In perhaps the most senseless legal proceeding since my brother Mike’s false-advertising claim against the film “The Neverending Story,” an Alabama man attempted to convince the Tax Court that the repayment of a $1,000,000 loan should give rise to a tax deduction.
Sam Johnson (Johnson) and his father owned Johnson & Associates Mortgage Co, Inc., a full-service mortgage company. To stay afloat during its formative years, the company entered into a $1,000,000 line of credit with a local bank. In addition to the corporation, Johnson and his father were also listed as borrowers on the note in their individual capacities.
In 2003, half of the line of credit was repaid using life insurance proceeds paid upon the death of Johnson’s father. The repaid balance was promptly replaced with a new $500,000 note, which again was entered into by both the corporation and Johnson in his individual capacity.
This replacement note was subsequently repaid from Johnson’s personal account in 2004. On his 2003 individual tax return, Johnson claimed a $1,000,000 bad debt deduction related to his payments on the line of credit.[i]
Johnson argued that he was permitted the deduction because he had personally guaranteed the corporate liabilities in that amount. Presumably, Johnson believed that because he paid the notes in his individual capacity, he was entitled to repayment from the corporation, and the failure of the corporation to “make him whole” entitled him to a bad debt deduction pursuant to I.R.C. § 166.
Needless to say, the Tax Court disagreed, holding that because Johnson was listed as a separate borrower on the corporate notes, he did not make payment as a guarantor, but rather as a primary obligor. Citing prior case history — as well as common sense — the court held that Johnson’s repayment of a loan on which he was primarily responsible did not give rise to a tax deduction.[ii]
Of course, the most notable aspect of this case is that it ever managed to find its way onto the court’s docket to begin with. With so many legitimate tax issues of first impression yet to find their way into judicial precedent, it’s fascinating that such a well-established and fundamental tax concept was actually tried in front of the Tax Court. It would appear Judge Dean felt the same sense of frustration, as he was quick to slap Johnson with an accuracy related penalty.
[i] Good luck working through the math here, as only $500,000 of the debt was repaid in 2003 by Johnson personally. The other $500,000 was paid by his father’s life-insurance company upon his death in 2003. Presumably, Johnson was the beneficiary on the policy so he felt he “paid” this portion of the note.
[ii] See Brenner v. Commissioner, 62 T.C. 878 (1974).