It is not uncommon for small businesses to rely on friends and family for loans to assist the business in meeting operating expenses. This is even more true given the on-going pandemic. Small businesses are scrambling to make sure they can meeting their operating expenses. Unfortunately, many of those small business owners are so focused on their business that they fail to properly execute the paperwork relating to those loans.
In the recent decision in Moore v. Comm’r of Revenue, T.C. Memo. 2019-100, the United States Tax Court evaluated the elements of a good-faith loan that are necessary for a taxpayer to deduct the interest relating to that loan.
Todd Moore was a tax preparer who founded and operated Moore Investment Group (MIG), a tax preparation business. MIG was a single-member LLC and, therefore, a disregarded entity for federal income tax purposes. In 2012, Moore solicited loans from several business associates to assist him in expanding his tax preparation business. Todd prepared “promissory notes” detailing a “loan period” and “return on investment” percentage. Only one of the promissory notes was signed by the lending party. On Todd’s 2013 income tax return, Todd deducted the payments towards these notes as an “investment expense.”
To be deductible interest, pursuant to Internal Revenue Code Section 163(a), the related payments must be for a bona-fide loan where both parties had an actual, good-faith intent to establish a creditor-debtor relationship when the funds were remitted. The Moore Court correctly noted that, when determining whether a creditor-debtor relationship exists, the Court can evaluate the presence of the following factors:
- A debt instrument.
- A statement that interest will be charge.
- A fixed schedule for repayment.
- Collateral to secure payment.
- Actual repayment.
- Reasonable prospects of advancement and repayment of the funds.
- The parties conducting themselves as if the transaction were a loan.
Ultimately, the Moore Court determined that Moore failed to establish that the transactions he entered into in 2012 were bona fide loans. The Court noted that only one of the “promissory notes” was signed, there was a reference to a “return on investment,” there was no reference to an interest rate, and the “promissory note” failed to detail any type of security interest for the amounts advanced.
The Moore decision is just another reminder that paperwork matters and that it is so important for small business owners to prepare and execute valid promissory notes when soliciting loans from family and friends. It does not have to be complex, but, it does have to satisfy the tenants of a bona fide loan detailed above.