Nephew moves in with Uncle – Nephew performs occasional services for Uncle — Uncle cuts Nephew $50,000 in checks with “loans” written on the memo line – Nephew treats the amounts as loans and does not reflect the $50,000 as income.
That’s where the IRS comes in, assessing a deficiency on Nephew, asserting that the payments reflected compensation for the services provided to Uncle.
In determining whether the payments represented loans or compensation, the Tax Court cited cases previously decided by the Ninth and Seventh Circuits to develop the following eight factors that required analysis:
(1) the ability of the borrower to repay;
(2) the existence or nonexistence of a debt instrument;
(3) security, interest, a fixed repayment date, and a repayment schedule;
(4) how the parties’ records and conduct reflect the transaction;
(5) whether the borrower has made repayments;
(6) whether the lender (Quinn) has demanded repayment;
(7) the likelihood that the loans were disguised compensation for services; and
(8) the testimony of the purported borrower and lender.
In holding that the payments were nontaxable loans, the Tax Court held that factors #1, 2, 3, 4, 7, and 8 were in Nephew’s favor, with factors #5 and 6 neutral.
The most noteworthy aspect of the ruling came in the court’s decision that Nephew had the ability to repay the amounts transferred (factor #1), as Nephew had few assets, a $200,000 mortgage, and an outstanding previous debt to Uncle, with no reliable source for future earnings. The court stated:
However, Nephew and Uncle reasonably expected that some of Uncle’s startup enterprises would become profitable and enable Nephew to repay his loans within a five-year period. Uncle had told Nephew: “We’re going to get something going down here and you’re going to have all the money in the world and you can pay me back.”
For some reasons unbeknownst to me, the Tax Court actually lent credence to this seemingly inane bit of rah-rah-go-team blind optimism. I would have thought the first factor would be measured purely on the borrower’s actual ability to repay the loan, rather than his potential ability to repay the loan. But then I’d be wrong.
Cite: Kaider v. Commissioner, T.C. Memo 2011-174