Wednesday, March 30, 2011

Venture Capitalist's Bad Debt Deduction For Loan To Business Associate Upheld

Dagres, (2011) 136 TC No. 12

The Tax Court has determined that a venture capitalist was entitled to claim a Code Sec. 166(a) business bad debt deduction for the amount that he forgave on a loan made to a business acquaintance to ensure that the borrower would first inform him of any promising investment opportunities. In so holding, the Court determined that the taxpayer was in the trade or business of managing venture capital funds and that his bad debt loss was proximately related to that trade or business, and rejected IRS's argument that the debt was personal in nature.

Background. Business bad debts are deductible as ordinary deductions. They are deductible if partially worthless as well as when wholly worthless. (Code Sec. 166(a)) A corporation's debts are always business debts. (Code Sec. 166(d))

Nonbusiness bad debts are deducted only as short-term capital losses, and only when wholly worthless. (Code Sec. 166(d)(1))

A nonbusiness debt is defined as any debt other than:

... a debt created or acquired in connection with the trade or business of the taxpayer; (Code Sec. 166(d)(2)(A), Reg. §1.166-5(b)(1)) or

... a debt the loss from the worthlessness of which is incurred in the taxpayer's trade or business. (Code Sec. 166(d)(2)(B), Reg. §1.166-5(b)(2))

Facts. From 2000 to 2003, Todd Dagres engaged in venture capital activities with a group of associated entities generally referred to as Battery Ventures. Battery Ventures consisted of: venture capital funds, each of which was organized as a limited partnership (LP); “General Partner LLCs” that served as the general partners of the Venture Fund LPs and provided management and investment services, each of which had a 1% investment interest as well as a 20% “carried interest” in the profits of its respective Venture Fund LP; and management companies that provided services to assist the operation of the Venture Fund LPs and their General Partner LLCs. BMC was a management company of which Dagres was a salaried employee and shareholder, and he also served as a Member-Manager of a General Partner LLC. Dagres and other Battery Ventures generally provided management and investment services for the Venture Fund LPs pursuant to a service agreement.

BMC assumed all the normal operating expenses of the General Partner LLCs, including compensating the officers and employees of BMC and paying the salaries of the Member Managers of the General Partner LLCs. Each Venture Fund LP paid annual service fees of 2 to 2.5% of the partners' total committed capital in the fund. The Venture Fund LPs paid these service fees to their respective General Partner LLCs, which in turn agreed to reimburse BMC for organizational expenses and pay a service fee to BMC. These service fees were used to pay BMC's salaries to its employees. However, the most significant financial incentive to BMC's employees, including Dagres, was the 20% carried interest in the Venture Fund LPs' profits.

Dagres earned substantial income while working for Battery Ventures: his salary, as a BMC employee; his share of service fees, as a BMC stockholder; and his share of carried interest as a Member-Manager of the General Partner LLCs. From’99 to 2003, he earned over $10 million in salary and over $43 million in capital gains attributable to carried interest. In 2000, the year of the disputed loan, he had over $40 million in capital gains.

Dagres had met William Schrader back in’94 when he served as the lead investment banker for the initial public offering of Schrader's company. Dagres viewed Schrader as an “early pioneer” of the commercial internet and found him to be an influential and useful contact and an important part of Dagres' professional network. Among other things, Schrader was an important source of leads on promising companies for Dagres to consider as potential investments for the venture funds.

Schrader was hard hit when the Internet stock bubble burst in 2000. After exhausting his personal funds and the money he could obtain from family and friends, he asked Dagres to lend him $5 million. Dagres made the loan on Nov. 7, 2000. It was evidenced by a demand note and included 8% interest. It was understood that in return for the loan, whenever Schrader learned about any promising new companies, Dagres would be the first he would tell about any opportunities.

Schrader repaid $800,000 in 2002. Then, to avoid forcing Schrader to file for bankruptcy, Dagres forgave the original loan and got a non-demand promissory note for $4 million with 1.84% interest. Schrader made six payments of $5,000 in 2003, then notified Dagres that he would not be able to make any further monthly payments on the note. They executed a settlement in which Dagres accepted $364,782 in securities from Schrader and forgave the balance of the $4 million loan. During the negotiations, Schrader again reinforced his commitment to giving any investment leads to Dagres.

Dagres claimed business bad debt losses on his Forms 1040 for 2002 and 2003. He attached a Schedule C, Profit or Loss From Business, to each year's returns that reported a sole proprietorship for which the principal business or profession in line A was “Loan and Business Promotions.” He didn't report any business income in 2003 despite receiving payments and securities from Schrader, and claimed a $3,635,218 loss (i.e., the difference between the forgiven debt and the value of the securities).

IRS disallowed the bad debt deduction as a personal loan not connected to Dagres' trade or business. Alternatively, IRS argued that the loan was incurred in Dagres' capacity as an employee; therefore, any loss arising from its worthlessness is deductible as an employee business expense subject to Code Sec. 67’s 2% floor.

Tax Court's analysis. The Tax Court determined that Dagres was in the trade or business of venture capital management, and his dominant motivation for lending $5 million to Schrader was to gain preferential access to companies and deals in order to use that information in his venture capital activities. Thus, the loan was made in connection with his trade or business and was deductible as a business bad debt loss in 2003.

The Court first found that, although an individual's investment and management of his money don't amount to a trade or business, an activity with an investment component can still qualify as a business. The Court then stated that, in cases such as this one where there are significant business promotion activities in addition to investing, one key way to distinguish between mere investment and the conduct of a trade or business is the presence of compensation beyond a return on investment, the existence of which tends to show that the taxpayer's activities rise above that of a passive investor.

The Tax Court then analyzed Dagres' dominant motive in making the loan, noting that a taxpayer can be in multiple lines of business within a year and that the tax consequences of the loan depend on whether it was made in respect to his employment, his investment, or his trade and business. Looking to the overall activities of Battery Ventures, the Court concluded that the General Partner LLCs were in the trade or business of managing venture capital funds, a service for which the fund manager (i.e., Dagres) received both service fees and a profits interest. It further found that Dagres was engaged in this trade or business where he provided management services continuously, regularly, and with the intent of making a profit. In so holding, the Tax Court stated that the General Partner LLCs were more like brokers, which buy and sell securities as inventory for commissions, than mere investment vehicles.

IRS's argument that the character of the General Partner LLCs' activities was governed by their 1% investments in their Venture Fund LPs was belied by the overall financial structure of the deal. Notably, the fact that the General Partner LLCs stood to make 20% of their Venture Fund LPs' profits showed that the “overwhelmingly predominant activity” of the General Partner LLCs was the management of their funds, the compensation for which was the 20% interest. The Court also found that a 1% interest wasn't de minimis, given that such an interest yielded millions of dollars during the years at issue. IRS's other argument that the capital gain character of the funds' income showed that it was derived from an investment activity rather than business was also rejected.

The Court then turned to the issue of to which activity—Dagres' employment, his trade or business, or his investment in the funds—the loan was proximately related. Considering that Dagres' 20% carried interest was by far his most significant source of revenue, the Court determined that the loan was made in regard to such interest (i.e., his venture capital business). And, although Dagres failed to clearly indicate this on his Schedule C, the Court found that wasn't dispositive, especially where “business promotions” was sufficiently broad to cover the management of venture capital funds.

References: For bad debt deductions, see FTC 2d/FIN ¶M-2401; FTC 2d/FIN ¶M-2901; United States Tax Reporter ¶1664.300; TaxDesk ¶320,501; TG ¶17126.

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