VHC, Inc. v. CIR

In the

United States Court of Appeals

For the Seventh Circuit

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Nos. 18-3717 & 18-3718

VHC, INC.,

Petitioner-Appellant,

v.

COMMISSIONER OF INTERNAL REVENUE,

Respondent-Appellee.

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Appeals from the United States Tax Court.

Nos. 4756-15 & 21583-15 — Kathleen Kerrigan, Judge.

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ARGUED JUNE 10, 2020 — DECIDED AUGUST 6, 2020

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Before FLAUM, BARRETT, and ST. EVE, Circuit Judges.

BARRETT, Circuit Judge. For more than a decade, Ron Van

Den Heuvel received cash payments from VHC, a company

founded by his father and owned by his family. These pay-

ments primarily supported Ron’s business ventures but also

helped him pay personal taxes and cover other personal ex-

penses. Ron didn’t pay VHC back, and the company wrote

down these payments as “bad debts” for which it received tax

deductions. After a years-long audit, the IRS concluded that

VHC never intended to be paid back and that these payments

2 Nos. 18-3717 & 18-3718

were not bona fide debts qualifying for the deduction. The

Tax Court upheld this determination and rejected VHC’s al-

ternative theories as to why the payments qualified for a de-

duction. We see no error in this decision and affirm the Tax

Court’s judgment.

I.

Ron Van Den Heuvel’s father founded VHC in 1985 to

provide services to the paper manufacturing industry. Ron

and his four brothers have all worked for VHC or its subsidi-

aries in some capacity, but Ron found particular success. He

started two of VHC’s subsidiaries, directed a number of its

other companies, and launched his own companies separate

from VHC.

Between 1997 and 2013, VHC advanced $111 million to

Ron and his companies. These payments took several forms

and fulfilled several purposes, including paying debts owed

by both Ron and his companies. Ron and his companies

would come to owe VHC $132 million, including interest, by

2013 but would only ever repay $39 million.

In 2002, Associated Bank, a creditor to both Ron and VHC,

demanded that VHC guarantee all of Ron’s debts to Associ-

ated—about $27 million—as a condition of preserving VHC’s

line of credit with Associated. VHC agreed and made similar

arrangements a year later with two other banks.

Ron’s companies do not appear to have turned a profit,

and in 2004 VHC began writing off its payments to Ron as

“bad debts,” ultimately writing off $95 million by 2013. After

an audit, the IRS issued a notice of deficiency to VHC, reject-

ing $92 million of these write-offs.

Nos. 18-3717 & 18-3718 3

VHC petitioned the Tax Court to review the agency’s de-

ficiency determination. The court held a ten-day bench trial,

during which VHC presented both documentary evidence

and live witness testimony. But the Tax Court upheld the

agency’s deficiency finding. It determined that VHC could

not deduct the payments to Ron as “bad debts” because Ron

and VHC lacked a bona fide debtor-creditor relationship. The

Tax Court also rejected VHC’s alternative arguments, includ-

ing its contention that its payments to Ron were ordinary and

necessary business expenses because of VHC’s 2002 agree-

ment with Associated. The Tax Court slightly reduced VHC’s

liability, however, concluding that the unpaid interest ac-

crued on the payments to Ron was not taxable as income be-

cause the debts were not bona fide.

VHC appeals the Tax Court’s ruling, arguing that the Tax

Court erroneously determined that the payments were not

deductible either as bad debts or as ordinary and necessary

business expenses, and contending that the Tax Court did not

sufficiently reduce VHC’s interest income.

II.

We begin with the two avenues by which VHC argues the

payments could have been deducted. From the outset, we

note that a petitioner who asserts entitlement to a deduction

faces a steep climb. Income tax deductions are “a matter of

legislative grace and … the burden of clearly showing the

right to the claimed deduction is on the taxpayer.” INDOPCO,

Inc. v. Comm’r, 503 U.S. 79, 84 (1992) (citation omitted). As a

result, when the Commissioner makes a deficiency assess-

ment, we place the burden on the taxpayer to prove that the

assessment was erroneous. Cole v. Comm’r, 637 F.3d 767, 773

(7th Cir. 2011). We give the Commissioner’s assessment a

4 Nos. 18-3717 & 18-3718

“presumption of correctness” but shift the burden of proof to

the Commissioner if the taxpayer can demonstrate that a de-

ficiency assessment “lacks a rational foundation or is arbitrary

and excessive.” Id. (citation omitted).

In evaluating whether an assessment is arbitrary and ex-

cessive, we review legal questions de novo and factual find-

ings for clear error, and we disturb a factual finding only if

we are “left with the definite and firm conviction that a mis-

take has been committed.” Id. (citation omitted). When evalu-

ating a claim of entitlement to a deduction, “[t]he tax court’s

determination that a taxpayer has failed to come forward with

sufficient evidence to support a deduction is a factual find-

ing.” Buelow v. Comm’r, 970 F.2d 412, 415 (7th Cir. 1992).

A.

VHC disputes the Tax Court’s determination that its cash

payments to Ron did not constitute loans that were deductible

as “bad debts” when they went unpaid. In general, taxpayers

may deduct “any debt which becomes worthless within the

taxable year” or the nonrecoverable part of a partially worth-

less debt that is written off within the taxable year. I.R.C.

§ 166(a). Treasury Regulations specify that “[o]nly a bona fide

debt qualifies for … section 166” and define a “bona fide

debt” as one that “arises from a debtor-creditor relationship

based upon a valid and enforceable obligation to pay a fixed

or determinable sum of money.” Treas. Reg. § 1.166-1(c). The

regulations specifically exclude any “gift or contribution to

capital” as qualifying as a bona fide debt. Id.

VHC’s ability to claim the deduction therefore turns on

whether it had a debtor-creditor relationship with Ron such

that he had an enforceable obligation to pay VHC a fixed sum.

Nos. 18-3717 & 18-3718 5

To determine whether such a relationship exists, we look to

“a number of factors” as “indications of intent,” and the bur-

den to establish the presence of such indicators lies with the

taxpayer. Busch v. Comm’r, 728 F.2d 945, 948 (7th Cir. 1984).

For its part, the Tax Court views intrafamily transfers with

particular skepticism. See Van Anda's Estate v. Comm’r, 12 T.C.

1158, 1162 (1949), aff’d per curiam, 192 F.2d 391 (2d Cir. 1951)

(“Intrafamily transactions are subject to rigid scrutiny ….

However, this presumption may be rebutted by an affirma-

tive showing that there existed at the time of the transaction a

real expectation of repayment and intent to enforce the collec-

tion of the indebtedness.”).

Though the question whether a debtor-creditor relation-

ship existed “has been variously described as one of fact and

one of law,” we conclude that the Tax Court reached the cor-

rect conclusion under either standard. In re Larson, 862 F.2d

112, 116 (7th Cir. 1988). The Tax Court looked to ten factors to

determine that Ron and VHC did not have a debtor-creditor

relationship. VHC does not confront these factors. Instead, it

argues that the Tax Court’s reliance on indicia of a debtor-

creditor relationship prevented it from seeing the forest for

the trees and that the only relevant factor is the intent of the

parties.

We need not belabor the other factors upon which the Tax

Court relied—even under VHC’s own theory it still loses. It

contends that it held out to third parties that the advances

were debts and signed promissory notes, indicating that it be-

lieved the advances to be debt for which it expected to be re-

paid. But, as the Tax Court noted, the way that VHC described

the advances does not match the way that VHC and Ron

treated these payments. For example, the Tax Court noted

6 Nos. 18-3717 & 18-3718

that, though many of the promissory notes had fixed maturity

dates, VHC routinely deferred payment or renewed the notes

without any receipt of payment. Further, the Tax Court

pointed to evidence that VHC did not expect to be repaid un-

less various other events occurred, such as Ron securing ad-

ditional investments and projects. But, as we have described,

this sort of relationship is that of an investor, not of a creditor:

“[T]he creditor expects repayment regardless of the debtor

corporation’s success or failure, while the investor expects to

make a profit … if, as he no doubt devoutly wishes, the com-

pany is successful.” In re Larson, 862 F.2d at 117. Though VHC

may have described the payments as debt, it did not treat

them as part of an ordinary debtor-creditor relationship and

therefore did not establish that the parties intended such a re-

lationship.

VHC bears the burden of demonstrating that its payments

to Ron were bona fide debts that arose from a debtor-creditor

relationship in which it expected Ron to pay VHC back in full.

VHC has not shown that it presented such evidence to the Tax

Court or that the Tax Court made grave errors in its evalua-

tion of the evidence. Because it failed to carry its burden, we

conclude that VHC’s payments to Ron were not “bad debts”

qualifying for a deduction.

B.

VHC has an alternative argument: that it could deduct its

payments to Ron as ordinary and necessary business ex-

penses, which are deductible under I.R.C. § 162. That provi-

sion provides a deduction for “all the ordinary and necessary

expenses paid or incurred during the taxable year in carrying

on any trade or business,” including salaries, travel expenses,

rentals, and payments made for continued use or possession

Nos. 18-3717 & 18-3718 7

of assets. I.R.C. § 162(a); see also Treas. Reg. § 1.162-1(a)

(providing a more comprehensive list). VHC argues that As-

sociated Bank—a creditor of both Ron and VHC—threatened

to terminate VHC’s line of credit, forcing VHC into bank-

ruptcy, if it did not float money to Ron to help him pay his

own debts to Associated.

To support its position, VHC highlights that the Tax Court

has previously determined that payments made by a taxpayer

for the benefit of a third party may be deductible as ordinary

and necessary business expenses if the taxpayer benefited

from the payment. VHC principally relies on Lohrke, in which

the Tax Court noted that generally an expense incurred to sat-

isfy the obligations of another taxpayer is not an ordinary or

necessary business expense. Lohrke v. Comm’r, 48 T.C. 679, 688

(1967); see also Baker Hughes, Inc. v. United States, 943 F.3d 255,

263 (5th Cir. 2019) (citing Lohrke). But the Tax Court “con-

clude[d] that in some situations an individual may deduct the

expenses of another person.” Lohrke, 48 T.C. at 688. To deter-

mine if a payment fell under this exception, the Tax Court

used a two-part test. First, the court would “ascertain the pur-

pose or motive which cause the taxpayer to pay the obliga-

tions of the other person,” then the court would determine if

that motive constitutes “an ordinary and necessary expense

of the [taxpayer’s] trade or business.” Id.

Here, the Tax Court determined that VHC had neither met

its burden to substantiate its claimed business expenses nor

established that the claimed business expenses, if substanti-

ated, qualified for the deduction under § 162. As for VHC’s

substantiation of the expenses, the Tax Court noted that

VHC’s records were “riddled with inconsistencies” and that

documentary evidence it provided either did not support or

8 Nos. 18-3717 & 18-3718

outright contradicted its spreadsheet purporting to list the de-

ductible expenditures.

VHC points generally to its summary records and spread-

sheets as evidence of its expenditures. But the Tax Court has

“repeatedly concluded that self-generated or nonitemized re-

ceipts or expense records are insufficient to substantiate ex-

penses.” Gorokhovsky v. Comm’r, 104 T.C.M. (CCH) 87 (2012),

aff’d, 549 F. App’x 527 (7th Cir. 2013). VHC has not pointed to

much in the way of specific evidence to bolster these general,

self-reported summaries, nor has it addressed the inconsist-

encies observed by the Tax Court, other than to comment that

one might expect some inconsistencies in records of such

large sums. That is not enough. VHC carries the burden to

highlight any error by the Tax Court, and it has not done so.

See Buelow, 970 F.2d at 415.

Even assuming VHC had substantiated these expenses,

however, we also agree with the Tax Court that VHC’s pay-

ments to Ron did not qualify as ordinary and necessary busi-

ness expenses. To qualify for this deduction, an expenditure

must (1) be paid or incurred during a taxable year, (2) be for

the purpose of carrying on a business, and (3) be an “expense”

(4) that is “necessary” and (5) “ordinary.” Comm’r v. Lincoln

Sav. & Loan Ass’n, 403 U.S. 345, 352 (1971). That Associated

required VHC to guarantee Ron’s loans does not automati-

cally make any related expenses ordinary and necessary, be-

cause “the fact that a payment is imposed compulsorily upon

a taxpayer does not in and of itself make that payment an or-

dinary and necessary expense.” Id. at 359. What’s more, even

if we assume that the payments were “necessary” for the pur-

poses of § 162, VHC has made no showing whatsoever that

such payments ordinarily occur in the paper services

Nos. 18-3717 & 18-3718 9

industry. See United Draperies, Inc. v. Comm’r, 340 F.2d 936, 937

(7th Cir. 1964) (“There is nothing to show that the practice was

a normal incident to the drapery manufacturing industry or

to suppliers of mobile home manufacturers generally.”). VHC

counters that securing access to credit comprises an ordinary

part of any business. But that oversimplifies what it says oc-

curred here. VHC’s arrangement was no simple extension of

credit by Associated. Rather, VHC and Associated entered

into a seemingly unusual arrangement through which VHC’s

credit depended on its support of a third party. The burden

rested with VHC to show that its payments to support Ron

under such an arrangement were ordinary in its industry. It

has not done so and thus cannot establish its entitlement to

the deduction.

III.

Finally, VHC argues that, if its payments to Ron did not

create bona fide debts, it should be allowed to reduce its tax-

able income in the amount of any interest that accrued on the

payments. Because VHC is an accrual method taxpayer, it de-

ducts the accrued interest on debts once it becomes entitled to

it, regardless of whether that interest is paid within the tax

year. Although the Tax Court deducted the unpaid interest

from VHC’s income, it did not deduct the relatively small

amount of interest that Ron did pay. VHC argues that all of

the interest should be deducted.

The Tax Court determined that the payments to Ron

stopped accruing interest in 2007 when VHC decided that it

did not expect repayment. VHC has pointed to no reason why

10 Nos. 18-3717 & 18-3718

this finding was clearly erroneous.1 And as for the interest

that accrued before 2007, VHC asked the Tax Court to reduce

its income only by the amount that was unpaid by Ron, not the

total amount it now requests on appeal. VHC may have com-

mitted a tactical error by limiting its request to the Tax Court,

but we will not search for error where the court below did

exactly as VHC requested. See Naeem v. McKesson Drug Co.,

444 F.3d 593, 609 (7th Cir. 2006) (“[W]hen error is invited, not

even plain error permits reversal.”). VHC asked the Tax Court

to deduct its income only by the unpaid interest amount and

the Tax Court did so for the period before 2007. Since we find

no error in the Tax Court’s determination that interest accru-

als stopped in 2007, we will not disturb its conclusion on the

interest deductions.

***

VHC has not demonstrated its entitlement to a deduction

under either I.R.C. § 166 or § 162. Nor has VHC shown any

error by the Tax Court in accounting for the interest that ac-

crued on the payments made to Ron. We therefore AFFIRM

the judgment of the Tax Court.

1VHC asserts that its records “made clear” that interest continued to

accrue on some of the payments after 2007. But its support for that prop-

osition is one blurry, illegible page of the record that appears to be an im-

age of a spreadsheet. This reference shows nothing about which payments

might have continued accruing interest or for how long, and it is nowhere

near enough to show that the Tax Court clearly erred.