. To all of the members of the bar, may all roads always rise to meet you. To my original mentors, Phil Erbacher, Gene McGannon and Harlow King, thanks for your confidence in me. May God continue to hold Phil and Harlow in the palm of his hand.