In the matter of VHC, Inc. and Subsidiaries (“VHC”) v. Commissioner of Internal Revenue (“IRS”), the IRS identified more than $32 million of deficiencies in VHC’s federal income tax liabilities for the tax years 2004-2013 [1]. For the tax years at issue, VHC claimed deductions related to bad debts that it claimed were owed by various related parties [2]. It was VHC’s position that it was entitled to business bad debt deductions for the years at issue for advances made to a related individual and his businesses which became partially worthless during those years [3]. The IRS, however, claimed that VHC failed to establish that such advances were debt in substance.[4]

In its review in this dispute, the Tax Court analyzed whether the advances represented bona fide debt, considering 14 “objective factors…to determine the parties’ intent and whether a bona fide loan occurred…,” asserting that “no single factor is dispositive.”[5]

To this end, the court relied on the factor analysis identified in Dixie Dairies Corp. v. Commissioner.[6] While considering certain factors indicating the formal documentation of the advances, including the names given to the various promissory notes and documentation of fixed maturity dates, the court also evaluated factors indicative of the economic substance of the advances to ascertain the intent of the parties to these transactions. The factors relating to the economic substance of the transactions considered by the court include:

• Source of Payments: “A bona fide debt cannot exist…where the obligation to repay the debt is subject to a contingency that has not occurred.”[7] A bona fide debt is considered an obligation not conditioned on any future event. The court found that VHC’s expectation of repayment of the advances was contingent upon several future events, based in part on the related parties’ history of success.[8] Specifically, the court determined that repayment of the advances was conditioned on the potential of lucrative projects, including the sale of certain assets and realization of speculative future earnings.[9] The court stated that “[a] tax payer willing to condition repayment of an advance on the financial well-being of the receiving company does not act ‘as a creditor expecting to be repaid regardless of the company’s success or failure’”[10]
• Thin Capitalization: “Thin capitalization – a high ratio of debt to equity – may suggest that an advance is not a loan.”[11] If a company is too thinly capitalized, it may be unable to repay a loan, indicating that an advance is instead intended as equity. In 2002, VHC guaranteed various debts of the related parties; had it not, the court determined, the debtor would have gone into bankruptcy. Indeed, the related parties were insolvent as early as 1999, and the petitioner failed to produce any evidence that the related entities ever became profitable.[12] Despite the amounts owed by the debtor to other creditors, VHC continued advancing funds without reasonable prospects of repayment, disregarding clear signs that the related parties were distressed.[13]
• Use of Advances: “The use of advances to finance initial business operations when repayment of the advances is contingent on future events suggests the advances are not debt.”[14] Many of VHC’s advances to the related entities were provided as those entities were first being organized, indicating that funds may have been utilized to support operating expenses.[15] Funds advanced to the related parties were also used to pay overdue water bills and personal federal and state income taxes. The court concluded that “advancing funds ‘to meet operating expenses is akin to making a capital contribution…[and] does not support a conclusion that the advances were loans.’”[16]

Based upon its analysis of the various factors, including those highlighted above, the court determined that VHC’s advances to the related parties did not represent bona fide debt, and that VHC did not reasonably expect repayment of the advances.[17] Accordingly, the court concluded that VHC was not entitled to bad debt deductions for the advances made to the related parties.[18]

Relying on the 14 factors set forth in Dixie Dairies Corp., the court in VHC performed a sophisticated and informative analysis of the intent of the parties pertaining to certain advances made by the petitioner. The objective factors established in Dixie Dairies Corp., and other similar factor tests, not only assist in the inquiry into the intent of the parties by considering the formalities of such funding arrangements, but also provide insight into their economic substance. While no single factor is dispositive in the court’s inquiry into the parties’ intent,[19] the factors highlighted above provide unique insight into how the court views the economic indicia of debt, and why those features of the VHC advances disqualify the petitioner’s treatment of such as indebtedness.

1. VHC, Inc. and Subsidiaries v. Commissioner of Internal Revenue, T.C. Memo 2017-220, page 4.
2. Id. at 48
3. Id. at 51
4. Id.
5. Id. at 53
6. Id. at 54
7. Id. at 57
8. Id. at 58
9. Id. at 59 - 60
10. Id. at 59
11. Id. at 62
12. Id. at 63
13. Id.
14. Id. at 64
15. Id.
16. Id. at 65
17. Id. at 70-71
18. Id. at 71
19. Id. at 53