Archive for March 29th, 2011

While the Internal Revenue Code allows a taxpayer to deduct a loan that has become worthless, it differentiates between “nonbusiness” and “business” debts. What’s the significance?

While business bad debts are afforded ordinary loss treatment, nonbusiness bad debts are deductible only as short-term capital losses. In an economy where capital gains are difficult to come by, this disparity provides tremendous motivation to classify a worthless debt as a business debt, thereby avoiding a potentially unusable short-term capital loss.

Unfortunately, the relevant history has been largely unfriendly to individuals seeking ordinary loss treatment; it is rare to find a loan made by an individual classified as a “business” bad debt by the IRS or the courts.

Today, however, the Tax Court provided just such a victory for the taxpayer in Dagres v. Commissioner, 136 T.C. 12 (2011). 

In Dagres,  the taxpayer was the Manager Member of several LLCs. Each LLC was a general partner in a venture capital fund, which invested in start-up technology companies. The LLCs managed the investments of each VC fund, and in addition to the 1% capital interest each LLC held in the VC fund, they were also granted a 20% profits interest in exchange for their management services.

In addition, Dagres was also an employee of a related corporation that provided services on behalf of the LLCs. While Dagres earned a sizable salary as an employee, the income from his share of the 20% profits interest he received for manging the LLCs was nearly 20 times larger.

During his career, Dagres fostered numerous business relationships that helped him identify potential investments. One of his primary referral sources suffered greatly when the technology bubble burst in the early 2000’s, and he came to Dagres for help. Dagres obliged, loaning the business associate $5 million. As consideration for the note, the debtor agreed to continue referring any potential investment opportunities exclusively to Dagres.

When the loan went bad, Dagres deducted the worthless piece as a business bad debt. The court agreed, acknowledging that even though Dagres was partially an investor (as a member in LLCs owning a 1% capital interest in the VC funds), and partially an employee, he made the loan neither in his capacity as an investor nor an employee, but rather in order to protect the main source of his income: the 20% profits interest he received for managing the investments of the VC fund.

The profits interest, according to the court, was not indicative of an investment, but rather as compensation granted to the LLCs for managing the VC funds’ investments, a trade or business that was attributed to Dagres as the managing member.

It should be interesting to see if the IRS appeals, but in the interim, Dagres provides a rare example of an individual taxpayer not engaged in the business of making loans being granted ordinary loss treatment because the dominant motivation for the loan was to secure his income from a related trade or business.

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