Ask The California Employment Tax And Payroll Tax Attorney – Establishing Entitlement To Claim A Business Bad Debt Deduction – The Patel Case

By Robert S. Schriebman

2023

Introduction

The proper tax treatment and deduction for bad debts can be complex. There are two types of bad debt loss deductions – business and non-business. Sometimes the line between the two can get blurry and confusing as we will see in the case of B. Patel and S. Patel. The Patel case was decided by the Office of Tax Appeals (OTA) and issued in November 2023. In this article, I will discuss the Patel case and explain the differences between income tax deductions relating to both types of bad debt losses. A true business bad debt loss is totally deductible against ordinary income providing the taxpayer can prove when the loss truly occurred. Non-business debt losses cannot be totally deductible against ordinary income because they are treated as short-term capital losses and, for the most part, can only be netted against short-term capital gains. If there are no offsetting short-term capital gains, the non-business bad debt loss is limited to only $3,000 per year. With that said, let’s look at the OTA decision in the Patel case.

The Patel Case

In the Matter of the Appeal of B. Patel and S. Patel, 2023-OTA-336

Patel was in the business of real estate development and hotel ownership and management. Patel invested in Signet Solar, Inc. Signet’s purpose was to raise money for thin silicon film photovoltaic modules – for simplicity let’s call them solar panels. Patel invested $1 million and received shares of stock, but he was not involved in daily business operations. Patel was merely a stockholder. In addition to being a stockholder, in 2009, he personally guaranteed a Bank of America line of credit for $16.5 million. Signet used up the entire line of credit.

In 2010, Signet ceased operations and commenced insolvency proceedings. Because of Patel’s personal guarantee, he remitted over $7 million towards Signet outstanding debt to Bank of America. In 2012, Signet filed for bankruptcy. Patel became a creditor in the bankruptcy case.

In 2013, Patel filed his FTB personal income tax return reporting close to an $8 million dollar business bad debt loss. Patel deducted the entire amount on his FTB return as a business bad debt loss. The FTB audited Patel and disallowed the deduction as a business loss. The FTB held that the loss was deductible only as a non-business bad debt. Such debts are deemed sales or exchanges of capital assets held for one year or less and result in a short-term capital loss. If there are no offsetting short-term capital gains, the loss is limited to only $3,000/per year IRC §§ 166(a) and 1241, as well as RTC §17201(a).

OTA Ruling

The OTA ruled in favor of the FTB’s decision. FTB decisions are generally presumed to be correct.  The taxpayer has the burden of proving otherwise. (Appeal of Vardell, 2020-OTA-190P).   The OTA concluded that Patel’s loss was a non-business bad debt governed by IRC § 166(a-d) and RTC § 17201.  A non-business bad debt is treated as a short-term capital loss if the bad debt becomes entirely worthless during the year the loss was claimed.   This type of loss must be netted against short-term capital gains, but if there are no such gains, the loss is limited to only $3,000/per year.

A business bad debt loss, on the other hand, is deductible against ordinary income.  However, it is not that simple.  Even if the taxpayer was engaged in a trade or business, the worthless debt must be “proximately related” to the conduct of the specific trade or business.  The dominant motive cannot be solely for investment purposes. (Whipple v. Commissioner (1963) 373 US 193, 202))

What was Patel’s dominant motive in making a personal guarantee of the Bank of America line of credit? During the audit by the FTB, Patel’s representative told the FTB auditor that Patel’s motive was investment related.  Patel wanted to protect his shares of stock and hoped that Signet’s success would increase the value of Patel’s stock.

The OTA concluded that Patel was in the real estate development business and also in the business of owning and operating a hotel.  Clearly, Patel was not in the solar panel business and was not involved in the day-to-day fiscal affairs of Signet.

Therefore, the OTA agreed with the FTB that Patel’s loss was a non-business bad debt loss.  Patel will have to live many years to recapture his multi-million loss at $3,000/per year!

Conclusion

There is another important lesson to be learned from this case. Taxpayers’ representatives need to learn when to keep their mouths shut. What sank Patel was his representative’s admission during the audit process that Patel’s motivation was solely investment related. The motto of the day should be “when in doubt, say nothing, for silence is in your friend.”

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Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD, and he is not employed by the EDD or any other agency of the State of California.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

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