Key takeaways

Taxpayers negotiating complex management or other agreements that involve revenue-sharing should be mindful of whether advances from one party to another under the agreement will be treated as debt or equity for tax purposes.

In more detail

AAM, which was owned by the Samueli family through a series of related entities, managed the Honda Center, a sports-and-entertainment arena in Anaheim, California, under an exclusive management agreement it entered into with the City on December 16, 2003. To the extent the Honda Center experienced funding shortfalls during the course of the agreement, AAM made advances in the form of Operating Loans (i.e., to fund day-to-day expenses), Debt Service Loans (i.e., to satisfy bond obligations), and Capital Expenditure Loans (i.e., for improvements to the facility).

The advances were documented by promissory notes identifying AAM as the lender and the Honda Center as the borrower, though the latter was not a separate legal entity and, instead, was a physical asset owned by the City. The AAM Chief Executive Officer and President, who was neither an employee of the City nor authorized to bind it, signed the notes on behalf of the Honda Center. Operating Loans and Debt Service Loans had a stated maturity of one year from the note's date while Capital Expenditure Loan maturity dates were generally tied to the life of the asset. In practice, these terms were not closely adhered to by the parties. For example, AAM treated Operating Loans and Debt Service Loans as a revolving line of credit, and when the maturity date on a note was reached, carried over the outstanding principal amounts to a new note with a new maturity date.

During 2015, a new Chief Financial Officer for the Samueli entities consulted advisors and ascertained that the various advances made by AAM under the management agreement would never be repaid, and AAM claimed a USD 51,465,228 bad-debt deduction on its tax return for the year ending December 31, 2015. After auditing the return, the IRS issued a Final Partnership Administrative Adjustment in which it disallowed the bad debt-deduction and determined an accuracy-related penalty under section 6662(a).

In determining whether section 166(a) applies to allow a deduction, the Court focused on whether the advances were bona fide debts and did not inquire into their worthlessness. In disallowing the deduction, the Court looked to the 11-factor debt-versus-equity test from the Nineth Circuit, to which the case was appealable. See A.R. Lantz Co. v. United States, (424 F2d 1330 (9^th Cir. 1970). These factors include:

1. Names given to the certifications evidencing the indebtedness
2. Presence or absence of a maturity date
3. Source of payments
4. Right to enforce payment of principal and interest
5. Participation and management
6. Equal or inferior status to regular corporate debtors
7. Intent of the parties
8. Thin or adequate capitalization
9. Identity of interest between creditor and stockholder
10. Payment of interest only out of dividend money
11. Ability of corporation to obtain loans from outside lending institutions.

The Court concluded that none of the 11 factors support the determination that the advances are debt instruments. In general, the Court viewed the advances as serving AAM's broader business interests and fulfilling its obligations under the terms of the management contract. Specifically, the Court noted that the advances were meant to ensure or increase AAM's residual profits from managing the Honda center, rather than representing a conventional lending arrangement. Further, the source and possibility of repayment were limited by the availability of revenue from the Honda Center's business activities.

The Court did not, however, impose any accuracy-related penalty under section 6662(a) because AAM had reasonable cause for and acted in good faith in claiming the bad-debt deduction. Whether a taxpayer acted with reasonable cause and in good faith is determined on a case-by-case basis; however, the most important factor is the extent of the taxpayer's effort to assess the proper tax liability. Here, the Court found that AAM had reasonable cause and acted in good faith because the Chief Financial Officer for the Samueli entities reasonably relied on the advice of accountants who were competent professionals with sufficient expertise to justify this reliance.

Conclusion

As the Court noted, "[t]he ultimate inquiry is resolved by the economic substance of the transaction, not its form." Documentation as debt in the form of promissory notes with accompanying interest terms and stated maturity dates did little to support the taxpayer's position because the economic reality was governed by the management agreement. While the substance of an instrument is determined by a multi-factor test, this case shows that a Court may view a revenue-sharing arrangement as an indicia against debt because of the "equity-like stakes" of the putative lender in the profits of the putative borrower. Taxpayers making advances in connection with a management agreement or other revenue-sharing arrangements should consider how these facts will impact the Court's debt-versus-equity determination.

Anaheim Arena Management also demonstrates the importance of competent advisors and the thorough and accurate basis for their advice for penalty protection purposes. Even though the accountants did not analyze the bona fides of the debt and, instead, focused on the worthlessness of the advances, their expertise and experience, and the taxpayer's provision of relevant and accurate information were sufficient to justify the taxpayer's reliance on the advice.