2590 Associates, LLC, 5615 Associates, LLC, as Successor in Interest to, 5615 Associates, LP, Tax Matters Partner v. Commissioner

T.C. Memo. 2019-3UNITED STATES TAX COURT
2590 ASSOCIATES, LLC, 5615 ASSOCIATES, LLC, AS SUCCESSOR IN
INTEREST TO, 5615 ASSOCIATES, LP, TAX MATTERS PARTNER,
Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 12924-16. Filed January 31, 2019.
Jaye A. Calhoun, Sean T. McLaughlin, and David P. Hamm, Jr., for
petitioner.
Emile L. Hebert III and Susan S. Canavello, for respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
GOEKE, Judge: Respondent issued a notice of final partnership
administrative adjustment (FPAA) to 2590 Associates, LLC (2590 Associates), for
2011 disallowing a worthless debt deduction of $2,926,692. The issue for
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[*2] consideration is whether 2590 Associates is entitled to deduct the worthless
debt.1 We hold it is entitled to the deduction.
FINDINGS OF FACT
When the petition was timely filed, 2590 Associates had its principal place
of business in Louisiana. 5615 Associates, LLC (5615 Associates), is the
successor in interest to 5615 Associates, LP, the tax matters partner of 2590
Associates.
Joseph Spinosa is a real estate developer who has been involved in the real
estate industry for several decades. Over that time he has developed apartment,
office, and retail buildings representing over 5,000 apartment units, 1.5 million
square feet of office space, and 600,000 square feet of retail space. He owns
multiple real estate ventures through numerous business entities and has
commingled funds among his different entities. His role in the real estate ventures
is to provide a vision of the development suitable for a site, assemble a team of
architects and engineers to convert the vision to reality, perform economic and
1
Unless otherwise indicated, all section references are to the Internal
Revenue Code (Code) in effect for the year at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All amounts are rounded to the
nearest dollar. The parties’ stipulation of facts with accompanying exhibits is
incorporated herein by this reference.
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[*3] market analyses of the development, and raise equity or debt to finance the
construction of the development.
I. Background of Perkins Rowe
Mr. Spinosa organized two companies, Perkins Rowe Associates, LLC
(Perkins Rowe I), and Perkins Rowe Associates II, LLC (Perkins Rowe II), to
acquire and develop two adjacent 20-acre parcels of real estate into a mixed-use
shopping center with 10 buildings of residential, retail, and office space. Perkins
Rowe I was owned 45% by Mr. Spinosa, 5% by the Spinosa Class Trust, a trust for
the benefit of Mr. Spinosa’s children, and 50% by members of the Schwegmann
family, the former owners of one of the 20-acre parcels. Perkins Rowe II was
owned 90% by Mr. Spinosa and 10% by the Spinosa Class Trust. Mr. Spinosa
was the manager of both entities. We refer to the two entities collectively as
Perkins Rowe and the two parcels as the Perkins Rowe property.
In early 2006 Perkins Rowe was in discussions with KeyBank National
Association (KeyBank) for a construction loan to finance the development of the
Perkins Rowe property. At that time sitework had begun. Before the loan’s
approval Perkins Rowe needed capital to continue the sitework. Mr. Spinosa
obtained a $2 million bridge loan from his acquaintance and business associate
Nick Saban (Saban loan). Mr. Spinosa had met Mr. Saban through Mr. Saban’s
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[*4] efforts as the head football coach at Louisiana State University (LSU) in
Baton Rouge, Louisiana, to improve the graduation rate of LSU athletes. The two
men often discussed real estate investments and had joint ownership of a number
of real estate ventures. At the time of the loan Mr. Saban was the head football
coach of the Miami Dolphins in the National Football League.
Perkins Rowe I and II jointly executed a promissory note dated April 11,
2006, to Mr. Saban of $2 million plus annual interest on the unpaid principal
balance at 16% with a maturity date of April 10, 2007 (2006 note). Mr. Saban
transferred $2 million to Perkins Rowe on April 12, 2006. The 2006 note was
unsecured. Under the terms of the note Perkins Rowe’s failure to pay the principal
and accrued interest within 10 days of its maturity date constituted a default, and
upon default, interest on the unpaid principal balance accrued at 18%. The note
also provided for an award of attorney’s fees to Mr. Saban in the event he engaged
an attorney in connection with collection of the loan. Mr. Saban did not have an
equity interest in Perkins Rowe, did not participate in its management, and did not
have any member voting rights.
II. The Construction Loan
On May 23, 2006, shortly after the execution of the 2006 note, KeyBank
obtained an appraisal of the Perkins Rowe property on a fee simple, as-is basis of
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[*5] approximately $34.4 million and a prospective market value of $240 million
for the developed, stabilized project upon its completion, estimated to occur on
May 1, 2008. At the time of the appraisal Perkins Rowe had preleased
approximately 70% of the retail space to major retailers, including a book store, a
grocery store, a pharmacy, a fitness center, and a movie theater, and approximately
50% of the office space. In July 2006 KeyBank, as lender and as agent of nine
lenders, and Perkins Rowe executed a loan agreement and mortgage, and Perkins
Rowe executed a promissory note for each lender for a total of $170 million
(construction loan) with an initial maturity date of August 1, 2009. The loan
agreement permitted Perkins Rowe to extend the initial maturity date for one year
if certain conditions were met. Perkins Rowe was not required to make any
payments on the principal until the maturity date. Mr. Spinosa executed a personal
guaranty for the loan.
Upon the closing of the loan Perkins Rowe received a disbursement of
approximately $23 million. As part of this initial disbursement Perkins Rowe
received approximately $3.7 million for reimbursement of excess equity, which it
used for construction costs, and approximately $8.5 million as a construction draw
for a total receipt of approximately $12.2 million. Originally, Mr. Spinosa had
planned to repay the Saban loan when Perkins Rowe received this first
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[*6] disbursement on the construction loan. However, he became concerned with
cost overruns and problems with the site preparation work that had already caused
the project to fall behind schedule. Mr. Spinosa decided not to use the initial
disbursement to repay the Saban loan. However, he did not view the delay as
significant because building construction had not started. He discussed the delays
and cost overruns with Mr. Saban. At that time Perkins Rowe was able to pay its
expenses as they came due in the ordinary course of its business.
III. Problems With the Development
In April 2007 Mr. Spinosa asked Mr. Saban to extend the due date for
repayment of the Saban loan because of problems with a general contractor that
was eventually terminated. Perkins Rowe executed a second promissory note
dated May 29, 2007 (2007 note), for a principal amount of $2,362,959 (the
original $2 million loan and accrued, unpaid interest) plus annual interest on the
unpaid principal balance at 16% with a maturity date of June 1, 2008. The parties
executed the 2007 note after the 2006 note’s maturity date. The 2007 note
included the same default terms and attorney’s fees award as the 2006 note. At
that time Perkins Rowe was able to pay its bills as they came due in the ordinary
course. At the time of the 2007 note Perkins Rowe had preleased approximately
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[*7] 70% to 80% of the development. In late 2007 Perkins Rowe also had
contracts for sale on approximately 80 condominium units (condos) in the
development.
In late 2007 Perkins Rowe discovered problems with the architecture plans
for the apartment complex. As construction neared completion Mr. Spinosa
worked with the architects and the construction crew to redesign the floor plans of
the apartments because of drainage problems. Despite his diligence in the hiring
process, Mr. Spinosa blamed engaging an architect who was inexperienced in
residential construction. The problems resulted in cost overruns and the need for
additional capital. In late 2007 Perkins Rowe sought a $15 million loan from
KeyBank. Ultimately it obtained the $15 million from a real estate investment
trust in exchange for an interest in another of Mr. Spinosa’s real estate projects
unrelated to Perkins Rowe.
Around this same time Perkins Rowe and KeyBank discussed refinancing
the $170 million construction loan and increasing the loan principal to $215
million. KeyBank orally approved the refinancing subject to an appraisal. In
January 2008 KeyBank obtained a second appraisal of the Perkins Rowe property.
The appraisal, dated January 15, 2008 (2008 appraisal), valued the development
between $227 million as is and $254 million upon completion (estimated to be in
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[*8] April or June 2008), plus $15.6 million in excess land. The 2008 appraisal
stated that the executed leases represented the occupancy rates for office and retail
space of approximately 73% and 87%, respectively, and letters of intent and leases
awaiting lessor signatures would have brought the retail occupancy rate to above
90%. Mr. Spinosa also attempted to raise capital for the project through the use of
tax-exempt Gulf Opportunity Zone (GO Zone) Government bonds.2 Perkins Rowe
had been approved to issue $250 million in GO Zone bonds. The appraisal valued
the completed project with the use of the GO Zone bonds at approximately $310
million.
Despite the fact the 2008 appraisal estimated that Perkins Rowe had
significant equity in the project, KeyBank did not approve the refinancing.
Moreover, it delayed informing Perkins Rowe of its decision. During 2008 the
real estate market experienced a significant economic downturn. Mr. Spinosa
surmised that KeyBank was aware of the problems in the real estate financing
market long before the public knew. He believed that KeyBank felt pressure to
reduce the amount of its outstanding loans. However, throughout this time he
2
The Gulf Opportunity Zone Act of 2005, Pub. L. No. 109-135, sec. 101(a),
119 Stat. at 2578, exempted from taxation interest paid on certain bonds, referred
to as GO Zone bonds, used to finance private development projects in areas
affected by Hurricane Katrina.
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[*9] assumed that KeyBank would refinance the construction loan, and he
remained optimistic about the success of Perkins Rowe.
IV. Transfer of the Saban Loan to 2590 Associates
Throughout this time Mr. Spinosa kept Mr. Saban informed about the
development’s progress, and Mr. Saban visited the development site on several
occasions to inspect the progress. Around the June 2008 maturity date of the 2007
note, Mr. Saban asked Mr. Spinosa about a plan to repay the Saban loan. Mr.
Saban wanted to know how Perkins Rowe would get it done. Mr. Spinosa did not
want to have Perkins Rowe pay the 2007 note at that time because the
development remained under construction. However, he understood that Mr.
Saban wanted options to get the loan satisfied and the debt paid off.
In a memorandum dated July 26, 2008 (July 2008 memorandum), Mr.
Spinosa offered Mr. Saban five options to “satisfy the debt currently due from
Perkins Rowe”: (1) transfer Mr. Spinosa’s 50% ownership in Watermarke
Apartments to Mr. Saban; Mr. Saban already owned the remaining 50%;
(2) transfer a percentage of Mr. Spinosa’s ownership in Cinco Ranch Apartments
to Mr. Saban; Mr. Saban already owned approximately 14% and Mr. Spinosa
owned 82%; (3) transfer an ownership interest in the Rouzan property to Mr.
Saban; (4) organize a new partnership between the two men to develop a hotel
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[*10] near the Perkins Rowe development with Mr. Saban contributing the 2007
note in exchange for his partnership interest and Mr. Spinosa’s contributing an
equal amount of capital; or (5) renegotiate the 2007 note to reduce the interest rate
to 12% and delay repayment until Perkins Rowe’s cashflow allowed.
Mr. Saban chose option (3), an ownership interest in the Rouzan property.
The Rouzan property was a 120-acre parcel of real estate in Baton Rouge,
Louisiana, that Mr. Spinosa planned to develop into a residential community
composed primarily of single-family houses. 2590 Associates owned the Rouzan
property. 5615 Associates was its sole member from its organization in October
1997 until the transaction transferring ownership to Mr. Saban in December 2008.
5615 Associates was owned 90% by the Spinosa Class Trust and 10% by JTS
Associates of Louisiana, Inc. (JTS Associates), an entity related to Mr. Spinosa.
Mr. Spinosa was the manager of 5615 Associates and 2590 Associates.
Mr. Spinosa had acquired the Rouzan property in 2005, but development
was delayed because of a prolonged dispute over zoning that lasted approximately
from 2005 to 2008. As originally zoned approximately 200 to 225 houses could
be constructed on the Rouzan property. Sometime around 2008 the property was
rezoned to allow for the construction of approximately 750 houses, significantly
increasing the property’s value. Mr. Saban had expressed an interest in the
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[*11] Rouzan property early on in the development process. The property became
a more attractive investment opportunity for him because the zoning dispute had
ended.
In the July 2008 memorandum Mr. Spinosa listed the appraised value of the
Rouzan property as $51,610,000 and his equity in the property as $24,550,000,
determined as follows:
Item Amount
Current appraised value $51,610,000
Discounted to 80% appraised value 41,288,000
Less current debt (15,500,000)
Less estimated design/engineering cost to date (750,000)
1
Equity 24,550,000
1
We note that the items and amounts listed in the July 2008 memorandum
calculate to equity of $25,038,000. The memorandum states that the estimated
design/engineering cost to date is “[e]xclusive of cost associated with TND status
and rezoning”. There is no further explanation of this cost in the July 2008
memorandum.
On the basis of these values Mr. Spinosa proposed that Mr. Saban would
receive a 12.2% interest in 2590 Associates representing his $3 million
investment, approximately equal to the 2007 note’s principal plus accrued, unpaid
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[*12] interest. Mr. Saban negotiated to decrease the value of the Rouzan property
thereby increasing his percentage ownership in 2590 Associates to 15%.
There was no business relationship between Perkins Rowe and 2590
Associates, and the developments were unrelated. However, Mr. Spinosa
managed both entities, and the entities had some common ownership. The
Spinosa Class Trust owned 90% of 2590 Associates through 5615 Associates, 5%
of Perkins Rowe I, and 10% of Perkins Rowe II. Mr. Spinosa owned 45% of
Perkins Rowe I and 90% of Perkins Rowe II. He also had an indirect ownership
interest in 2590 Associates through JTS Associates’ 10% ownership. There was
no discussion about the value of the 2007 note in the negotiations over Mr.
Saban’s percentage ownership in 2590 Associates, and Mr. Spinosa did not
consider that the note had a fair market value less than its face value.
Mr. Saban did not want to directly own 2590 Associates because of privacy
concerns. At the time he was the head football coach at the University of Alabama
and felt there was negative public sentiment toward him in the Baton Rouge area
because of his decision to leave LSU. He wanted to receive his interest through a
business entity. On November 26, 2008, Henry C. Perret, Jr., Mr. Saban’s
attorney, organized TLS Investments, LLC (TLS Investments), to hold Mr.
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[*13] Saban’s ownership in 2590 Associates. TLS, LLC (TLS), was TLS
Investments’ sole member. Mr. Saban and his wife were TLS’ sole members.
Perkins Rowe I executed a promissory note dated December 2, 2008, for
$2,926,692 (2008 note), plus annual interest on the unpaid principal of 16%
compounded annually, payable to Mr. Saban on August 19, 2010. Mr. Perret
structured the transaction including the transfer of the 2008 note. For reasons
unclear from the record, Perkins Rowe II did not join in executing the 2008 note.
Similar to the two prior notes, the 2008 note was unsecured, charged a 16%
interest rate that increased to 18% upon default, and provided for an award of
attorney’s fees for any collection actions. The 2008 note stated that it was “given
in substitution” for the 2007 note. The 2007 note did not contain this term with
respect to the 2006 note. Mr. Saban endorsed the 2008 note to TLS Investments
as a capital contribution, and TLS Investments transferred the 2008 note to 2590
Associates through Mr. and Mrs. Saban’s endorsement. 2590 Associates took
physical possession of the note. Thereafter Mr. Saban did not have physical
possession of a note issued by the Perkins Rowe entities.
On December 2, 2008, 2590 Associates amended its operating agreement to
recognize TLS Investments’ admission as a member in exchange for the
contribution of the 2008 note to the capital of the company. The amended
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[*14] operating agreement provided that the members recognized that the fair
market value of the 2008 note was its face value, $2,926,692, and listed TLS
Investments’ capital account as that same amount. The amended operating
agreement listed 5615 Associates’ capital account as $16,584,586. Under the
amended operating agreement, TLS Investments received a 15% allocation of the
profit, gain, and loss. The amended operating agreement provided: “WHEREAS,
Investor Member has contributed a certain promissory note of Perkins Rowe
Associates, L.L.C. to the capital of the Company and the original Member and the
Manager desire to admit him into the Company as an additional Member having
the interest shown herein.” Under the amended operating agreement, Mr. Saban,
rather than TLS Investments, received the required member notices. At Mr.
Saban’s insistence, the operating agreement was also amended to impose
restrictions on the amount of debt 2590 Associates could incur.
V. Foreclosure Filing
In November and December 2008 Perkins Rowe failed to make required
interest payments on the construction loan. No principal repayment was due until
August 2009. In late 2008 Mr. Spinosa had been attempting to refinance the
construction loan for nearly one year. He remained optimistic that Perkins Rowe
could refinance the loan, and he remained optimistic about the future of the
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[*15] project. In 2007 Mr. Spinosa sought to convert the apartments in the
development to condos to make the development more economically viable and to
address budget shortfalls. By late 2007 the condos were almost completed and
most of the condos had contracts for sale. In June 2008 KeyBank and Perkins
Rowe amended the loan agreement to allow the conversion of 88 apartments to
condos and added Perkins Rowe Block A Condominiums, LLC, as a borrower.
The amended loan agreement also gave Perkins Rowe the right to convey certain
property within the development for a roadway to provide greater vehicular access
to the development.
Many issues that Perkins Rowe faced were beyond its control. KeyBank
also experienced financial problems during that time because of the crisis in the
real estate financial market. KeyBank closed one of its offices that Perkins Rowe
had worked with. In 2009 Perkins Rowe began to experience unusually long
delays in disbursements from the construction loan, affecting its ability to pay
contractors and vendors and causing delays in construction. In early 2009 Perkins
Rowe lost the sale of a substantial number of the condos under contract because
KeyBank delayed the release of its mortgage against the condos. KeyBank
eventually released the mortgage in March or April 2009. The roadway was not
completed. Perkins Rowe also lost some retail tenants that had preleased space
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[*16] because of the tenants’ inability to finance leasehold improvements,
although some retail tenants were in place.
On July 28, 2009, KeyBank, representing nine lenders on the $170 million
construction loan, filed a complaint against Perkins Rowe and Mr. Spinosa to
collect on the loan, to foreclose on the property, and to enforce Mr. Spinosa’s
guaranty (foreclosure case). See KeyBank Nat’l Ass’n v. Perkins Rowe Assoc.,
LLC (KeyBank), No. 09-497-JJB-SCR (M.D. La. July 28, 2009). In the
complaint, KeyBank alleged that Perkins Rowe had failed to make required
monthly interest payments from November 2008 through July 2009. Principal
repayment was not yet due. It was due at the loan’s maturity, August 1, 2009. Mr.
Spinosa believed that Perkins Rowe was approximately 90 days from being able to
make the required loan payments. However, construction had already slowed
considerably because of financing issues.
On July 29, 2009, the District Court granted KeyBank’s request to
sequestrate Perkins Rowe’s assets and records and to appoint a keeper. The U.S.
Marshals Service seized Perkins Rowe’s assets and records and delivered them to
the keeper who took over Perkins Rowe’s operations. Perkins Rowe filed
counterclaims against KeyBank and the other lenders. KeyBank filed a motion to
dismiss the counterclaims, which the District Court granted in part and denied in
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[*17] part, keeping alive most counterclaims. KeyBank, No. 09-497-JJB-SCR,
2010 U.S. Dist. LEXIS 59619 (M.D. La. June 16, 2010). After the foreclosure
case’s filing, Perkins Rowe continued to operate, and its tenants continued to pay
rent. However, Perkins Rowe never received any funds or disbursements from the
operation of the business. During this period Perkins Rowe also faced multiple
lawsuits from contractors and vendors. Between August 2009 and March 2010
Perkins Rowe had a positive cashflow of nearly $900,000, which the keeper used
to pay the keeper’s expenses.
Despite the foreclosure case Mr. Spinosa believed that he could resolve the
financing problems and could complete the Perkins Rowe project. He continued
to negotiate with KeyBank and the other lenders. On multiple occasions he came
close to negotiating a refinancing deal that would have stopped the foreclosure.
However, one lender had sold its note to a hedge fund shortly after the foreclosure
case began, and the hedge fund refused to renegotiate the terms of the loan or to
accept any of the deals that KeyBank had brokered. Mr. Spinosa was also
negotiating with other lenders and investors to refinance the construction loan if
Perkins Rowe could settle the foreclosure case. He attempted to use the GO Zone
bonds to entice new lenders and investors. However, the GO Zone bonds issued
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[*18] to Perkins Rowe were terminated in 2011 because of its failure to place the
bonds with investors.
Mr. Spinosa believed that many of KeyBank’s actions resulted from
pressures the bank faced to reduce its real estate debt. He believed that the bank
representatives he met with were not interested in resolving the issue in a manner
that would help Perkins Rowe survive. He believed that they were concerned with
the bank’s survival. He had considered filing bankruptcy to protect Perkins Rowe,
but his attorneys advised against it. Throughout this time the Schwegmann family
members continued to own 50% of Perkins Rowe I. Mr. Spinosa kept them
informed of the financial issues and discussed possible alternative solutions with
them.
On June 7, 2011, the District Court dismissed Perkins Rowe’s affirmative
defenses and the remainder of its counterclaims as a sanction for discovery abuses.
KeyBank, No. 09-497-JJB-SCR, 2011 U.S. Dist. LEXIS 61161 (M.D. La. June 7,
2011). On August 8, 2011, the District Court granted summary judgment in
KeyBank’s favor on its right to foreclose and to enforce the guaranty. KeyBank,
No. 09-497-JJB-SCR, 2011 U.S. Dist. LEXIS 87564 (M.D. La. Aug. 8, 2011).
After the summary judgment in KeyBank’s favor, two counts of KeyBank’s
complaint on issues separate from the foreclosure and guaranty remained
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[*19] unresolved. Accordingly, the District Court delayed its final judgment
entering it on September 4, 2012, in KeyBank’s favor. KeyBank, No. 09-497-JJB-
SCR (M.D. La. Sept. 4, 2012). Perkins Rowe filed a writ of mandamus with the
Court of Appeals for the Fifth Circuit, which was denied on October 22, 2012.
The keeper was released on October 23, 2013. 2590 Associates did not take any
enforcement actions to collect on the 2008 note, which would have been futile.
VI. The Deduction
2590 Associates filed a partnership tax return for 2011 claiming worthless
debt deductions of $4,894,890, including $2,926,692 for the 2008 note. Perkins
Rowe’s accountant recommended deducting the debt. The 2011 partnership return
listed Mr. Saban, rather than TLS Investments, as a 15% member and gave him the
right to notice as a member. For its 2011 tax year Perkins Rowe I recognized
cancellation of indebtedness income of $2,815,652 in connection with the 2008
note. 2590 Associates reported that Mr. Saban, rather than TLS Investments, had
a capital account of $1.2 million at the end of 2011. 2590 Associates issued the
2011 Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., to Mr.
Saban individually rather than to TLS Investments. Mr. Saban divested his
interest in 2015 by selling it to 5615 Associates for a cash payment of $2.8 to $2.9
million. There is no information in the record concerning 2590 Associates’
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[*20] activities or financial condition from 2008 through 2015 except for
information reported on its 2011 partnership return.
In the FPAA respondent disallowed $2,926,692 of the worthless debt
deduction, the amount of the 2008 note. Respondent asserted: “Since the
partnership did not establish that the cash transfer was a bona fide loan, the
amount has been determined to be a contribution to capital.” Respondent did not
challenge the year that the debt became worthless in the FPAA or in his answer.
OPINION
Section 166(a) generally allows taxpayers to deduct “any debt which
becomes worthless within the taxable year.” For a section 166 worthless business
debt deduction, taxpayers must show: (1) the deducted amount represents a bona
fide debt, (2) the debt became worthless during the year, and (3) the debt was
incurred in connection with a trade or business. Sensenig v. Commissioner, T.C.
Memo. 2017-1, at *17-*18; sec. 1.166-1(c), Income Tax Regs. Deductions are a
matter of legislative grace, and taxpayers bear the burden of proving their
entitlement to any deduction allowed by the Code. INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 84 (1992).
Petitioner filed a motion in limine arguing the issue before us should be
limited to the existence of a bona fide debt. We held that the issue of whether the
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[*21] debt became worthless during 2011 was properly before the Court as
respondent raised the issue in his pretrial memorandum. However, we held that
the year of worthlessness was a new matter for which respondent would have the
burden of proof. See Rule 142. Petitioner bears the burden to establish that the
debt was bona fide.
A bona fide debt is a debt that arises from a debtor-creditor relationship on
the basis of a valid and enforceable obligation to pay a fixed or determinable sum
of money. Sec. 1.166-1(c), Income Tax Regs. Whether an advance gives rise to a
bona fide debt for Federal tax purposes is determined from all the facts and
circumstances. Dixie Dairies Corp. v. Commissioner, 74 T.C. 476, 493 (1980).
To constitute a bona fide debt, at the time of the transfer there must be a real
expectation of repayment and an intent on the part of the purported creditor to
secure repayment. Haag v. Commissioner, 88 T.C. 604, 616 (1987), aff’d without
published opinion, 855 F.2d 855 (8th Cir. 1988); Andrew v. Commissioner, 54
T.C. 239, 245 (1970). Where the facts indicate that no bona fide debt was created,
an advance may properly be classified as a contribution to capital. See Davis v.
Commissioner, 69 T.C. 814, 835-836 (1978); Rutter v. Commissioner, T.C.
Memo. 2017-174. Contributions to capital may not be deducted under section
166. Kean v. Commissioner, 91 T.C. 575, 594 (1988); sec. 1.166-1(c), Income
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[*22] Tax Regs. Generally, shareholders place their money at the risk of the
business while lenders seek a more reliable return. See Midland Distribs., Inc. v.
United States, 481 F.2d 730, 733 (5th Cir. 1973).
Whether a transfer of funds constitutes a loan may be inferred from
objective characteristics surrounding the transfer. The Court of Appeals for the
Fifth Circuit, to which this case is appealable, considers 13 nonexclusive factors to
determine whether a bona fide debt exists: (1) the names given to the certificates
evidencing the indebtedness, (2) a fixed maturity date, (3) the source of
repayment, (4) a legally enforceable right of repayment, (5) the creditor’s right to
participate in the debtor’s management, (6) the subordination of the obligation to
other debts, (7) the intent of the parties, (8) the debtor’s capitalization and use of
the funds, (9) the identity of interest between creditor and stockholder, (10) the
payment of interest, (11) the corporation’s ability to obtain loans from outside
lending institutions, (12) the extent to which the advance was used to acquire
capital assets, and (13) the failure of the debtor to repay on the due date or to seek
a postponement. See Estate of Mixon v. United States, 464 F.2d 394, 402 (5th
Cir. 1972). The factors are not of equal importance, and no single factor is
determinative. See Dillin v. United States, 433 F.2d 1097, 1100 (5th Cir. 1970);
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[*23] Segel v. Commissioner, 89 T.C. 816, 827 (1987). Some factors may not be
relevant in a given situation. Estate of Mixon, 464 F.2d at 402.
The object of the inquiry is not to count the factors but to evaluate them.
Tyler v. Tomlinson, 414 F.2d 844, 848 (5th Cir. 1969). The factors aid in our
determination of whether the parties intended to create indebtedness with a
reasonable expectation of repayment and whether that expectation comported with
economic reality. See Estate of Mixon, 464 F.2d at 407. The Court of Appeals for
the Fifth Circuit recognizes that the “real issue for tax purposes has long been held
to be the extent to which the transaction complies with arm’s length standards and
normal business practice.” Id. at 402-403. We apply special scrutiny to
transactions between entities in the same corporate family or with shared
ownership. See Kean v. Commissioner, 91 T.C. at 594; Malone & Hyde, Inc. v.
Commissioner, 49 T.C. 575, 578 (1968); Vinikoor v. Commissioner, T.C. Memo.
1998-152.
Respondent has conceded that the Saban loan was bona fide; i.e., the cash
transfer from Mr. Saban to Perkins Rowe created a bona fide debt between Mr.
Saban and Perkins Rowe. The debt was evidenced by three promissory notes with
fixed maturity dates. Each note provided for an interest charge, increased the
interest rate upon default, and provided for the payment of attorney’s fees for any
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[*24] collection actions. Upon default, Mr. Saban negotiated with Perkins Rowe
to ensure repayment, first by extending the maturity date for one year (the 2007
note) and a second time by again extending the maturity date (the 2008 note) after
which he transferred the note to 2590 Associates as a capital contribution, placing
the risk of the debt with the company.
Respondent argues that the transfer of the 2008 note to 2590 Associates did
not create a bona fide debtor-creditor relationship between Perkins Rowe and 2590
Associates.3 Rather, he argues that Mr. Saban’s receipt of the interest in 2590
Associates satisfied the Saban loan, citing State contract law. He argues that
Perkins Rowe and Mr. Saban entered into a contract to modify and extinguish the
Saban loan through the transfer of an interest in 2590 Associates. According to
respondent, the parties to the Saban loan, including Mr. Spinosa by his own
testimony, viewed Mr. Saban’s receipt of an interest in 2590 Associates as
satisfaction of Perkins Rowe’s debt to Mr. Saban. In addition, he argues that there
was no transfer of funds between Perkins Rowe and 2590 Associates that could
create a debt.
3
Although the FPAA mentions only a “cash transfer” (presumably referring
to the cash transfer from Mr. Saban to Perkins Rowe), respondent’s answer denies
that there was a bona fide debt between 2590 Associates and Perkins Rowe.
Accordingly, the issue of the existence of a bona fide debt between Perkins Rowe
and 2590 Associates is properly before the Court.
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[*25] We find that Mr. Saban entered into a legitimate debt with Perkins Rowe
and transferred the debt to 2590 Associates. Mr. Saban’s transfer of the debt to
2590 Associates did not negate the legitimacy of the debt. While the transaction
may not have been typical of a normal business relationship because of Mr.
Spinosa’s personal relationship with Mr. Saban, it was a transfer of a legitimate
debt. Although Perkins Rowe had failed to make the November and December
interest payments on the construction loan at or around the time it executed the
2008 note, respondent did not argue that Perkins Rowe was insolvent at the time
of the 2008 note. The January 2008 appraisal indicated that Perkins Rowe had a
significant amount of equity in the project. By late 2008 construction neared
completion. Retail tenants were in place, and condos were sold. Mr. Spinosa
believed Perkins Rowe was 90 days from making the required payments on the
construction loan. He continued to negotiate with Perkins Rowe’s lenders and to
seek refinancing. He remained optimistic that the Perkins Rowe development
would be successfully completed.
We recognize that Perkins Rowe was less than seven months from a
foreclosure lawsuit and arguably Mr. Saban received a windfall by exchanging his
debt for an equity interest in 2590 Associates. An unrelated third party may not
have accepted the 2008 note at its face value as a capital contribution as 2590
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[*26] Associates did. However, respondent has not argued that the value of the
2008 note should have been discounted when Mr. Saban contributed it to 2590
Associates. Nor has he raised any arguments relating to 2590 Associates’ adjusted
basis in the 2008 note. Rather, he argues that there was a complete lack of a bona
fide debt. 2590 Associates made a business decision, likely influenced by
personal relationships, to give Mr. Saban an ownership interest in exchange for the
face value of the 2008 note, i.e., the principal of the Saban loan and the accrued,
unpaid interest. Mr. Spinosa expressed the intent in the July 2008 memorandum
to “satisfy the debt” to Mr. Saban. However, we find that the transaction
postponed the need for Perkins Rowe to repay the debt; it did not discharge the
debt. It allowed Perkins Rowe to delay repayment of the debt under the extended
maturity date to a time when Mr. Spinosa believed Perkins Rowe would be
economically viable. Each option in the July 2008 memorandum was a means to
delay repayment of the Saban loan rather than to cancel the debt.4
Respondent attempts to characterize the options in the July 2008
memorandum, including the offer of an investment opportunity in 2590
Associates, as being made by Perkins Rowe. However, it was Mr. Spinosa who
4
Respondent raises an issue with the fact that the July 2008 memorandum
mentioned the transfer of a note only with respect to the hotel venture. We do not
find this fact dispositive.
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[*27] made the offer in the July 2008 memorandum. Perkins Rowe did not own
2590 Associates and could not offer an ownership interest in it to satisfy the Saban
loan. The purpose of the July 2008 memorandum was to provide alternatives to
the immediate repayment of the Saban loan. Four of the five options in the
memorandum included the transfer of an ownership interest in a real estate project
unrelated to Perkins Rowe. The fifth option was to extend the maturity date of the
2007 note and to lower the interest rate. Mr. Saban wanted to be repaid, or at the
least, he no longer wanted to have his money at risk in the Perkins Rowe
development. He viewed the Rouzan property as an attractive investment
opportunity because of the recent success with rezoning the property for
significantly more homes.
Respondent further argues that 2590 Associates did not intend to collect on
the debt. We disagree. Had Perkins Rowe become economically viable, 2590
Associates would have collected on the debt. We find Mr. Spinosa’s testimony to
be credible on this point.
Lastly, we consider respondent’s concerns with the relationship between
Perkins Rowe and 2590 Associates. Perkins Rowe and 2590 Associates had
common management, Mr. Spinosa, and common, related owners. However, they
did not have identity of ownership because the Schwegmann family owned 50% of
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[*28] Perkins Rowe I, the only named debtor on the 2008 note.5 The Spinosa
Class Trust owned 90% of 2590 Associates but only 5% of Perkins Rowe I. Thus,
the Spinosa Class Trust increased its risk on the debt. Mr. Spinosa owned 45% of
Perkins Rowe I. This fact alone does not negate our finding that Mr. Saban
transferred a legitimate debt to 2590 Associates. Mr. Spinosa had intermingled
funds of his various real estate projects owned through different entities in the
past. Even with Perkins Rowe, he injected $15 million into the development from
a separate real estate deal when Perkins Rowe needed capital in late 2007.
Under the 13 factors considered by the Court of Appeals for the Fifth
Circuit, we find that a bona fide debt existed between Perkins Rowe and 2590
Associates. Respondent did not address the 13 factors used by the Court of
Appeals. 2590 Associates held a promissory note with a fixed maturity date and
accrued interest at an above-market rate. The interest rate increased upon default,
and the note provided for an award of attorney’s fees for any collection actions.
We find that at the time of the 2008 note’s transfer, 2590 Associates intended to
collect the debt from Perkins Rowe. Mr. Spinosa believed that Perkins Rowe
would succeed and would repay the debt. 2590 Associates had the right to enforce
5
Perkins Rowe II did not execute the 2008 note; the reason is unclear from
the record. Mr. Spinosa owned 90% of Perkins Rowe II.
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[*29] payment. However, as the note was unsecured, collection attempts would
have been futile. Mr. Spinosa credibly testified that he believed the Perkins Rowe
development could be successful at the time Mr. Saban contributed the note to
2590 Associates and even after the foreclosure case’s filing. Mr. Spinosa had
extensive experience in real estate investments, and he was optimistic that Perkins
Rowe would be successful despite the difficulties it encountered. The source of
repayment was not limited to Perkins Rowe’s income. There is no evidence of a
thin capitalization. In fact, the 2008 appraisal performed for KeyBank indicated
that there was substantial equity in Perkins Rowe. The 2008 note was not given to
acquire capital assets. Each of these factors weighs in favor of the existence of a
bona fide debt.
Two factors weigh against a bona fide debt, the note’s subordination to
secured creditors and Perkins Rowe’s failure to repay the debt and accrued
interest. Finally, two remaining factors for us to address are Perkins Rowe’s
ability to obtain outside loans and the nature of the relationship between 2590
Associates and Perkins Rowe. We find both factors to be neutral in the light of the
other factors supporting the existence of a bona fide debt. By the time of the 2008
note’s execution, Perkins Rowe had been attempting to refinance the construction
loan for nearly one year. Ultimately, the loan was not refinanced, and the property
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[*30] was foreclosed on. However, at the time of the 2008 note and even after the
foreclosure case began, Mr. Spinosa believed he could work out a refinancing and
continued to negotiate with lenders and potential investors. Mr. Spinosa was able
to amend the terms of the construction loan agreement in 2008, and all but one
lender agreed to a refinancing deal after the foreclosure began. Nor do we find the
relationship between Perkins Rowe and 2590 Associates, discussed infra, to
negate the other factors supporting a bona fide debt. On the basis of the Court of
Appeals for the Fifth Circuit’s 13 factors, we find that the debt between Perkins
Rowe and 2590 Associates was bona fide.
II. Satisfaction of Debt Under State Law
Both parties rely on State law to support their respective positions. The
form of the instrument or its validity under State law does not control its treatment
for Federal tax purposes. United States v. Snyder Bros. Co., 367 F.2d 980 (5th
Cir. 1966); W.O. Covey, Inc. v. Commissioner, T.C. Memo. 1969-273. The issues
for Federal tax purposes are whether the parties intended to create a bona fide debt
and whether the intention comports with economic reality. Estate of Mixon, 464
F.2d at 407. Nevertheless, we briefly address the parties’ positions.
Respondent argues that Perkins Rowe and Mr. Saban entered into a valid
contract under Louisiana law to satisfy and extinguish the Saban loan. He cites
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[*31] four requirements for a valid contract under Louisiana law: (1) the parties’
capacity to contract, (2) their mutual consent, (3) a cause or reason for the parties
to obligate themselves, and (4) a lawful object of the contract. Leger v. Tyson
Foods, 670 So. 2d 397, 401 (La. Ct. App. 1996). Respondent argues that there
was capacity, consent, cause, and lawful object. He argues that 2590 Associates
was a third party rendering performance of the contract by transferring the 15%
ownership interest to Mr. Saban, albeit indirectly through TLS Investments, in
satisfaction of the Saban loan.6 See La. Civ. Code Ann. art. 1977 (2018) (“The
object of a contract may be that a third person will incur an obligation or render a
performance.”).
Petitioner argues that the parties must abide by the State law of novation to
discharge the Saban loan rather than the requirements of a contract respondent
cites. A novation releases a debtor of its liability to a creditor. Id. art. 1879.
Under Louisiana law, a novation is defined as “the extinguishment of an existing
obligation by the substitution of a new one.” Id. Petitioner argues that there was
no novation of the debt owed by Perkins Rowe. It argues that there was a
6
The decision to structure the transaction for Mr. Saban to receive indirect
ownership in 2590 Associates does not affect the analysis of the transaction.
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[*32] substitution of promissory notes but the underlying debt continued to exist.
Rather, there was a creditor’s valid assignment of a promissory note. We agree.
Under Louisiana law,
Novation takes place when, by agreement of the parties, a new
performance is substituted for that previously owed, or a new cause is
substituted for that of the original obligation. If any substantial part
of the original performance is still owed, there is no novation.
* * * * * * *
Mere modification of an obligation, made without intention to
extinguish it, does not effect a novation. The execution of a new
writing, the issuance or renewal of a negotiable instrument, or the
giving of new securities for the performance of an existing obligation
are examples of such a modification.
Id. art. 1881. Novation may not be presumed, and “[t]he intention to extinguish
the original obligation must be clear and unequivocal.” Id. art. 1880. A novation
occurs when a new obligor is substituted for a prior obligor who is discharged by
the obligee. Id. art. 1882.
Mr. Spinosa’s intent for engaging in the transaction was to satisfy Mr.
Saban’s desire for repayment, which he accomplished by transferring an
ownership interest in 2590 Associates to Mr. Saban in exchange for the debt.
2590 Associates received the right to collect the debt, which we have found it
intended to do. Mr. Saban did not want to extend the loan’s maturity and did not
want to have his money at risk with Perkins Rowe. He was aware of Perkins
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[*33] Rowe’s construction problems, cost overruns, and financial condition as Mr.
Spinosa kept him informed. Mr. Saban wanted out, and he choose an investment
in 2590 Associates to replace the debt owed to him from Perkins Rowe. However,
2590 Associates received a note enforceable under State law. See La. Rev. Stat.
§ 10:3-104 (2006) (defining requirements for a negotiable instrument).
It is unclear from the record why Perkins Rowe II did not join in executing
the 2008 note, and it is possibly because of an oversight by Mr. Saban’s attorney.
Petitioner argues that Perkins Rowe II’s failure to execute the 2008 note with
Perkins Rowe I as it had for the prior two notes is inconsequential because it was
not a novation. We agree. Perkins Rowe I remained liable for the debt evidenced
by the 2008 note. See La. Civ. Code Ann. art. 1885. Furthermore, the 2008 note
stated that it was given in substitution for the 2007 note. Perkins Rowe I included
the entire amount of the 2008 note as cancellation of indebtedness income for
2011. On the basis of these facts, Perkins Rowe I was not discharged by Mr.
Saban, TLS Investments, or 2590 Associates, and there was no novation.
III. Year of Worthlessness
As we have found the debt was bona fide, we turn to respondent’s
alternative argument that the debt did not become worthless in 2011, the year of
the deduction. He argues that the debt was worthless in either 2009, the year the
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[*34] foreclosure case began and Perkins Rowe’s assets were seized, or 2012, the
year of the final judgment in the foreclosure case. He has not argued that the 2008
note did not have any value at the time Mr. Saban contributed it to 2590
Associates in 2008.
For a section 166 deduction, the debt must become worthless during the tax
year, i.e., it must have had value at the beginning of the year and become
worthless during that year. Milenbach v. Commissioner, 106 T.C. 184, 204
(1996), aff’d in part, rev’d in part on other grounds, 318 F.3d 924 (9th Cir. 2003).
A debt’s worthlessness is determined by identifiable events that occurred to render
the debt worthless during the year. Am. Offshore, Inc. v. Commissioner, 97 T.C.
579, 594 (1991). A debt becomes worthless when the taxpayer has no reasonable
expectation of repayment. Crown v. Commissioner, 77 T.C. 582, 598 (1981).
Some objective factors considered by the Court in determining worthlessness
include the value of property securing the debt, the debtor’s earning capacity,
events of default, the debtor’s refusal to pay, actions to collect the debt, any
subsequent dealings between the parties, and the debtor’s lack of assets. Am.
Offshore, Inc. v. Commissioner, 97 T.C. at 594-595. No single factor is
conclusive. Id. at 595. The determination of when a debt becomes worthless
depends upon the particular facts and circumstances of each case. Riss v.
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[*35] Commissioner, 56 T.C. 388, 407 (1971), aff’d, 478 F.2d 1160 (8th Cir.
1973). At trial we held that respondent has the burden of proof with respect to the
issue of worthlessness in 2011. We find that respondent has failed to satisfy his
burden of proof and that the debt became worthless in 2011.
Without question, Perkins Rowe was in serious financial distress in 2009
when KeyBank filed the foreclosure case. However, part of the development was
completed, and it generated revenue. Mr. Spinosa believed that Perkins Rowe was
90 days away from making the required payments on the construction loan at the
time of the foreclosure case’s filing. Perkins Rowe had defaulted on
approximately $4 million of interest payments from November 2008 to July 2009
on the $170 million construction loan. Mr. Spinosa continued to negotiate with
the lenders and was optimistic a deal could be reached to avoid foreclosure. In
fact he came close to a deal with only one creditor holding out. There was a
reasonable expectation of repayment at the end of 2009 even though Perkins Rowe
ultimately did not receive any income from the seized assets. On the basis of these
facts, we find that the debt did not become worthless in 2009.
Nor do we find that the debt became worthless in 2012 as respondent
alternatively argues. Rather, we find that the debt became worthless in 2011. That
year the GO Zone bonds issued to Perkins Rowe were terminated because of its
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[*36] failure to find investors to purchase them. With the termination of the
bonds, Mr. Spinosa did not see a viable means to obtain refinancing of the
development project. In addition in 2011 Mr. Spinosa’s negotiations with
KeyBank to avoid foreclosure broke down, and the District Court dismissed
Perkins Rowe’s counterclaims and affirmative defenses in the foreclosure case.
The final judgment in the foreclosure case was delayed to 2012 for resolution of
unrelated issues. With these events it was reasonable to abandon hope of recovery
on the 2008 note by the end of 2011. We find that the 2008 note had value at the
beginning of 2011 and became worthless that year.
In reaching our holdings herein, we have considered all arguments made,
and, to the extent not mentioned above, we conclude they are moot, irrelevant, or
without merit.
To reflect the foregoing,
Decision will be entered for
petitioner.