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By Peter C. Barton, JD, CPA and Roy C. Weatherwax, PhD, CPA, University of Wisconsin-Whitewater

In Bowman v. Commissioner, the Tax Court ruled that the $35,000 advanced by a father to his daughter of a risky business venture was a bona fide debt entitled to a bad debt deduction even though no note was executed between the parties.

IRC Sec. 166(d) allows a "nonbusiness" bad debt as a debt not created in connection with the lender's trade or business. Reg. Sec. 1.66-1(c) requires the debt to be "bona fide," which is a debt arising "from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money." The key issue in advances between relatives is whether there is a bona fide loan or a gift. Previous case law has established a presumption that transfers between family members are gifts and therefore not deductible.

In Bowman, Cathy Bowman, age 23, decided to open a new skating rink in Morristown, Tennessee, when the local rink burned down. Although involved in skating for many years, Cathy had no formal business education and limited business experience. She attended vocational school and eventually became a licensed practical nurse. Cathy's father, Loy, was the owner of a successful garbage-collection business. Cathy and Loy each asked different skating rink owners in nearby cities about operating a skating rink. Concluding that the prior Morristown skating rink had been profitable, Cathy leased a building for $750 per month, beginning in August 1985.

Believing that the business could be successful, Loy advanced Cathy $22,000 in September 1985, consisting of an $18,000 cashier's check and $4,000 personal check. He wrote "loan" on the personal check. There was no other written documentation for these advances. Loy expected Cathy to begin repayment in one to two years, but did not ask her to sign a note. These transactions followed Loy's approach in making other personal loans. Between 1985-88, Loy made several undocumented loans from $3,000-30,000 from other family members and friends. All but one of these loans were eventually partially or fully repaid.

Cathy opened the skating rink, Panther Springs, in November 1985. Loy advanced her an additional $14,890 between October 1985 and January 1986. The only evidence for these advances was her bank deposit slips and two of Loy's personal checks totalling $5,500. He also wrote "loan" on these checks. The remaining $9,390 was in cash.

Panther Springs never became profitable. Cathy's 1986 return reported gross receipts of $7,734 and a net loss of $9,564, with no other income. In mid-1987, Loy refused her request for additional advances. In August 1987, Panther Springs closed when the landlord took possession of the building for unpaid rent. In 1988, Cathy received a bankruptcy discharge. Loy claimed a nonbusiness bad debt deduction of $35,000 on his 1987 return. (Loy had actually advanced Cathy $36,890.) The IRS disallowed the deduction, claiming the advances were gifts, not loans.

The Tax Court pointed out that the gift presumption can be overcome if the taxpayer proves that "a real expectation of repayment existed and there was an intent to enforce collection of the indebtedness." The court ruled that a note is helpful but not required in proving that the transfer is a loan. Also, the court stated that the facts must be examined in light of "the manner in which transactions are handled in the normal and everyday course of doing business." The Tax Court then ruled that the advances were loans, not gifts, due to the following factors: Loy's and Cathy's credible testimony, Loy's other loans made in a similar manner that were mostly repaid, and the notation "loan" on Loy's personal checks.

Using the court's "real expectation of repayment" and "normal and everyday course of doing business" criteria, the facts of Bowman appear to provide only marginal support for the existence of a loan. Given Cathy's age, lack of capital, and lack of business experience, Panther Springs was an extremely risky venture.

The best approach to loans between relatives or friends is to execute a note providing for interest and a repayment schedule. (Bowman made no mention of interest.) However, for taxpayers with an undocumented bad debt and/or a bad debt arising from a risky personal loan, Bowman provides support for deductibility.

Source: Bowman v. Commissioner, T.C. Memo 1995-259 (June 13, 1995)

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