Psychic Never Saw it Coming: IRS Recharacterizes Loan as Income
On July 25, 2019, in Dufresne v. Commissioner,the Tax Court held that purported intrafamily loans between a son and his mother failed to withstand heightened scrutiny to qualify as bona fide loans. The decision emphasizes the need for careful record-keeping and convincing substantiating evidence. Without such documentation, the government is poised to look through purported loans and recharacterize them as income.
Taxpayer’s mother was a well-known psychic. During tax years 2010-2014, Taxpayer was a full time psychic counselor in his mother’s business, Corporation (an S corporation). Taxpayer charged clients $200 for a 30-minute reading.
Taxpayer’s mother was a majority shareholder in Corporation, until she died in 2013. She was ill for several years before her death. For tax years 2012 and 2013, Taxpayer’s Schedules K-1 showed that he owned .01% interest in Corporation.
Taxpayer lacked access to Corporation’s books and records. After his mother died, he became sole heir of her estate and the Corporation. In 2015, the Corporation dissolved.
From 2010-2014, Taxpayer reported wages from Corporation as follows:
Taxpayer had much higher income from 2004-2010—approximately $14 million.
Significantly, Taxpayer had unreported taxable cash deposits from tax years 2010-2013. These deposits totally $1,505,546. Petitioner claims that the deposits were repayments made by his mother for loans of around $1,490,388. These purported loans were payments for past due Federal taxes and the purchase of real estate properties. Taxpayer’s mother was in debt when she died.
From 1985 to 2007, Taxpayer purchase five real estate properties. Taxpayer provided a letter, signed by his mother, dated January 1, 2008, indicating that she owed Taxpayer over $1.1 million dollars for the purchases.
During the years at issue, Taxpayer held two of the properties in his name. From 2010-2013, he held two other properties in his name, before selling them in 2013. One of the properties, a timeshare, was held in Taxpayer’s name throughout the years at issue. Additionally, Taxpayer co-owned two condominiums with his mother.
Although Taxpayer was unaware tax liens against his mother and the amount of her delinquent Federal tax liability, Taxpayer claimed that he gave his mother a loan to pay a Federal tax liability. Taxpayer provided a letter from February 2010, wherein his mother acknowledged that she owed her son $307, 718 for delinquent taxes. His mother signed the letter.
No formal loan documents were created for either the property purchases or the delinquent taxes, and neither letter detailed how or when repayment would occur, a rate of interest, or collateral.
In 2014, the IRS examined Taxpayer’s returns and determined that Taxpayer omitted significant cash deposits as taxable income on his returns for tax years 2010-2013. Specifically, the IRS determined the following amounts:
In 2017, the IRS issued a notice of deficiency determining that the cash deposits were taxable income and finding substantial understatement penalties applicable under Internal Revenue Code (IRC) §6662. Taxpayer, of course, argued that the cash deposits were repayment of loans and, thus, not taxable income.
The court considered that per IRC §61(a), income is defined “as all income from whatever source derived.” Gross income includes any funds that the taxpayer receives lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay.” The court clarified that loans are not included.However, intrafamily loans are subjected to heightened scrutiny, noted the court.
According to the court, a bona fide loan requires an “actual, good-faith intent to establish a debtor-creditor relationship at the time the funds were advanced.”The court explained that such intent exists where the debtor intends to repay and the creditor intends to enforce repayment.The court then considered the following factors to evaluate whether Taxpayer’s cash deposits were loan repayments:
- the ability of the borrower to repay;
- the existence or nonexistence of a debt instrument;
- security, interest, a fixed repayment date, and a repayment schedule;
- how the parties’ records and conduct reflect the transaction;
- whether the borrower has made repayments;
- whether the lender had demanded repayment;
- the likelihood that the loans were disguised compensation for service, and
- the testimony of the purported borrower and lender.
After analyzing the factors listed above, the court concluded that the purported loans failed to qualify as bona fide loans. First, noting Taxpayer’s mother’s poor credit after her bankruptcy filing, the court found no evidence that Ms. Browne had the actual ability to repay Taxpayer.
Second, the court considered it significant that no contemporaneous debt instruments were drafted for the loans—rather, Taxpayer “produced two letters purportedly signed by Ms. Browne attesting to the purported loans in 2008 and 2010, years after the first purported borrowing for a real estate property.”
As for the third and fourth factors, the court found (1) the letters lacking in that they failed to provide interest rates, fixed repayment schedules, or security, and (2) the overall evidence lacking to corroborate Taxpayer’s record of payments to him, such as cancelled checks.
In light of the fifth and sixth factors, the court determined that Taxpayer lacked sufficient evidence to support his claim that his mother made unscheduled payments to him per his requests.
Next, the court found it significant that Taxpayer’s income decrease during the years at issue, and that accounting for the cash deposits, combined with his Corporate salary, reflected a salary more in line with the prior years’ salaries.
Finally, the court considered that there was no evidence to support Taxpayer’s claim that he purchased properties for his mother with the understanding that she would repay him for those purchases. The court noted that Taxpayer reported all income and tax benefits from those properties on his returns.
Emphasizing the lack of records and substantiating evidence, the court concluded that the purported intrafamily loans failed to withstand heightened scrutiny to qualify as bona fide loans. The court found that the cash deposits should have been included in Taxpayer’s taxable income in tax years 2010-2013. Furthermore, the court determined that Taxpayer was liable for the IRS §6662 accuracy-related penalties.
Again, particularly in the context of intrafamily loans, this decision highlights the need for diligent record-keeping and convincing substantiating evidence. Otherwise, the government is likely to look through the transactions and recharacterize them as income.
If you have questions or concerns related to intrafamily loans and tax consequences, call Frost Law today at 202-505-6216.
T.C. Memo 2019-93 (July 25, 2019). CitingCommissioner v. Tufts, 461 U.S. 300 , 307 , 103 S. Ct. 1826 , 75 L. Ed. 2d 863 (1983). CitingEstate of Van Anda v. Commissioner, 12 T.C. 1158 , 1162 (1949),aff’d per curiam, 192 F.2d 391 (2d Cir. 1951). Citing Beaver v. Commissioner, 55 T.C. 85, 91 (1970). CitingWelch v. Commissioner, 204 F.3d at 1230, andKaider v. Commissioner, T.C. Memo. 2011-174.