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United States Tax Court
CORRECTED
T.C. Memo. 2025-68
ANAHEIM ARENA MANAGEMENT, LLC, H&S INVESTMENTS I,
LP, A PARTNER OTHER THAN THE TAX MATTERS PARTNER,
Petitioner
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent
—————
Docket No. 16724-19.
Filed June 30, 2025.
—————
Steve Ray Mather, for petitioner.
Kevin W. Coy, Hans Famularo, Heather K. McCluskey, and Michelle A.
Monroy, for respondent.
TABLE OF CONTENTS
MEMORANDUM FINDINGS OF FACT AND OPINION ..................... 3
FINDINGS OF FACT .............................................................................. 3
I.
The Samueli entities ........................................................................ 4
II.
The Honda Center; the management agreement ............................ 4
III. Deloitte’s financial statements and AUP reports for the
Honda Center’s business activities; the financial
performance of the Honda Center business activities from
2004–16 ........................................................................................... 16
IV. AAM’s advances to fund the Honda Center’s business
activities .......................................................................................... 22
A.
The promissory notes and “Request for Advance” forms....... 22
Served 07/08/25
2
[*2] B.
V.
AAM’s advances ...................................................................... 26
Bolar and Bellew’s advice on whether AAM could claim a
bad-debt deduction; AAM’s claim of a bad-debt deduction ........... 33
VI. IRS audit and determination; the FPAA ....................................... 35
OPINION ................................................................................................ 37
I.
AAM cannot deduct its advances as a bad debts because the
advances are not debts. .................................................................. 41
A.
Names ...................................................................................... 44
B.
Maturity date .......................................................................... 46
C.
Source of payments ................................................................. 47
D.
Right to enforce repayment .................................................... 47
E.
Participation and management .............................................. 48
F.
Status equal to or inferior to other creditors ......................... 48
G.
The parties’ intent ................................................................... 50
H. “Thin” or adequate capitalization........................................... 51
II.
I.
Identity of interest .................................................................. 51
J.
Payment of interest only out of “dividend” money ................ 52
K.
The ability to obtain loans from outside lenders on
substantially similar terms .................................................... 53
L.
Conclusion ............................................................................... 53
An accuracy-related penalty is not applicable to AAM’s claim
of a bad-debt deduction because AAM had reasonable cause
for and acted in good faith in claiming the bad-debt
deduction. ........................................................................................ 53
A.
The IRS satisfied section 6751(b)(1)....................................... 56
3
[*3]
B.
1.
If Senior Counsel Coy made the IRS’s initial
determination to assert the penalty, his determination
was approved by his supervisor. ..................................... 56
2.
If Senior Counsel Coy did not make the initial
determination to assert the penalty, the initial
determination was made by RA Swann and approved
by his supervisor. ............................................................. 57
AAM had reasonable cause and acted in good faith
because Schulman reasonably relied on the advice of
Bolar and Bellew when claiming AAM’s bad-debt
deduction. ................................................................................ 58
MEMORANDUM FINDINGS OF FACT AND OPINION
MORRISON, Judge: This is a TEFRA 1 partnership-level
proceeding brought under section 6226(b). 2 We have jurisdiction under
section 6226(f). The Internal Revenue Service (IRS or respondent)
issued a Notice of Final Partnership Administrative Adjustment (FPAA)
to H&S Investments I, LP (H&S Investments), which is a member of
Anaheim Arena Management, LLC (AAM). The FPAA disallowed a
$51,465,228 bad-debt deduction AAM claimed on its tax return for the
year ended December 31, 2015, and determined a section 6662(a)
accuracy-related penalty, related to the bad-debt deduction, under
section 6662(b)(1) or (2). We sustain the IRS’s disallowance of the baddebt deduction, but we do not sustain the section 6662(a) accuracyrelated penalty.
FINDINGS OF FACT
The parties’ stipulations of fact are incorporated herein by this
reference.
1 Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), Pub. L. No. 97-
248, §§ 401–407, 96 Stat. 324, 648–71.
2 Unless otherwise indicated, references to sections to the Internal Revenue
Code, Title 26 U.S.C., in effect at all relevant times, regulation references are to the
Code of Federal Regulations, Title 26 (Treas. Reg.), in effect at all relevant times, and
Rule references are to the Tax Court Rules of Practice and Procedure. We round all
monetary amounts to the nearest dollar.
4
[*4] I.
The Samueli entities
Henry Samueli and his family own the following five business
entities, which operated in or near Orange County, California: AAM;
H&S Investments; H&S Management, LP (H&S Management); H&S
Ventures, LLC (H&S Ventures); and HS Portfolio, LP (HS Portfolio).
When referring to the five entities collectively, we will call them the
Samueli entities.
AAM is a limited liability company organized under California
law. It is treated as a partnership for federal income tax purposes.
From December 31, 2003, through June 30, 2011, the members of
AAM and their ownership percentages were (1) H&S Investments (80%),
(2) H&S Management (10%), and (3) H&S Ventures (10%). From July 1,
2011, through December 31, 2015, the members of AAM and their
ownership percentages were (1) H&S Investments (55%) and (2) HS
Portfolio (45%).
II.
The Honda Center; the management agreement
The Honda Center is a sports-and-entertainment arena in
Anaheim, California. 3
On December 16, 2003, AAM and the City of Anaheim (City)
entered into a facility management agreement (management
agreement) granting AAM the exclusive license to manage the Honda
Center on behalf of the City.
The pertinent provisions of the management agreement are
reproduced below: 4
1. Exclusive License to Operate. Effective on the
Effective Date, Owner [defined as the City] grants
Manager [defined as AAM], and Manager accepts, (a) an
exclusive license to operate the Facility [i.e., the Honda
Center] on the terms set forth in this Agreement and (b) an
3 The arena was known as the “Arrowhead Pond of Anaheim” before its name
was changed to the Honda Center. The name change occurred between July 1, 2006,
and June 30, 2007.
4 All capitalized terms in the provisions below are terms defined by the
management agreement. We have included in this Opinion only those definitions
necessary to our conclusions.
5
[*5]
exclusive right consistent, except as otherwise expressly
stated in Sections 3 and 4 below, with the usual and
customary arena industry business practices of other major
sports and entertainment facilities in the United States
owned or managed by private-sector entities (or their
affiliates), to purchase, create, produce, self-promote, copromote, coordinate and stage for the benefit of Manager
and Owner all acts and events to be held at the Facility, in
accordance with this Agreement . . . .
2. Term.
2.1 Base Term. The term of this Agreement (the
“Term”) . . . continues in effect to and including June 30,
2023 (the “Base Term”) . . . .
....
2.3 Effect of Termination.
(a) On termination of this Agreement, Manager shall
promptly deliver to Owner possession and control of the
Facility and all Personal Property[5] (or comparable
property, in substitution for the Personal Property) in
Acceptable Condition,[6] and copies of any and all records
in its custody relating to the Facility or to operations under
this Agreement.
(b) In addition, on termination of this Agreement:
5 The management agreement defined “Personal Property” as the equipment,
furniture, and fixtures of the Honda Center.
6 The management agreement defined “Acceptable Condition” as
a condition no worse than that existing on the Effective Date,
reasonable wear and tear excepted, and at least comparable to the
standards of maintenance and level of service existing at the Anaheim
Convention Center and Edison International Field of Anaheim
(making allowances for differences in age and disregarding for
purposes of determining Manager’s compliance with this standard the
effect of any major renovations or retrofitting of such other facilities)
but giving effect to ongoing Maintenance and Repairs in accordance
with this Agreement (including capital expenditures in accordance
with the Annual Budget).
6
[*6]
(i) Surrender of Funds. Manager shall surrender
control of the Operating Account, the Reserve Account, the
Insurance and Condemnation Account and the Third Party
Funds Account and all funds therein . . . .
(ii) Repayment of Operating Loans. Manager shall be
entitled to receive from Owner repayment of the
outstanding balance (unpaid principal and accrued
interest) of all Operating Loans, if any, existing as of the
termination date after application of the funds described in
Section 2.3(b)(i); provided that such Operating Loan
balances shall be paid solely from Adjusted Net Revenues
(excluding from the definition of “Adjusted Net Revenues”
for this purpose the reference to amounts paid pursuant to
Section 5.2(b)(viii)) from time to time as they become
available therefor, and any such balance due shall be
carried until paid in full; provided further that if
repayment in full of such balance is not made on the
termination date, such outstanding balance shall bear
interest at a rate of Prime plus 1% per annum, payable at
the end of each calendar month in arrears solely from
Adjusted Net Revenues (excluding from the definition of
“Adjusted Net Revenues” for this purpose the reference to
amounts paid pursuant to Section 5.2(b)(viii)), until paid in
full; and provided further that if the termination is the
result of Owner’s exercise of remedies following a Manager
Event of Default . . . , any Operating Loan balances
otherwise payable as provided in this Section 2.3 are
subject to offset for Owner’s damages, if any . . . .
....
(c) Upon termination of this Agreement, if the Net
Working Capital balance for the Facility is a negative
number as of the termination date, Manager shall restore
such Net Working Capital balance to zero by depositing to
the Operating Account an amount equal to the amount of
such negative Net Working Capital balance . . . .
3. Manager’s Duties. Manager has the exclusive
right and responsibility to manage and operate all aspects
of the Facility subject to all terms and conditions of this
Agreement. Without limiting the generality of the
7
[*7]
foregoing, but subject to the limitations set forth in Section
4 below, Manager shall do, and shall have the right to do,
the following, in each case in accordance with usual and
customary arena industry practices consistent with those
of other major sports and entertainment facilities of similar
age, size and facilities:
(a) enter into agreements for purchasing, booking,
promotion, coordination, and staging of all acts and events
to be held at the Facility, subject to the reserved rights of
Owner as described in Section 4 below;
(b) establish, maintain and administer all funds and
accounts as provided in this Agreement;
....
(e) maintain the Facility and the level of service
provided in Acceptable Condition, including all
Maintenance and Repairs;
....
8
[*8]
(g) pay when due (on a cash basis) all Operating
Expenses,[7] all Debt Service[8] . . . and the Contingent
7 The management agreement defined “Operating Expenses” as:
collectively, on a cash basis, for any period, all expenses of equipment
leases; expenses of licensing, operating, maintaining, repairing and
replacing portions of the Arena and of maintaining and operating the
Parking Areas, including (but not limited to) utilities, costs of
insurance, wages of employees of the Facility and related payroll
expense and all costs of entering into service and other contracts as
contemplated by this Agreement; costs of materials and supplies;
talent expense; advertising and promotional cost and other direct
expenses; amounts actually paid to or held back by the operator under
the Food and Beverage Concessions Contract (if included in Gross
Revenues); amounts paid to vendors from Severable Improvement
Revenues . . . ; without duplication, payments made during such period,
or deposits made during such period to the Reserve Account as
reasonable Reserves, for Maintenance and Repairs; . . . costs of third
party claims relating to use and operation of the Facility and not
covered by insurance; amounts paid over from the Operating Account
to the Insurance and Condemnation Account; all charges, assessments,
fees and taxes which may now or at any future time be imposed by any
governmental body having jurisdiction on the uses and operation of the
Facility provided for in this Agreement or on Owner’s interest in the
Facility (including any possessory interest of Manager under this
Agreement); legal and other professional fees incurred in the ordinary
course of operation of the Facility not specifically excluded below; . . .
and the Guaranteed Waiver and Consent Fee payable to the Equity
Investor pursuant to the Waiver and Consent Agreement; but
specifically excluding . . . (iii) interest and principal payments on
Operating Loans, Other Debt, [and] Debt Service Loans . . . ; (iv) 2003
Facility Financing Debt Service; (v) Capital Expenditures (except as
otherwise provided above in this definition of “Operating Expenses”);
(vi) amounts expended from the Reserve Account for Maintenance and
Repairs; [and] (vii) amounts paid out from the Third Party Funds
Account . . . .
8 The management agreement defined “Debt Service” as “collectively, the 2003
Facility Financing Debt Service and any Other Debt Service.” The management
agreement defined the “2003 Facility Financing Debt Service” as principal and interest
due in an operating year on the “2003 Facility Financing.” The “2003 Facility
Financing” was defined by the management agreement as including the “issuance by
the Anaheim Public Financing Authority of its Taxable Lease Revenue Bonds
[Anaheim Arena Financing Project] Series 2003.” Copies of these “Bonds” are not in
the record. The management agreement defined “Other Debt Service” to include “all
amounts of principal and interest due . . . on Other Debt.” “Other Debt” was defined as
“debt incurred in order to finance Additions.”
9
[*9]
Waiver and Consent Fee,[9] all as provided in Section 5.2(b),
provided that: (i) in the event that cash on hand in the
Operating Account and, as applicable, the Reserve Account
is insufficient to pay Operating Expenses and any other
amount payable pursuant to Section 5.2(b)(i), 5.2(b)(v),
5.2(b)(vi), 5.2(b)(viii), or 5.2(b)(xi), Manager shall make, or
cause an Affiliate or a third party lending institution to
make, Operating Loans for such purposes, (ii) in the event
that cash on hand in the Operating Account and, as
applicable, the Reserve Account, is insufficient to pay Debt
Service, Manager shall make, or cause an Affiliate or a
third party lending institution to make, Debt Service Loans
for such purposes . . . ;
....
(k) hire such employees or contract with others for
provision of services necessary or desirable for all
operations of the Facility which are the responsibility of
Manager under this Agreement . . . ; Manager and Owner
agree that in no event will the employees and other
personnel at the Facility be considered employees of the
City of Anaheim;
....
(x) cause an Annual Budget to be prepared . . . .
....
4.
Matters
Requiring
Owner
Consent.
Notwithstanding the powers of Manager described in
Section 3 above, the consent of Owner . . . shall be required
prior to Manager entering into any binding agreement
relating to the following:
....
9 The Contingent Waiver and Consent Fee was to be paid until January 2, 2019,
and equaled “30% of all facility net revenues for each year ended June 30 in excess of
the first $7,100,000, but not to exceed the sum of $600,000, plus a carryover amount of
up to $600,000 for each such year.”
10
[*10]
(d) making any Capital Expenditure[10] not described
in an Annual Budget;
....
5. Handling of Funds; Accounting, and Payment of
Expenses.
5.1 Handling of Funds.
(a) All funds received or held by Manager in
connection with the operation and management of the
Facility are subject to this agreement and, as applicable,
the Financing Pledges.
(b) All funds received (including Advance Deposits)
by Manager in connection with operation of the Facility
shall be deposited promptly by Manager in accounts held
and controlled by Manager for the benefit of Owner in
accordance with this Agreement . . . all in accordance with
the following:
(i) All funds other than Advance Deposits, Insurance
and Condemnation Proceeds and Reserves shall be held in
an account designated as the “Operating Account” (the
“Operating Account”).
(ii) All Advance Deposits shall be held in a
segregated Third Party Funds Account. Amounts held in
the Third Party Funds Account for disbursement to third
parties shall be paid from the Third Party Funds Account
to the Persons entitled to the same as and when the same
become due pursuant to the specific contract related
thereto. Any amounts held in the Third Party Funds
Account which are not owed to third parties shall be
transferred to the Operating Account at the time the
related revenue is recognized in accordance with generally
accepted accounting principles. Advance Deposits held in
10 The management agreement defined “Capital Expenditure” as “expenditures
for property, components, systems and structures with a useful life of not less than
three (3) years or which extend the life of the structure or improvement into which
incorporated by not less than three (3) years, having a unit cost of not less than
$10,000.”
11
[*11] the Third Party Funds Account which are required to be
refunded pursuant to the specific contract under which
such Advance Deposit was made or which otherwise
become refundable in accordance with industry custom and
practice shall be refunded to the Persons entitled to the
same.
(iii) All Insurance and Condemnation Proceeds shall
be held in a segregated account designated as the
“Insurance and Condemnation Account” (the “Insurance
and Condemnation Account”) pending application thereof
as provided in this Agreement. Amounts in the Insurance
and Condemnation Account shall be used to rebuild, repair,
replace and/or reconstruct the Facility . . . . In the event
that there are excess Insurance and Condemnation
Proceeds after completion of the related rebuilding, repair,
replacement or reconstruction, such Insurance and
Condemnation Proceeds shall be transferred to the
Operating Account. . . .
(iv) Reserves shall be held in a segregated account
designated the “Reserve Account” (the “Reserve Account”)
pending application thereof as provided in this Agreement.
Amounts held in the Reserve Account shall be used to pay
costs for which such funds were reserved, including, as
applicable, for Maintenance and Repairs as and when
needed (including Capital Expenditures) and for Operating
Expenses.
(c) Manager shall have the right to invest cash on
hand in Permitted Investments[11] from time to time,
subject to the requirements of the LILO Sublease and the
2003 Facility Financing Documents.
11 The management agreement defined “Permitted Investments” to include
“direct obligations of the United States of America and agencies guaranteed by the
United States government having a final maturity of one year or less from the date of
purchase thereof” and short-term investments in entities with the highest credit rating
from Moody’s or Standard & Poor’s.
12
[*12]
5.2 Payment of Expenses and Other Amounts.
(a) All Gross Revenues[12] and proceeds of Operating
Loans, Debt Service Loans . . . and Other Debt under this
Agreement are the property of Owner . . . and during the
Term . . . Owner grants Manager the power and authority,
and hereby directs the Manager, to collect, deposit and
distribute Gross Revenues and proceeds of Operating
Loans, Debt Service Loans . . . and Other Debt in strict
accordance with the terms of this Agreement. . . .
(b) From time to time during the Term, Manager
shall pay amounts as and when specified below during each
Operating Year from and to the extent of cash available . . .
in the following order of priority:
(i) First, as and when due, payment of Operating
Expenses;
12 The management agreement defined “Gross Revenues” as:
collectively, on a cash basis, for any period, any and all payments, fees
and deposits of every nature received by Manager or Owner (including
from any revenue streams not presently contemplated by this
Agreement) for use of the Facility or services at or in respect of rights
granted by the Facility, including revenues derived under the Food and
Beverage Concessions Contract; . . . Marquee Revenues; promotion
revenues; rent; advertising revenues; ticket agent rebates; signage
revenues; payments from the Insurance and Condemnation Account to
the Operating Account; Severable Improvement Revenues; parking
fees or taxes of any kind; facility fees or taxes of any kind; ticket fees
or taxes of any kind; vendor refunds; membership fees; sponsorship
(including, if applicable, marquee-related) and licensing fees; premium
seating fees; proceeds from the sale of programs, novelties; . . . all funds
received from any other source in connection with events held at the
Facility including rebates or rights fees paid by third parties to the
extent attributable to operations at the Facility directly or indirectly
and allocated in a manner which equitably compensates the Facility
for its proportionate contribution to such rebates or rights fees; and all
funds expressly identified in this Agreement as constituting Gross
Revenues; but specifically excluding . . . proceeds of Operating Loans,
Debt Service Loans . . . and Other Debt; and . . . earnings on Permitted
Investments.
13
[*13]
(ii) Second, on each Distribution Date . . . payment
to the Equity Investor[13] of the Contingent Waiver and
Consent Fee then due;
(iii) Third, as and when due, payment of amounts for
any LILO Claims pro rata according to the total due each
to the Equity Investor, the Trustee,[14] [and] the Equity
Investor Guarantor[15] . . . ;
(iv) Fourth, as and when due, payment of amounts
for any LILO Claims pro rata according to the total due
each to the Debt Payment Undertaker[16] and the Debt
Payment Undertaker Guarantor[17] . . . ;
(v) Fifth, as and when due, payment of items in the
Annual Budget for such Operating Year not described in
any other provision of this Section 5.2(b);
(vi) Sixth, as and when due, payment of principal of
and interest on Other Debt;
(vii) Seventh, as and when due, payment of 2003
Facility Financing Debt Service;
(viii) Eighth, payment of interest accrued on, and
repayment of the principal amount of, Operating Loans;
(ix) Ninth, payment of principal of and interest on
Debt Service Loans . . . due for such Operating Year;
13 The management agreement defined “Equity Investor” as Bankers
Commercial Corp.
The management agreement defined “Trustee” as U.S. Bank National
Association.
14
15 The management agreement defined “Equity Investor Guarantor” as
UnionBanCal Corp.
The management agreement defined “Debt Payment Undertaker” as
“American International Group, Inc. (AIG)-FP Special Finance (Cayman) Ltd.”
16
17
The management agreement defined “Debt Payment Undertaker
Guarantor” as AIG.
14
[*14]
(x) Tenth, payment of amounts then due to the
issuer of the letter of credit pursuant to the
Reimbursement Agreement;[18] and
(xi) Eleventh, on each Distribution Date . . . payment
to Manager, Owner and County of Orange of their
respective shares of Adjusted Net Revenues for the
Operating Year just ended (the “Respective Shares”),
determined as follows . . . :
(A) For any Operating Year through the end of the
Base Term, the Respective Shares shall be determined as
follows:
(1) First, the Manager shall be entitled to an amount
of Adjusted Net Revenues which, when added to the
amounts paid for such Operating Year pursuant to
Sections 5.2(b)(ii), 5.2(b)(iii), 5.2(b)(iv), 5.2(b)(vii), 5.2(b)(ix)
and 5.2(b)(x) (without any duplication of amounts
thereunder), equals $12,000,000; and
(2) Manager, Owner and County of Orange shall
share in all Adjusted Net Revenues (if any) in excess of
$12,000,000 for such Operating Year as follows:
....
(i) 5% to the County of Orange;
(ii) 20% to Owner; and
(iii) 75% to Manager;
....
18 The management agreement defined “Reimbursement Agreement” as “the
New Debt Reimbursement Agreement as defined in the Glossary.” The parties in our
case stipulated that “‘New Debt Reimbursement Agreement’ means the
Reimbursement Agreement dated as of December 16, 2003, between the City and
Westdeutsche Landesbank.” The parties stipulated that Exhibit 292-J is the “Letter of
Credit Reimbursement Agreement.”
15
[*15]
24. Miscellaneous Provisions.
24.1 Relationship. Owner is the sole and exclusive
owner of the Facility. Nothing in this Agreement shall be
construed to create a partnership or joint venture.
Manager acknowledges that Manager has no possessory or
property interest in the Facility, nor any interest in its
business or assets, except for the interest of Manager in
fees and profits strictly as described in this Agreement.
....
29. Special Obligation of Owner. Notwithstanding
anything to the contrary contained herein, the obligation of
Owner to make any payment required by or resulting from
this Agreement is a special obligation of Owner payable
only from the Gross Revenues available therefor in
accordance with the priority of payment set forth in Section
5.2(b) of this Agreement and not from any other funds or
monies of Owner. The full faith and credit of Owner is not
available for or pledged to any payment required by or
resulting from this Agreement. The obligation of Owner to
make any payment required by or resulting from this
Agreement does not constitute an obligation of Owner for
which it is obligated to levy or collect any form of taxation
or for which Owner has levied or pledged any form of
taxation or any of its property, assets, income, funds or
monies other than the Gross Revenues available therefor
in accordance with the priority of payment set forth in
Section 5.2(b) of this Agreement.
The management agreement defined “Additions” as
any of the following: (a) an addition to the original major
equipment and components of the Facility, (b) a change in
the physical structure of the Facility that results in a
material change in the uses, purpose or operations of the
Facility, (c) a replacement of or addition to the scoreboard
or audio and video capability of the Facility, or (d) any
single Capital Expenditure required under a Long-Term
Agreement whose cost is more than $50,000 (as adjusted
by the CPI Adjustment).
16
[*16] The management agreement defined “Debt Service Loan” as
a loan made by Manager, its affiliates or a third party
lending institution, the proceeds of which are used to pay
Debt Service; provided that any such loan made by
Manager or its affiliates shall bear interest at an annual
rate equal to Prime plus 1%.
The management agreement defined “Operating Loan” as
a loan (other than a Debt Service Loan . . . ) made by
Manager, its affiliates or a third party lending institution,
the proceeds of which are used to pay Operating Expenses,
interest or principal due under an Operating Loan and/or
any other amount payable pursuant to Section 5.2(b)
(including distributions of Adjusted Net Revenues) other
than Debt Service . . . ; provided that any such loan made
by Manager or its affiliates shall bear interest at an annual
rate equal to Prime plus 1%.
The management agreement defined “Prime” as “the prime rate listed
from time to time in The Wall Street Journal, which listing appears as
of the date hereof under the caption ‘Money Rates.’”
When the management agreement went into effect on December
16, 2003, AAM opened four bank accounts for the funds that it controlled
and used for the Honda Center on behalf of the City. The four accounts
were classified and governed by section 5.1(b) of the management
agreement as (1) the Operating Account, (2) the Third-Party Funds
Account, (3) the Insurance and Condemnation Account, and (4) the
Reserve Account. At all times, the funds in the four bank accounts were
the property of the City even though the accounts were opened and
controlled by AAM.
III.
Deloitte’s financial statements and AUP reports for the Honda
Center’s business activities; the financial performance of the
Honda Center business activities from 2004–16
Deloitte & Touche LLP (Deloitte) created (1) annual financial
statements of the Honda Center’s business activities, (2) combined
annual financial statements of the Honda Center’s business activities
and AAM’s business activities, and (3) Agreed-Upon Procedure (AUP)
reports of the Honda Center’s business activities. The AUP reports were
created to ensure that AAM allocated the Honda Center’s
17
[*17] revenues in accordance with section 5.2(b) of the management
agreement.
The following table shows the financial performance of the Honda
Center business activities for the fiscal years ended June 30, 2004–16,
as reported in the AUP reports:
Fiscal
year
ended
June 30
Gross
revenues
Operating
expenses
Net
revenues
Earnings on
permitted
investments
Net revenues
plus earnings
on permitted
investments
2004
$21,274,205
$15,367,071
$5,907,134
$13,147
$5,920,281
2005
27,225,036
26,767,530
457,506
164,277
621,783
2006
46,263,714
36,240,051
10,023,663
513,598
10,537,261
2007
54,280,064
42,821,860
11,458,204
820,184
12,278,388
2008
59,562,764
48,850,148
10,712,616
620,007
11,332,623
2009
59,939,129
47,125,649
12,813,480
211,520
13,025,000
2010
51,065,939
40,696,442
10,369,497
14,443
10,383,940
2011
51,733,170
43,284,434
8,448,736
17,534
8,466,270
2012
42,197,558
38,379,860
3,817,698
4,187
3,821,885
2013
41,462,672
43,071,617
−1,608,945
3,240
−1,605,705
2014
68,181,158
65,030,019
3,151,139
2,511
3,153,650
2015
79,953,080
73,999,331
5,953,749
594
5,954,343
2016
73,336,615
71,963,464
1,373,151
-0-
1,373,151
The table above reflects the following information.
Column 1 states the year-end date for the fiscal years ended June
30, 2004–16.
Column 2 states the gross revenues earned by the Honda Center’s
business activities for each fiscal year using the definition of “Gross
Revenues” provided in the management agreement. See supra note 12.
Column 3 states the operating expenses incurred during each
fiscal year using the definition of “Operating Expenses” provided in the
management agreement. See supra note 7. The management agreement
required AAM to pay the Honda Center’s operating expenses first in the
priority of payment in section 5.2(b) of the management agreement.
18
[*18] Column 4 states the Honda Center’s net revenues for each fiscal
year in accordance with the definition of “Net Revenues” in the
management agreement. The management agreement defined “Net
Revenues” as, “for any period, the positive number, if any, determined
by computing Gross Revenues for such period minus Operating
Expenses for such period.” Thus, the amounts in column 4 are calculated
by subtracting the operating expenses stated in column 3 from the gross
revenues stated in column 2.
Column 5 states the “earnings on permitted investments” for each
fiscal year in accordance with the definition of “Permitted Investments”
in the management agreement. See supra note 11.
Finally, column 6 states the combined net revenues and earnings
on permitted investments for each fiscal year. The amounts in column 6
are the sum of the net revenues stated in column 4 and the earnings on
permitted investments stated in column 5. The amounts in column 6
were the amounts of revenue and earnings that AAM had left over from
the Honda Center’s business activities to make all of the payments for
the Honda Center that are listed in section 5.2(b)(ii)–(x) of the
management agreement. Any revenues left over after AAM made the
required payments were divided between AAM, the City, and Orange
County pursuant to section 5.2(b)(xi) of the management agreement.
The table below shows the “Contingent Waiver and Consent Fee”
paid by AAM for the fiscal years ended June 30, 2004–16, as reported in
the AUP reports.
Fiscal year
ended June 30
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Amount of
payment
$325,479
0
600,000
600,000
600,000
600,000
600,000
404,621
0
0
0
0
0
19
[*19] AAM paid all amounts owed for the Contingent Waiver and
Consent Fee when due. For example, AAM paid $325,479 for the
Contingent Waiver and Consent Fee for the fiscal year ended June 30,
2004. The $325,479 payment equaled the amount owed for the
Contingent Waiver and Consent Fee for that fiscal year. Under section
5.2(b)(ii) of the management agreement, the Contingent Waiver and
Consent Fee was second in the priority of payment.
Under section 5.2(b)(iii) of the management agreement, “amounts
for any LILO Claims pro rata according to the total due each to the
Equity Investor, the Trustee, [and] the Equity Investor Guarantor” were
third in the priority of payment. During the fiscal years ended June 30,
2004–16, AAM did not make any payment pursuant to section 5.2(b)(iii)
of the management agreement because no payment was ever owed
under that provision of the management agreement.
Under section 5.2(b)(iv) of the management agreement, “amounts
for any LILO Claims pro rata according to the total due each to the Debt
Payment Undertaker and the Debt Payment Undertaker Guarantor”
were fourth in the priority of payment. During the fiscal years ended
June 30, 2004–16, AAM did not make any payment pursuant to section
5.2(b)(iv) of the management agreement because no payment was ever
owed under that provision of the management agreement.
The table below shows the amounts owed under section 5.2(b)(v)
of the management agreement for “items in the Annual Budget for such
Operating Year not described in any other provision of this Section
5.2(b)” during the fiscal years ended June 30, 2004–16, as reported in
the AUP reports:
20
[*20]
Fiscal year
ended June 30
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Amount of
expenses
$1,365,887
1,395,339
4,063,028
7,802,322
1,441,537
1,455,340
1,962,052
2,967,867
1,422,752
3,767,678
7,071,161
3,427,039
2,339,199
Beginning with the fiscal year ended June 30, 2005, AAM paid all
amounts owed under section 5.2(b)(v) of the management agreement
when due. For example, AAM paid $1,395,339 under section 5.2(b)(v) of
the management agreement for the fiscal year ended June 30, 2005. The
$1,395,339 payment equaled the amount owed under section 5.2(b)(v) of
the management agreement during that fiscal year. However, as
indicated by the AUP report for fiscal year ended June 30, 2004, of the
$1,365,887 amount owed for that fiscal year, only $956,627 was paid
(leaving $409,260 unpaid).
Under section 5.2(b)(v) of the management agreement, the
amounts in the table above were paid fifth in the priority of payment.
The table below shows the required payments for the “2003
Facility Financing Debt Service” during the fiscal years ended June 30,
2004–16, as reported in (1) the AUP reports, (2) the annual financial
statements for the Honda Center’s business activities, or (3) the
combined annual financial statements for the Honda Center’s business
activities and AAM. 19
19 The AUP reports do not state the amounts paid by AAM for the 2003 Facility
Financing Debt Service during either the fiscal year ended June 30, 2005, or the fiscal
year ended June 30, 2016. Our determination of the amounts paid by AAM during
those two fiscal years is based on the annual financial statements for the Honda
Center’s business activities and the combined annual financial statements for the
Honda Center’s business activities and AAM, which are the only information in the
record showing those amounts.
21
[*21]
Fiscal year
ended June 30
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
Amount of
payment
$3,134,560
5,055,049
5,514,190
5,433,433
5,356,733
5,279,622
5,680,509
5,531,835
5,383,161
5,234,487
5,585,513
5,368,915
5,652,009
AAM paid all amounts owed for the 2003 Facility Financing Debt
Service when due. For example, AAM paid $3,134,560 for the 2003
Facility Financing Debt Service for the fiscal year ended June 30, 2004.
The $3,134,560 payment equaled the amount owed for the 2003 Facility
Financing Debt Service during that fiscal year. Under section 5.2(b)(vii)
of the management agreement, payments for the 2003 Facility
Financing Debt Service were seventh in the priority of payment.
Under section 5.2(b)(x) of the management agreement, “amounts
then due to the issuer of the letter of credit pursuant to the
Reimbursement Agreement” were tenth in the priority of payment.
During the fiscal years ended June 30, 2004–16, AAM did not make any
payment pursuant to section 5.2(b)(x) of the management agreement
because no payment was ever owed under that provision of the
management agreement.
Under section 5.2(b)(xi)(A)(1) of the management agreement,
AAM was to receive “an amount of Adjusted Net Revenues which, when
added to the amounts paid for such Operating Year pursuant to Sections
5.2(b)(ii), 5.2(b)(iii), 5.2(b)(iv), 5.2(b)(vii), 5.2(b)(ix) and 5.2(b)(x) (without
any duplication of amounts thereunder), equals only $12,000,000.” AAM
was paid under section 5.2(b)(xi)(A)(1) of the management agreement
for two fiscal years. For the fiscal year ended June 30, 2004, AAM
received $1,163,271. For the fiscal year ended June 30, 2010, AAM
received $879,731. The amounts AAM received under section
5.2(b)(xi)(A)(1) of the management agreement were equal to the
amounts AAM was entitled to receive under that provision of the
management agreement.
22
[*22] Under section 5.2(b)(xi)(A)(2) of the management agreement,
AAM, the City, and Orange County were to divide the remaining net
revenues from the Honda Center among themselves. AAM would receive
75% of any remaining net revenues, while the City and Orange County
would receive 20% and 5%, respectively. AAM, the City, and Orange
County were never paid during any fiscal year pursuant to section
5.2(b)(xi)(A)(2) of the management agreement because the Honda
Center’s business activities never earned sufficient revenue to trigger a
payment under that provision of the management agreement.
IV.
AAM’s advances to fund the Honda Center’s business activities
While it was the manager of the Honda Center, AAM repeatedly
made advances to remedy the Honda Center’s shortfalls in funding.
These advances were of three types. First, AAM made advances that
were Operating Loans within the meaning of that term as defined in the
management agreement. Second, AAM made advances that were Debt
Service Loans within the meaning of that term as defined in the
management agreement. Third, AAM made advances to fund capital
expenditures for the Honda Center. We refer to the third type of advance
as a Capital Expenditure Loan (Cap Ex Loan), a term that is not defined
in the management agreement. Any references to AAM’s advances as
“Operating Loans,” “Debt Service Loans,” and “Cap Ex Loans” are to
distinguish the different types of advances that AAM made while
managing the Honda Center. This should not be read as a legal
conclusion that AAM’s advances are debt for tax purposes. In addition,
we sometimes refer to “interest” that AAM received on its advances. This
should not be read as a legal conclusion that the return AAM received
on the advances qualifies as “interest” for tax purposes. For reasons
discussed infra OPINION Part I, we conclude that none of the advances
is debt.
A.
The promissory notes and “Request for Advance” forms
AAM documented its advances as follows.
First, AAM executed promissory notes, each of which named
“AAM” as the lender and “the Honda Center” as the borrower. Timothy
Ryan, AAM’s chief executive officer and president, signed all of the notes
on behalf of the Honda Center. Some of the notes were signed by AAM,
too. These notes were signed on AAM’s behalf by Michael Schulman,
who was an officer of AAM and chair of H&S Ventures.
23
[*23] Even though each note named “the Honda Center” as the
purported borrower of the advances, the Honda Center is a physical
asset of the City. It is not a distinct legal entity with the legal capacity
to borrow money. Ryan, who signed all the notes on behalf of the Honda
Center, was not (1) an employee of the City or (2) authorized to bind the
City to the terms of the notes. Therefore, AAM could sue neither the City
nor “the Honda Center” to seek repayment under the terms of the notes.
AAM could enforce repayment of its advances only under the terms of
the management agreement. Under the management agreement, the
City is the recipient of AAM’s advances. 20 For simplicity, however, we
will refer to the Honda Center as the borrower in our discussion of the
notes in this section of the Opinion because that is the purported
borrower named in the notes.
Each note specified the maximum amount that the Honda Center
could owe at any specific point in time as to various types of advances.
For example, the first note, dated July 1, 2004, stated that the Honda
Center could owe up to $8 million as to all three types of advances. Thus,
under the terms of the note dated July 1, 2004, the Honda Center could
borrow up to $8 million in total advances from AAM.
When the advances from AAM reached the maximum amount
allowed under the then-current note, a new note or an amendment to
the prior note increased the maximum amount allowed. For example,
the note dated July 1, 2012, allowed the Honda Center to receive up to
$17 million in total advances as to all three types of advances. On
December 1, 2012, AAM and Ryan, on behalf of the Honda Center,
amended the note to increase the maximum amount allowed to $32
million.
Beginning on July 1, 2014, the notes separated the types of
advances as follows. One note documented the Operating Loans and the
Debt Service Loans. The second note documented the Cap Ex Loans. For
example, there were two notes dated September 30, 2014. The first note
20 Although AAM does have control of the bank accounts for the Honda Center’s
business activities, section 5.1(b) of the management agreement provides that AAM is
operating and controlling the accounts “for the benefit of [the City].” Furthermore,
section 5.2(a) of the management agreement provides that “[a]ll Gross Revenues and
proceeds of Operating Loans, Debt Service Loans, . . . and Other Debt under this
agreement are the property of [the City].” Thus, when AAM transferred the funds that
it received from its members to the bank accounts that AAM used for the Honda
Center’s business activities, the funds in that account became the property of the City.
Under the terms of the management agreement, the City is the recipient of AAM’s
advances.
24
[*24] dated September 30, 2014, stated that the Operating Loans and
the Debt Service Loans could have a combined maximum outstanding
balance of $35 million. The second note dated September 30, 2014,
stated that the Cap Ex Loans could have a maximum outstanding
balance of $11,100,000.
Each note stated that the interest rate on each advance made
with respect to the note was equal to the prime rate plus 1%.
The notes stated that the Operating Loans and the Debt Service
Loans had a maturity date one year from the date of the note. In actual
practice, however, AAM treated the Operating Loans and the Debt
Service Loans as a revolving line of credit that had no maturity date.
Whenever the maturity date was reached, AAM would carry over the
outstanding principal balance on the Operating Loans and the Debt
Service Loans to a new note with a new maturity date. The notes stated
that the entire principal balance on the Operating Loans and Debt
Service was due on the maturity date, and no payments of principal were
due before that date.
The maturity date for the Cap Ex Loans stated by the notes
varied:
Date of note or
amendment to note
Beginning of
maturity term
Length of maturity term
7/1/06
Borrowing request
Life of asset, but not less than 3 years
or more than 5 years
7/1/07
Borrowing request
Life of asset, but not more than 4 years
7/1/08
Borrowing request
Life of asset, but not more than 4 years
7/1/09
Borrowing request
Life of asset, but not more than 4 years
7/1/10
Borrowing request
Life of asset, but not more than 4 years
7/1/11
Borrowing request
Life of asset, but not more than 4 years
7/1/12
Borrowing request
(1) Life of asset, but not more than 4
years, (2) 5 years for Grand Terrace
6/26/13
Borrowing request
(1) Life of asset, but not more than 4
years, (2) 5 years for Grand Terrace
7/31/13
Borrowing request
(1) Life of asset, but not more than 4
years, (2) 5 years for Grand Terrace
9/30/14
Date of note
5 years
25
[*25] The notes dated before June 30, 2015, stated that interest on all
three types of advances was due on “the last Banking Day of each
calendar quarter.” The notes defined “Banking Day” as “any day on
which commercial banks are not authorized or required to close in Los
Angeles, California.” The last note, which was dated June 30, 2015, and
which related to Cap Ex Loans, stated that interest was due only on the
maturity date of June 30, 2016.
The notes dated before September 30, 2014, stated that principal
repayments for the Cap Ex Loans “based on the agreed upon
amortization schedule” were due on “the last Banking Day of each
calendar quarter” except for the first note, dated July 1, 2016, which
required no principal payments on Cap Ex Loans before their maturity
date. The note dated September 30, 2014, set forth an actual repayment
schedule (with dates and amounts) of principal on the Cap Ex Loans.
The first date on that schedule was June 30, 2016. Thus no principal
payments were required at the end of the fourth quarter 2014, the first
quarter 2015, the second quarter 2015, the third quarter 2015, the
fourth quarter 2015, or the first quarter 2016.
All of the notes stated that
[i]f . . . the Borrower shall fail to pay . . . interest . . . when
due and payable . . . the lender may . . . declare the unpaid
principal amount of this Note, accrued interest thereon and
all other amounts payable under this Note due and payable
whereupon the same shall be due and payable without
presentment, demand, protest or further notice of any kind
....
In addition, all of the notes stated that any failure by the Honda Center
to pay interest when due would be an “Event of Default.” All of the notes
further stated that in the Event of Default the “principal shall bear
interest from and including the date of such Event of Default until paid
in full at a rate per annum equal to the Default Rate, such interest to be
payable on demand.” All of the notes defined the “Default Rate” as “a
rate per annum equal to a floating rate of 2% above the rate of interest
otherwise payable.” Because the notes stated that the interest rate for
all advances was equal to the prime rate plus 1%, the Default Rate for
all advances was equal to the prime rate plus 3%.
All of the notes stated that “[t]he [Honda Center] shall give [AAM]
notice of each borrowing request in the form attached as Exhibit A.”
26
[*26] Exhibit A of the Notes was a “Request for Advance” form. A
“Request for Advance” form for each of AAM’s advances was introduced
into evidence. Each of the “Request for Advance” forms was signed by
Ryan on behalf of the Honda Center.
Each “Request for Advance” form included the following
information. First, the forms specified the amount of the requested
advance. Second, the forms specified the type of advance that was being
requested (i.e., an Operating Loan, a Debt Service Loan, or a Cap Ex
Loan). Third, for only Cap Ex Loans, each “Request for Advance” form
specified a maturity date. In particular, such forms specified that the
maturity date was either four or five years. This was inconsistent with
the notes, which stated that the maturity dates differed.
The “Request for Advance” forms did not include a maturity date
for either the Operating Loans or the Debt Service Loans.
To pay the principal and interest on the advances, AAM, which
managed the bank accounts used to fund the Honda Center’s business
activities on behalf of the City, would transfer the principal and interest
payments from the accounts used for the Honda Center to AAM’s own
business account. All of the payments were documented by invoices
(written by AAM to the “Honda Center”) that stated (1) the type of
advance, (2) whether only interest or both interest and principal were
being paid, (3) the amount of the payment, and (4) wiring instructions
for the payment. These invoices stated amortization schedules for the
advances, including the Cap Ex Loans, thus stating due dates for
repayment of principal on the Cap Ex Loans. We believe these
amortization schedules in the invoices were “agreed upon amortization
schedule[s]” referred to in the notes dated before September 30, 2014,
related to CapEx Loans.
To make the advances to fund the Honda Center’s business
activities, AAM received advances from its members.
B.
AAM’s advances
The table below shows AAM’s Cap Ex Loans from 2011 to 2015: 21
21 AAM made an additional $3,500,000 Cap Ex Loan on July 13, 2006. This
Cap Ex Loan was fully repaid by June 30, 2010. This means that the Cap Ex Loan
made on July 13, 2006, is not reported by AAM as part of its bad-debt deduction for
27
[*27]
Date of
advance
8/01/2011
8/01/2012
8/15/2012
12/03/2012
1/02/2013
1/10/2014
10/31/2014
Amount of
Cap Ex Loan
$2,500,000
2,500,000
2,500,000
3,000,000
2,000,000
2,000,000
900,000
The amounts in the table above are the amounts of Cap Ex Loans made
by AAM without taking into account any principal payments that AAM
received for the Cap Ex Loans. For example, AAM made a $2,500,000
Cap Ex Loan on August 1, 2011. AAM then made another $2,500,000
Cap Ex Loan on August 1, 2012.
The table below shows the interest received by AAM on the Cap
Ex Loans:
Payment
date
Amount
of interest
9/30/2011
$17,708
12/30/2011
25,275
3/30/2012
24,067
6/29/2012
22,847
9/28/2012
52,898
12/31/2012
80,791
3/19/2013
118,432
6/28/2013
112,551
9/30/2013
106,371
12/31/2013
100,126
3/31/2014
112,940
6/30/2014
107,706
9/30/2014
107,706
12/30/2014
115,384
3/31/2015
117,269
6/30/2015
118,571
2015. For simplicity, we have excluded this Cap Ex Loan from the table showing AAM’s
Cap Ex Loans.
28
[*28] The amounts shown in the table above as paid were equal to the
interest owed on the Cap Ex Loans under the terms of the notes for each
quarter. For example, under the terms of the notes, AAM was owed
$17,708 of interest on the Cap Ex Loans for the quarter ending on
September 30, 2011. As the table above shows, AAM was paid $17,708
of interest on the Cap Ex Loans on September 30, 2011. In total, AAM
received all interest on the Cap Ex Loans when due through December
31, 2015.
The interest payments for the Cap Ex Loans were calculated
using the prime rate plus 1% on the outstanding balance of the Cap Ex
Loans.
The table below shows the principal payments received by AAM
for the Cap Ex Loans:
Payment
date
Amount of
principal payment
9/30/2011
12/31/2011
3/30/2012
6/29/2012
9/28/2012
12/31/2012
3/29/2013
6/28/2013
9/30/2013
12/20/2013
3/31/2014
$121,215
113,649
114,856
116,076
363,643
501,832
575,709
581,589
587,769
594,014
692,612
AAM did not receive any principal payments for the Cap Ex Loans
after March 31, 2014. This was not within the meaning of a default of
the notes for two reasons. First, AAM waived the required principal
payment on the Cap Ex Loan due on June 30, 2014. Under the terms of
the waiver, the principal payment for the Cap Ex Loans originally due
for the quarter ending on June 30, 2014, was to be paid on September
30, 2014. Second, beginning with the note dated September 30, 2014, all
principal payments for the Cap Ex Loans (including the principal
payment due for the quarter ending on September 30, 2014) were paused
until June 30, 2016.
The Cap Ex Loans were “Other Debt” in the management
agreement. The principal and interest payments on the Cap Ex Loans
29
[*29] were sixth in the priority of payment in section 5.2(b) of the
management agreement (i.e., section 5.2(b)(vi)).
The table below shows AAM’s Operating Loans from November
17, 2004, to December 31, 2015: 22
Date of
advance
11/17/2004
12/13/2004
5/16/2005
7/06/2005
10/05/2005
11/18/2005
12/20/2006
8/01/2012
1/02/2013
3/29/2013
6/24/2013
10/25/2013
3/19/2014
5/16/2014
7/09/2014
8/28/2014
10/01/2014
12/01/2014
5/26/2015
7/07/2015
10/01/2015
12/01/2015
Amount of
Operating Loan
$4,000,000
1,600,000
2,000,000
1,000,000
1,000,000
2,500,000
1,700,000
1,000,000
1,000,000
1,000,000
2,500,000
1,500,000
900,000
1,100,000
3,500,000
1,600,000
2,400,000
2,000,000
2,500,000
1,500,000
1,500,000
1,500,000
The amounts in the table above are the amounts of Operating Loans
made by AAM without taking into account any principal payments that
AAM received for the Operating Loans. For example, AAM made a
22 An additional $2 million Operating Loan was made on January 4, 2004.
Nothing in the record specifies the exact repayment date for the $2 million Operating
Loan made on January 4, 2004; however, the annual financial statements for the
Honda Center’s business activities report that this Operating Loan was fully repaid
with interest during the fiscal year ended June 30, 2005. The Operating Loan made on
January 4, 2004, was not reported by AAM as part of its bad-debt deduction for 2015.
For simplicity, we have omitted this Operating Loan from the table showing AAM’s
Operating Loans.
30
[*30] $4 million Operating Loan on November 17, 2004. AAM then made
another $1,600,000 Operating Loan on December 13, 2004.
The table below shows the interest received by AAM on the
Operating Loans:
Payment
date
12/31/2006
3/30/2007
6/27/2007
9/27/2007
12/28/2007
3/31/2008
6/30/2008
9/30/2008
12/31/2008
4/01/2009
6/30/2009
9/30/2009
12/31/2009
3/31/2010
6/30/2010
9/30/2010
12/31/2010
3/31/2011
6/30/2011
9/30/2011
12/30/2011
3/31/2012
6/30/2012
9/30/2012
12/31/2012
3/31/2013
6/30/2013
9/30/2013
12/31/2013
3/31/2014
6/30/2014
9/30/2014
12/31/2014
3/31/2015
6/30/2015
Amount of
interest
$1,727,640
319,125
322,671
304,958
283,201
228,038
180,054
149,500
126,073
103,594
101,439
62,451
62,451
61,094
61,773
62,451
62,451
61,094
61,773
62,451
62,451
61,773
61,773
69,653
73,313
82,580
95,271
97,761
109,803
112,954
128,455
176,905
224,553
233,761
246,983
31
[*31] As can be seen above, AAM was paid $1,727,640 of interest on the
Operating Loans on December 31, 2006. Before December 31, 2006,
AAM had not been paid interest on the Operating Loans even though,
under the terms of the notes, interest should have been paid at the end
of each quarter.
In addition, AAM was paid $103,594 of interest on April 1, 2009.
As discussed supra, interest payments were due on the last banking day
of each quarter. An interest payment was therefore due on March 31,
2009, which means that the April 1 payment was late.
The interest payments for the Operating Loans were calculated
using the prime rate plus 1% on the outstanding balance of the
Operating Loans. This was inconsistent with the terms of the notes.
Because the required quarterly interest payments were not made before
December 31, 2006, the Operating Loans were in default under the
terms of the notes. The notes stated that, if the Operating Loans were
in default, the interest on the outstanding balance of the Operating
Loans would accrue at a rate equal to the prime rate plus 3% until AAM
received full payment of the principal on the Operating Loans.
Therefore, under the terms of the notes, AAM should have received more
interest on the Operating Loans than it was paid.
The table below shows the principal payments received by AAM
for the Operating Loans:
Payment
date
6/29/2007
12/31/2007
3/27/2008
6/30/2008
6/23/2009
6/28/2013
Amount of
principal payment
$800,000
500,000
750,000
2,000,000
4,000,000
2,248,998
As can be seen in the table above, AAM received few principal payments
for the Operating Loans. All but one of the principal payments occurred
from June 29, 2007, to June 23, 2009. AAM did not receive any principal
payments for the Operating Loans after the fiscal year ended June 30,
2013. Whenever there was insufficient revenue to pay the principal on
the Operating Loans, AAM waived the required principal payment and
carried over the outstanding principal balance on the Operating Loans
to the next note.
32
[*32] The principal and interest payments for the Operating Loans
were eighth in the priority of payment in section 5.2(b) of the
management agreement (i.e., section 5.2(b)(viii)).
The table below shows AAM’s Debt Service Loans from 2012 to
2015: 23
Date of
advance
11/26/2012
5/20/2013
6/24/2013
10/01/2013
12/20/2013
3/28/2014
Amount of Debt
Service Loan
$1,867,244
3,367,244
2,943,138
694,140
694,140
805,552
The table below shows the interest received by AAM on the Debt
Service Loans:
Payment
date
12/31/2012
3/31/2013
6/30/2013
9/30/2013
12/31/2013
3/31/2014
6/30/2014
9/30/2014
12/31/2014
3/31/2015
6/30/2015
Amount
of interest
$7,936
19,839
39,188
88,818
97,341
102,018
111,421
112,646
112,646
110,197
111,421
The amounts shown in the table above as paid were equal to the interest
owed on the Debt Service Loans under the terms of the notes. For
example, under the terms of the notes, AAM was owed $7,936 of interest
on the Debt Service Loans for the quarter ending on December 31, 2012.
As the table above shows, AAM was paid $7,936 of interest on the Debt
Service Loans on December 31, 2012. In total, AAM received all required
interest on the Debt Service Loans when due through December 31,
2015.
23 AAM did not make any Debt Service Loans before November 26, 2012.
33
[*33] The interest payments for the Debt Service Loans were calculated
using the prime rate plus 1% on the outstanding balance of the Debt
Service Loans.
AAM never received any principal payments for the Debt Service
Loans. Whenever there was insufficient revenue to pay the principal on
the Debt Service Loans, AAM waived the required principal payment
and carried over the outstanding principal balance on the Debt Service
Loans to the next note.
The principal and interest payments for the Debt Service Loans
were ninth in the priority of payment in section 5.2(b) of the
management agreement (i.e., section 5.2(b)(ix)).
Deloitte’s annual financial statements for the Honda Center and
for AAM reported AAM’s advances as debt.
None of AAM’s advances is debt. See infra OPINION Part I.B.
V.
Bolar and Bellew’s advice on whether AAM could claim a bad-debt
deduction; AAM’s claim of a bad-debt deduction
In March 2015, Bill Foltz became chief financial officer of the
Samueli entities. One of Foltz’s first projects as chief financial officer
was to review AAM’s performance and obligations under the
management agreement. Foltz had internal discussions with the
following individuals: (1) Ryan; (2) Schulman; (3) James Pearson, an
employee of AAM who worked as the controller for the Honda Center;
(4) David Murphy, the tax director for H&S Ventures; and (5) Bernard
Schneider, an attorney for the Samueli entities who had represented
AAM in negotiating the management agreement with the City.
Schneider advised Foltz that it was unlikely that AAM’s advances would
ever be repaid.
Foltz agreed that AAM’s advances would never be repaid, a
conclusion he explained in a memorandum to Murphy on December 31,
2015. Foltz further discussed the advances with Murphy and Schulman.
The three concluded that they should consult Dan Bolar on the
appropriate tax treatment of the advances. Bolar is a certified public
accountant (CPA) and is a partner in the accounting firm Bolar Hirsch
& Jennings (BHJ). BHJ had done accounting work for the Samueli
entities since late 2002 or early 2003 and became involved with AAM
shortly after AAM entered into the management agreement with the
City on December 16, 2003.
34
[*34] Bolar enlisted Christopher Bellew, a CPA who worked with Bolar
at BHJ, to determine the correct tax treatment of the advances. Bolar
chose Bellew to analyze the issue because Bellew was one of the most
technically proficient CPAs at BHJ. Before this project, Bellew had not
done work for AAM but had done work for other of the Samueli entities.
Both Schulman and Murphy considered Bolar and Bellew to be
experts in accounting and tax matters.
Bolar and Bellew understood that their task was to determine the
correct tax treatment of the advances.
Bellew requested and received documents from Murphy
concerning the history of AAM’s advances and the current financial
situation of the Honda Center business. These documents included (1) a
copy of the management agreement; (2) the memo from Foltz to Murphy
dated December 31, 2015, explaining why he believed the advances
would not be repaid; (3) Deloitte’s combined annual financial statements
for the Honda Center’s business activities and AAM for the fiscal years
ended June 30, 2014 and 2015; (4) the outstanding balance of all the
advances as of June 30, 2015; (5) a copy of the note for the Operating
Loans and the Debt Service Loans dated June 30, 2015; (6) a copy of the
note for the Cap Ex Loans dated September 30, 2014; (7) schedules
listing all of AAM’s advances and any principal and interest payments
received by AAM for the advances; and (8) two valuation reports from
Cogent Valuation, an independent appraiser that reviewed the advances
and the Honda Center’s business activities and concluded that all of the
advances were worthless as of December 31, 2015.
As part of his analysis of the correct tax treatment of the
advances, Bellew concluded that all of the advances were debt.
With Bolar’s help, Bellew wrote a memo, dated March 4, 2016,
stamped as a “draft,” that analyzed the appropriate treatment of the
advances. Bellew’s memo did not specifically analyze whether the
advances were debt (i.e., loans) but did refer to the advances as loans.
The memo concluded that AAM had a bad-debt deduction for the
advances for tax year 2005.
On March 11, 2016, Foltz, Murphy, Bolar, and Bellew met to
review Bellew’s memo. Whether the advances were debt was not
discussed during the meeting on March 11, 2016. Foltz and Murphy
informed Bolar and Bellew that (1) the facts as stated in Bellew’s memo
were correct and (2) there were no remaining questions or issues that
35
[*35] needed to be addressed. After the meeting with Foltz and Murphy,
Bolar and Bellew did not see a need to complete another version of
Bellew’s memo. Thus, Bellew’s memo “DRAFT” effectively became the
final opinion given by Bolar and Bellew on whether AAM could claim a
bad-debt deduction for its advances.
After March 11, 2016, but before June 16, 2016, Schulman
reviewed Bellew’s memo. Schulman had the final authority to claim the
bad-debt deduction on AAM’s return. After discussing Bellew’s memo
with Foltz and Murphy, Schulman decided to claim the bad-debt
deduction on AAM’s 2015 return.
Schulman relied on Bellew’s memo to determine whether to claim
a bad-debt deduction for its advances on AAM’s 2015 return.
The table below shows the outstanding principal and interest
balances for each type of advance as of December 31, 2015:
Type of advance
Operating Loans
Debt Service Loans
Cap Ex Loans
Total
Principal
$29,001,002
10,371,457
11,037,036
$50,409,496
Interest
$588,539
226,371
240,822
$1,055,733
Total
$29,589,541
10,597,829
11,277,858
$51,465,228
Bolar prepared AAM’s 2015 Form 1065, U.S. Return of
Partnership Income, and signed the Form 1065 as AAM’s tax preparer
on June 16, 2016. On line 12 of the Form 1065, AAM claimed a
$51,465,228 bad-debt deduction.
AAM’s 2015 Form 1065 stated that H&S Investments was AAM’s
tax matters partner for 2015. The Form 1065 gave the mailing address
for H&S Investments. The Form 1065 included Schedule K–1, Partner’s
Share of Income, Deductions, Credits, etc., for each of AAM’s members
for 2015 (i.e., HS Portfolio and H&S Investments). The Schedule K–1 for
HS Portfolio stated that HS Portfolio (1) was the “LLC membermanager” for 2015 and (2) had a 45% profits interest in AAM. The
Schedule K–1 for H&S Investments stated that H&S Investments
(1) was an “other LLC member” for 2015, (2) was not the “LLC membermanager” for 2015, and (3) had a 55% profits interest in AAM.
VI.
IRS audit and determination; the FPAA
The IRS audited the 2015 return of AAM. The audit was assigned
to Revenue Agent John Swann (RA Swann).
36
[*36] On January 30, 2019, RA Swann sent a letter to H&S
Investments purporting to designate it the tax matters partner of AAM:
H&S Investments I, LP [i.e., H&S Investments] is the Tax
Matters Partner for the Limited Liability Company year(s)
[i.e., 2015] since that person is the member-manager with
the largest profits interest as of the end of the year(s) in
question or, because that member-manager is the one
whose name appears first in the alphabetical listing of
partners with the same profits interest.
In February 2019, RA Swann concluded the audit and sent AAM
a revenue agent report (February 2019 RAR). The February 2019 RAR,
which is not in the record, did not assert a penalty. This reflected RA
Swann’s view at the conclusion of the audit, that a penalty should not
be asserted.
In April 2019, RA Swann sent AAM a new revenue agent report
(April 2019 RAR) to correct an error in the February 2019 RAR. The
April 2019 RAR, which is not in the record, did not assert a penalty.
RA Swann sent a draft FPAA regarding AAM to Kevin Coy
(Senior Counsel Coy), a senior counsel with IRS Office of Chief Counsel.
The draft FPAA did not assert a penalty.
Senior Counsel Coy determined that the FPAA should assert an
accuracy-related penalty.
On May 30, 2019, Hans Famularo (Associate Area Counsel
Famularo), who was Associate Area Counsel (SB/SE), wrote a
memorandum stating that Senior Counsel Coy had determined to assert
the accuracy-related penalty and that he approved it. Associate Area
Counsel Famularo was Senior Counsel Coy’s immediate supervisor.
On May 30, 2019, Senior Counsel Coy wrote a memorandum to
Nimfa Destreza, IRS TEFRA coordinator, explaining that Associate
Area Counsel Famularo had on that day approved Senior Counsel Coy’s
determination to assert the accuracy-related penalty. Senior Counsel
Coy advised that the Examination Division to execute a penaltyapproval form before the issuance of the FPAA.
On May 31, 2019, RA Swann completed and signed a civilpenalty-approval form determining that an accuracy-related penalty
37
[*37] should be asserted as to (1) a substantial understatement of
income tax and (2) negligence or disregard of rules and regulations.
On June 3, 2019, Rachel Houston (Acting Group Manager
Houston) signed the civil-penalty-approval form. Acting Group Manager
Houston was RA Swann’s immediate supervisor.
On June 7, 2019, the IRS mailed H&S Investments the FPAA
regarding AAM. The FPAA explained the disallowance of AAM’s baddebt deduction as follows: “Because there was no valid enforceable
obligation to pay a fixed or determinable sum of money, your bad debt
deduction was disallowed.” The FPAA made no other adjustments to
AAM’s Form 1065 for 2015. The FPAA asserted an accuracy-related
penalty related to AAM’s claimed bad-debt deduction on the basis of an
underpayment attributable to (1) a substantial understatement of
income tax and (2) negligence or disregard of rules or regulations. The
FPAA stated that the tax matters partner of AAM must file a petition
within 90 days to contest the FPAA. That deadline was September 5,
2019. The FPAA also stated that if the tax matters partner did not file
a petition within 90 days, any notice partner could file a petition within
150 days. That deadline was November 4, 2019.
On September 10, 2019, H&S Investments filed a Petition with
this Court under section 6226(b) disputing the FPAA. In its Petition,
H&S Investments stated that it was filing a Petition “in its capacity as
a partner other than the [tax matters partner].” It explained: “There is
confusion over which partner is tax matters partner. H&S Investments
. . . may be the tax matters partner but is filing this petition in its
capacity as a partner other than the tax matters partner to ensure a
valid petition.” When the Petition was filed, AAM’s principal place of
business was in California.
OPINION
Before we begin our analysis of the substantive issues in this
Opinion, we address our jurisdiction over this case. A timely-filed
petition is a prerequisite for the Court’s jurisdiction. See Seneca, Ltd. v.
Commissioner, 92 T.C. 363, 365 (1989), aff’d, 899 F.2d 1225 (9th Cir.
1990) (unpublished table decision). We conclude that AAM’s Petition
was timely.
Section 6226(a) provides that “[w]ithin 90 days after the day on
which a notice of a final partnership administrative adjustment is
mailed to the tax matters partner, the tax matters partner may file a
38
[*38] petition for a readjustment of the partnership items for such
taxable year with . . . the Tax Court.” Section 6231(a)(7) defines the term
“tax matters partner”:
(7) Tax matters partner.—The tax matters partner
of any partnership is—
(A) the general partner designated as the tax
matters partner as provided in regulations, or
(B) if there is no general partner who has been
so designated, the general partner having the
largest profits interest in the partnership at the
close of the taxable year involved (or, where there is
more than 1 such partner, the 1 of such partners
whose name would appear first in an alphabetical
listing).
If there is no general partner designated under
subparagraph (A) and the Secretary determines that it is
impracticable to apply subparagraph (B), the partner
selected by the Secretary shall be treated as the tax
matters partner. . . .
Treasury Regulation § 301.6231(a)(7)-1 provides rules for
determining which partner is the tax matters partner:
Treas. Reg. § 301.6231(a)(7)-1 Designation or selection of
tax matters partner.
(a) In general. A partnership may designate a
partner as its tax matters partner for a specific taxable
year only as provided in this section. . . . If a partnership
does not designate a general partner as the tax matters
partner for a specific taxable year, . . . the tax matters
partner is the partner determined under this section.
(b) Person who may be designated tax matters
partner—(1) General requirement. A person may be
designated as the tax matters partner of a partnership for
a taxable year only if that person—
(i) Was a general partner in the
partnership at some time during the taxable
year for which the designation is made; or
(ii) Is a general partner in the
partnership as of the time the designation is
made.
....
39
[*39]
(c) Designation of tax matters partner at time
partnership return is filed. The partnership may designate
a tax matters partner for a partnership taxable year on the
partnership return for that taxable year in accordance with
the instructions for that form.
....
(m) Tax matters partner where no partnership
designation made—(1) In general. The tax matters partner
for a partnership taxable year shall be determined under
this paragraph (m) if—
(i) The partnership has not designated
a tax matters partner under this section for
that taxable year; . . .
....
(2) General partner having the largest profits
interest is the tax matters partner. The tax matters
partner for any partnership taxable year to which
this paragraph (m) applies is the general partner
having the largest profits interest in the partnership
at the close of that taxable year (or where there is
more than one such partner, the one of such partners
whose name would appear first in an alphabetical
listing). . . . For purposes of this paragraph (m)(2),
the general partner with the largest profits interest
is determined based on the year-end profits interests
reported on the Schedules K–1 filed with the
partnership income tax return for the taxable year
for which the determination is being made.
....
(n) Selection of tax matters partner by
Commissioner when impracticable to apply the largestprofits-interest rule. If the partnership has not designated
a tax matters partner under this section for the taxable
year and it is impracticable . . . to apply the largest-profitsinterest rule of paragraph (m)(2) of this section, the
Commissioner will select a tax matters partner . . . .
Treasury Regulation § 301.6231(a)(7)-2 provides rules for
applying section 6231(a)(7) and Treas. Reg. § 301.6231(a)(7)-2 to a
limited liability company that is treated as a partnership for federal tax
purposes:
40
[*40] Treas. Reg. § 301.6231(a)(7)-2 Designation or selection of
tax matters partner for a limited liability company (LLC).
(a) In general. Solely for purposes of applying section
6231(a)(7) and § 301.6231(a)(7)–1 to an LLC, only a
member-manager of an LLC is treated as a general
partner, and a member of an LLC who is not a membermanager is treated as a partner other than a general
partner.
(b) Definitions—
....
(2) Member. Solely for purposes of this
section, member means any person who owns an
interest in an LLC.
(3) Member-manager. Solely for purposes of
this section, member-manager means a member of
an LLC who, alone or together with others, is vested
with the continuing exclusive authority to make the
management decisions necessary to conduct the
business for which the organization was formed.
Generally, an LLC statute may permit the LLC to
choose management by one or more managers
(whether or not members) or by all of the members.
If there are no elected or designated membermanagers (as so defined in this paragraph (b)(3)) of
the LLC, each member will be treated as a membermanager for purposes of this section.
Section 6226(b)(1) provides that, if the tax matters partner does
not file a petition within 90 days after the IRS mails the FPAA, “any
notice partner . . . may, within 60 days after the close of the 90-day
period set forth in subsection (a), file a petition” with the Tax Court. A
notice partner is “a partner who, at the time in question, would be
entitled to notice under subsection (a) of section 6223.” § 6231(a)(8).
Section 6223(a) requires the IRS to mail an FPAA to each partner whose
name and address is furnished to the IRS (for example, on the
partnership return, § 6223(c)(1)).
Only a tax matters partner can file a petition under section
6226(a), which permits a petition to be filed within 90 days after the
FPAA is mailed. The Petition, filed by H&S Investments, was not filed
by the 90-day deadline specified by section 6226(a).
41
[*41] Section 6226(b) provides that if the 90-day deadline imposed by
section 6226(a) expires without the filing of a petition by the tax matters
partner, any notice partner may file a petition within 60 days after the
close of the 90-day period in which the tax matters partner may petition
the court. H&S Investments was a notice partner. Therefore, its
Petition, filed on day 95, was timely. This is true even if H&S
Investments was also the tax matters partner. See Barbados #6 Ltd. v.
Commissioner, 85 T.C. 900, 904–05 (1985) (holding that a tax matters
partner who fails to file a petition by the 90-day deadline may file a
petition in its capacity as a notice partner by the 150-day deadline). We
conclude that we have jurisdiction to readjust partnership items of AAM
for 2015. See § 6226(a). As explained infra OPINION Part II, we also
have jurisdiction over the applicability of the accuracy-related penalty
for that year.
I.
AAM cannot deduct its advances as a bad debts because the
advances are not debts.
Our authority to determine the merits of AAM’s bad-debt
deduction is found in section 6221. Section 6221 provides that “the tax
treatment of any partnership item . . . shall be determined at the
partnership level.” Section 6231(a)(3) defines the term “partnership
item” to mean
with respect to a partnership, any item required to be
taken into account for the partnership’s taxable year under
any provision of subtitle A to the extent regulations
prescribed by the Secretary provide that, for purposes of
this subtitle, such item is more appropriately determined
at the partnership level than at the partner level.
Treasury Regulation § 301.6231(a)(3)-1 provides, in relevant part:
Treas. Reg. § 301.6231(a)(3)-1(a) In general. For purposes
of subtitle F of the Internal Revenue Code . . . , the
following items which are required to be taken into account
for the taxable year of a partnership under subtitle A of the
Code are more appropriately determined at the
partnership level than at the partner level and, therefore,
are partnership items:
(1) The partnership aggregate and each
partner’s share of each of the following:
42
[*42]
(i) Items of income, gain,
deduction, or credit of the partnership;
loss,
AAM’s bad-debt deduction is a “deduction . . . of the partnership,” Treas.
Reg. § 301.6231(a)(3)-1(a)(1)(i), and is thus a partnership item. We have
jurisdiction to readjust the FPAA’s adjustment to that deduction.
The burden of proof is borne by H&S Investments. In general, the
IRS’s adjustments reflected in an FPAA are presumed correct, and the
taxpayer has the burden of proving that the IRS’s adjustments are
erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933);
Republic Plaza Props. P’ship v. Commissioner, 107 T.C. 94, 104 (1996).
Section 7491(a)(1) shifts the burden of proof as to any factual issue to
the IRS if the “taxpayer introduces credible evidence with respect to any
factual issue relevant to ascertaining the liability of the taxpayer for any
tax imposed by subtitle A or B” and if the taxpayer satisfies the
conditions in section 7491(a)(2). A taxpayer bears the burden of proving
that the conditions in section 7491(a)(2) are satisfied. See Higbee v.
Commissioner, 116 T.C. 438, 440–41 (2001). Because H&S Investments
has neither contended nor adduced evidence that the requirements of
section 7491(a)(2) are met, section 7491(a)(1) does not shift the burden
of proof to the IRS. Therefore, H&S Investments has the burden of
proving that the IRS’s adjustment in the FPAA to AAM’s bad-debt
deduction is erroneous. Additionally, H&S Investments has the burden
of proving that the accuracy-related penalty does not apply. See Rule
142(a)(1); Green Valley Invs., LLC v. Commissioner, T.C. Memo. 202515, at *37.
Section 166(a)(1) allows a deduction against ordinary income for
“debt which becomes worthless within the taxable year.” Thus, a baddebt deduction under section 166(a)(1) is allowed if (1) there is a debt
owed to the taxpayer and (2) that debt became worthless during the
taxable year.
Whether AAM’s advances became worthless during 2015 is not at
issue. 24 Therefore, AAM can deduct its advances as bad debts if they are
debts.
24 The FPAA explained the disallowance of AAM’s bad-debt deduction as
follows: “Because there was no valid enforceable obligation to pay a fixed or
determinable sum of money, your bad debt deduction was disallowed.” Thus, by its
terms, the FPAA did not disallow AAM’s bad-debt deduction on the grounds that the
43
[*43] Treasury Regulation § 1.166-1(c) provides: “Only a bona fide debt
qualifies for the purposes of section 166. A bona fide debt is a debt which
arises from a debtor-creditor relationship based upon a valid and
enforceable obligation to pay a fixed or determinable sum of money.” The
U.S. Court of Appeals for the Ninth Circuit, to which appeal of this case
will lie absent stipulation by the parties otherwise, see § 7482(b)(1)(E),
considers the following factors for determining whether there is a debt
for federal income tax purposes:
(1) the names given to the certificates evidencing the
indebtedness; (2) the presence or absence of a maturity
date; (3) the source of the payments; (4) the right to enforce
the payment of principal and interest; (5) participation and
advances had not become worthless during 2015. The IRS’s Answer similarly did not
assert that the advances did not become worthless during 2015. It was only on
September 18, 2020, shortly before the scheduled October 29 and 30, 2020, trial that
the IRS asserted that the advances did not become worthless during 2015.
On September 18, 2020, the IRS moved for a continuance on the grounds that
it needed more time to prepare for trial on the issue of whether AAM’s advances were
debt. At the beginning of the Motion, the IRS stated there were two issues for trial:
(1) whether the advances were debt and (2) if the advances were debt, whether they
were bad debt (i.e., whether they had become worthless during 2015).
On October 5, 2020, the IRS filed its Pretrial Memorandum. The Pretrial
Memorandum asserted that the advances did not become worthless during 2015.
On October 13, 2020, the Court ordered struck the portions of the IRS Pretrial
Memorandum asserting that the advances had not become worthless during 2015. Our
Order stated that the only proper nonpenalty issue for trial was whether the advances
were debt. The Court explained that (1) the worthlessness issue had not been raised
in the FPAA, (2) the issue had not been properly pleaded by the IRS, and (3) trial of
the issue would prejudice H&S Investments.
On October 29 and 30, 2020, the first phase of the trial addressed issues other
than the applicability of the accuracy-related penalty. Relying on the Court’s Pretrial
Order of October 13, 2020, H&S Investments did not present evidence regarding the
worthlessness issue.
On February 24, 2021, after the first phase of the trial, the IRS filed a Motion
to Conform the Pleadings to the Proof under Rule 41(b)(1). The Motion sought the
Court’s permission to amend the IRS’s Answer to assert that even if the advances were
a bona fide debt, the debt did not become worthless during 2015.
On February 25 and 26, 2021, the second phase of the trial occurred, which
related only to the applicability of the section 6662(a) penalty.
On June 3, 2021, we denied by Order the IRS’s Motion to Conform the
Pleadings to the Proof because we concluded that H&S Investments would be
prejudiced if the Answer were amended to assert that the advances did not become
worthless during 2015.
44
[*44] management; (6) a status equal to or inferior to that of
regular corporate creditors; (7) the intent of the parties;
(8) “thin” or adequate capitalization; (9) identity of interest
between creditor and stock holder; (10) payment of interest
only out of “dividend” money; (11) the ability of the
corporation to obtain loans from outside lending
institutions.
A.R. Lantz Co. v. United States, 424 F.2d 1330, 1333 (9th Cir. 1970)
(quoting O.H. Kruse Grain & Milling v. Commissioner, 279 F.2d 123,
125–26 (9th Cir. 1960), aff’g T.C. Memo. 1959-110). No one factor is
determinative. Id. The ultimate inquiry is resolved by the economic
substance of the transaction, not its form. Id. at 1334.
A.
Names
The first factor to consider is the “names given to the certificates
evidencing the indebtedness.” See A.R. Lantz Co., 424 F.2d at 1333
(quoting O.H. Kruse Grain & Milling v. Commissioner, 279 F.2d
at 125–26). H&S Investments contends that this factor indicates that
the advances are debt. It argues that “every advance that became part
of one of the Three Loans was made pursuant to a Subordinated
Promissory Note.” It further argues that “[t]hese were standard notes
that clearly were labeled as debt instruments.”
Each advance is related to a note, and each such note is titled
“SUBORDINATED PROMISSORY NOTE.” The label is suggestive of
debt. See Hardman v. United States, 827 F.2d 1409, 1412 (9th Cir. 1987)
(“The issuance of a . . . note indicates a bona fide indebtedness.”).
Furthermore, the notes purport to impose on the “Borrower” (defined as
“Arrowhead Pond of Anaheim”) an obligation to repay a principal
amount to the “Lender” (defined as AAM). These words too are
suggestive of debt.
But most of the notes have only one signatory, “the Honda
Center.” The remaining notes are signed by both AAM and the Honda
Center. But the Honda Center is a building managed by AAM. It is not
a legal person with the ability to enter into an enforceable contract or
the ability to sue and be sued. Thus, the notes are not agreements
between legal persons and therefore do not constitute self-standing
contracts. Their legal significance must be found elsewhere. The actual
role of the notes is indicated by this and similar statements in their
prefaces: The “loans may be used to fund operating expenses (operating
45
[*45] loans) debt service (debt service loans) or capital expenditures
(capital expenditure loans) . . . as defined in . . . the Facilities
Management Agreement between the City of Anaheim and Anaheim
Arena Management LLC dated December 16, 2003.” This statement
correctly suggests that it is the management agreement that governs
the advances to which the notes relate.
We therefore turn to the management agreement to determine
what label it gives the advances. Again, there are words suggestive of
debt. The management agreement refers to “Other Debt,” “Operating
Loans,” and “Debt Services Loans.” It is undisputed that these terms
include the three types of advances made by AAM. The waterfall
provision of the management agreement gives sixth priority to “Other
Debt,” which indisputably includes the Cap Ex Loans. The eighth
priority is given “Operating Loans,” which indisputably includes the
Operating Loans. And the ninth priority is given to “Debt Service
Loans,” which indisputably includes the Debt Service Loans.
However, other provisions of the management agreement suggest
that the advances are not mere loans. Section 1 of the management
agreement gives AAM “an exclusive license to operate the Facility
[defined as the arena and parking lot, i.e., the Honda Center].” Section
1 of the management agreement provides that AAM has “an exclusive
right . . . to “purchase, create, produce, self-promote, co-promote,
coordinate and stage . . . all acts and events to be held at the Facility.”
Section 1 of the management agreement imposes on AAM the duty to
“maintain the Facility . . . as a sport and entertainment facility in
Acceptable Condition.” Section 3 of the management agreement imposes
further specific duties on AAM. One such duty, imposed by section 3(g)
of the management agreement, is, if there is a shortfall in the finances
of the Honda Center business, to “make, or cause . . . a third party
lending institution to make, Operating Loans or Debt Service Loans.”
Although AAM could have made up the financial shortfall through thirdparty borrowings, it did not do so. It makes advances only with its own
funds. These provisions granting AAM rights (and imposing on it duties)
as manager indicate that its advances were made as part of its
contractual role as the manager of the Honda Center.
Another relevant provision of the management agreement is a
portion of the waterfall provision, found in section 5.2(b)(11) of the
management agreement, that entitles AAM to residual profits from the
Honda Center operations. AAM was entitled to 100% of the residual
profits up to $12 million, and 75% of the residual profits above $12
46
[*46] million. The right to residual profits indicates that advances by
AAM functioned to help ensure the success of the Honda Center
business so as to increase the amount that AAM would receive as its
share of the residual profits.
Thus, the provisions of the management agreement demonstrate
that the advances were not mere loans in exchange for the promise of
repayment of principal and interest. The advances fulfilled AAM’s
contractual duty as manager of the Honda Center, imposed by sections
1 and 3 of the management agreement, satisfaction of which was
rewarded with a share of the residual profits under section 5.2(b)(11) of
the management agreement.
debt.
In conclusion, labels given the advances do not indicate they are
B.
Maturity date
The second factor that indicates debt is a maturity date. See A.R.
Lantz Co., 424 F.2d at 1333. A maturity date supports the conclusion
that an advance is a debt. See Estate of Mixon v. United States, 464 F.2d
394, 404 (5th Cir. 1972). By contrast, “[t]he absence of a fixed maturity
date indicates that repayment is tied to the fortunes of the business” and
that the advance is not a debt. Hardman, 827 F.2d at 1413. H&S
Investments argues that the existence of a maturity date in each note
indicates that the advances are debt.
A maturity date means the date by which a borrower must repay
the entire principal. See Monon R.R. v. Commissioner, 55 T.C. 345, 359
(1970) (“[A] definite maturity date on which the principal falls due for
payment, without reservation or condition, . . . is a fundamental
characteristic of a debt.”). Not all debts may have maturity dates.
All the notes to which the Operating Loans and Debt Service
Loans relate provide that the advances had a maturity date one year
from the date of the note. The notes to which the Cap Ex Loans relate
also have maturity dates. The maturity dates vary.
The mere existence of these maturity dates does not indicate that
the advances are debt.
First, under the terms of the notes, each maturity date could be
extended at the sole discretion of AAM. Because AAM controls the
money which the notes are to be paid (through its management of the
47
[*47] Honda Center), the maturity date is not a true deadline. And in
practice, AAM exercised this discretion: It decided not to repay the
Operating Loans and the Debt Service Loans on the maturity dates in
the notes. Second, the obligation to repay principal and interest could be
paid only if there were sufficient residual profits from the Honda Center
business. Third, under the provisions of the management agreement,
the investment return on the advances was not solely in the form of
interest and principal. It also made the payment in order to maximize
and preserve its share of the residual profits under section 5.2(b)(xi) of
the management agreement. By its nature, this portion of AAM’s
investment return had no maturity date on the advances.
We conclude that this factor does not indicate that the advances
were debt.
C.
Source of payments
The third factor is the “source of the payments.” A.R. Lantz Co.,
424 F.2d at 1333 (quoting O.H. Kruse Grain & Milling v. Commissioner,
279 F.2d at 125–26). When payment is limited to the borrower’s profits
or to a specific source of money, this limitation indicates that the
advance is not debt. See Hardman, 827 F.2d at 1413; Anchor Nat’l Life
Ins. Co. v. Commissioner, 93 T.C. 382, 406 (1989) (finding an advance
does not have the appearance of debt “[i]f repayment is possible only out
of corporate earnings”).
The parties to this case agree that repayment of AAM’s advances,
and payment of the Honda Center’s residual profits, is limited to the
revenues generated by the Honda Center’s business activities. H&S
Investments argues that there are many forms of debt in which the
source of repayment is limited to a specific revenue stream. See, e.g.,
Monon R.R., 55 T.C. at 360–61. But the fact that repayment of the
advances, and the payment of residual profits, can be made only from
the Honda Center’s revenues, greatly increases the uncertainty of
repayment of the advances or payment of an investment return on the
advances. See Curry v. United States, 396 F.2d 630, 634 (5th Cir. 1968)
(stating that a true lender is concerned about a reliable return on its
investment). For these reasons, this factor does not indicate that the
advances are debt.
D.
Right to enforce repayment
The fourth factor is the right of the lender to enforce repayment.
See A.R. Lantz Co., 424 F.2d at 1333. An enforceable and definite
48
[*48] obligation to repay an advance indicates the advance is a debt.
Hardman, 827 F.2d at 1413.
The notes themselves are not self-standing legal obligations
because they were executed only by AAM. Thus, the notes alone do not
evidence a right by AAM to enforce repayment of the advances. The
management agreement provides that AAM will receive payment only
if the Honda Center’s business activities produce sufficient revenues.
When the Honda Center’s business activities do not generate sufficient
revenues, AAM has no recourse to enforce repayment of the advances,
or payment of any residual profits under section 5.2(b)(xi) of the
management agreement. AAM would instead have to wait until there is
sufficient revenue before it could receive payment. There was always the
possibility that revenue would be insufficient to repay any advances to
AAM, or any investment return on these advances. We therefore
conclude that this factor does not indicate that the advances are debt.
E.
Participation and management
The fifth factor is whether the advances increase AAM’s
participation in and management of the Honda Center’s business
activities. See A.R. Lantz Co., 424 F.2d at 1333. When an advance
provides the taxpayer with a right to participate in management, this
participation indicates that the advance is not debt. See Hardman, 827
F.2d at 1413.
H&S Investments argues that this factor indicates the advances
are debt because the advances did not “[increase] AAM’s management
rights in any respect.” We disagree. AAM made the advances as part of
its duties as manager. Had AAM failed to make the advances, AAM
would have been in violation of its obligations in the management
agreement. AAM would then have been at risk of losing its right to
manage the Honda Center. Therefore, AAM’s commitment to make the
advances preserved AAM’s exclusive management rights in the Honda
Center’s business activities. This factor does not indicate that the
advances are debt.
F.
Status equal to or inferior to that of other creditors
The sixth factor is whether the putative lender has a repayment
status equal to or inferior to that of the putative borrower’s creditors.
See A.R. Lantz Co., 424 F.2d at 1333. If the advances are subordinated
to “regular” creditors, this indicates that the advances are not debt. See
49
[*49] Hardman, 827 F.2d at 1413; Am. Offshore, Inc. Commissioner, 97
T.C. 579, 603 (1991).
H&S Investments contends that this factor indicates that the
advances are debt because AAM’s advances are higher in priority in the
waterfall agreement than the claims of certain other claimants who,
H&S Investments contends, hold rights that are undisputably debt.
H&S Investment observes that principal and interest on the Cap Ex
Loans were sixth in the priority of payment, which places the principal
and interest on the Cap Ex Loans ahead of the required payments for
(1) the 2003 Facility Financing Debt Service (seventh in the priority of
payment) and (2) the Reimbursement Agreement (tenth in the priority
of payment). H&S Investments further observes that principal and
interest on the Operating Loans were eighth in the priority of payment,
that principal and interest on the Debt Service Loans were ninth in the
priority of payment, thus placing principal and interest on the
Operating Loans and the Debt Service Loans ahead of the required
payment for the Reimbursement Agreement.
We are unpersuaded of the significance of the position of the
seventh and tenth priorities in relation to the priority accorded the
advances. The obligations given the seventh and tenth priorities are not
so firm as to be clearly characterized as debt. Repayment of these
obligations appears to be contingent on sufficient revenues from the
Honda Center’s business activities. We do not conclude that the holders
of these obligations are regular creditors. See Am. Offshore, 97 T.C. at
603. We therefore do not assign great significance to the priority of these
obligations in comparison to AAM’s advances.
Furthermore, except for the seventh and eight priorities (i.e., the
2003 Facility Financing Debt Services and the Reimbursement
Agreements, respectively), the three types of advances made by AAM
were ahead of all other creditors except those who share the 11th
priority to portions of the residual profit. Furthermore, in our view,
AAM’s right to a portion of the residual profit was part of the investment
return that AAM expected to receive in exchange for all three types of
advances. This conclusion is reinforced by the low interest rate on the
advances—prime rate plus 1%. Pearson (the controller for the Honda
Center) and Robert Zadek (an expert witness in midmarket financing
called by the IRS) persuasively testified that a third party would not
have made the advances for such low rates. AAM made the advances to
satisfy its management obligations under the management agreement
and to preserve the residual profits to which it was entitled. That part
50
[*50] of AAM’s investment return on the advances was 11th in the
priority of payment and was not superior to or equal to any of the Honda
Center’s creditors.
We therefore conclude that this factor does not indicate that the
advances are debt.
G.
The parties’ intent
The seventh factor is “the intent of the parties.” A.R. Lantz Co.,
424 F.2d at 1333 (quoting O.H. Kruse Grain & Milling v. Commissioner,
279 F.2d at 125–26). This factor looks to objective evidence of the parties’
intent. See Hewlett-Packard Co. & Consol. Subs. v. Commissioner, 875
F.3d 494, 498–99 (9th Cir. 2017), aff’g T.C. Memo. 2012-135.
H&S Investments argues that three types of documents evidence
the parties’ intent to treat the advances as debt. First, H&S Investments
points to the labels of the notes documenting the advances. Second,
Deloitte completed financial statements for both AAM and the Honda
Center’s business activities, and these financial statements recorded the
advances as debt. Third, the City referred to the advances as “loans” in
the discussion section of its annual financial statements.
In our view, the “parties” to the advances consist of AAM and the
City. Although the ostensible borrower of the advances was the Honda
Center, the Honda Center is a building without legal personhood. Thus,
although the Honda Center signed the notes, the notes have no legal
significance outside the management agreement. The parties to the
management agreement were AAM and the City. The best evidence of
their intent is the management agreement itself, the provisions of which
indicate that the advances are not debt. In our view, the amounts of the
advances, as recorded on Deloitte’s financial statements, helped
measure AAM’s compliance with the management agreement and
rewards under the management agreement. They do not communicate
AAM’s view that it has a debt obligation to a borrower. That the City
referred to the advances as “loans” similarly does not communicate the
City’s view that it is a borrower.
We conclude that AAM and the City have not objectively
manifested their intent to treat the advances as debt. This factor does
not indicate that the advances are debt.
51
[*51] H.
“Thin” or adequate capitalization
The eighth factor is whether the party receiving the advance was
adequately capitalized when the advance was made. See A.R. Lantz Co.,
424 F.2d at 1333. Capitalization is often measured by comparing the
borrower’s debt to its equity. See, e.g., Bauer v. Commissioner, 748 F.2d
1365, 1368–70 (9th Cir. 1984), rev’g T.C. Memo. 1983-120. The
management agreement limited the source for payment to only the
revenues generated by the Honda Center’s business activities.
The history of payments on the Cap Ex Loans indicates that the
Honda Center earned sufficient revenues to pay principal and interest
on the Cap Ex Loans through at least March 31, 2014. But AAM did not
receive any principal payments for the Cap Ex Loans after March 31,
2014. This indicates that the Honda Center’s revenues were insufficient
to fully repay the principal payments for the Cap Ex Loans after March
31, 2014.
The history of payments on the Operating Loans and the Debt
Service Loans shows that the Honda Center’s revenues were sufficient
to at least pay the interest on the Operating Loans and the Debt Service
Loans. However, AAM received no principal payments for the Debt
Service Loans and received few principal payments for the Operating
Loans. This strongly indicates that the Honda Center’s revenues were
insufficient to fully repay the Operating Loans and the Debt Service
Loans.
Finally, part of AAM’s return was its claim to a portion of the
Honda Center’s residual profits under section 5.2(b)(xi) of the
management agreement. AAM was paid under section 5.2(b)(xi) of the
management agreement in only two of the fiscal years that AAM
managed the Honda Center. This strongly indicates that the Honda
Center’s revenues were insufficient to pay AAM residual profits under
section 5.2(b)(xi) of the management agreement.
Therefore, we conclude that this factor does not indicate that the
advances are debt.
I.
Identity of interest
The ninth factor is whether there is an identity of interest
between the creditor making the advance and the owner of the entity
receiving the advance. See A.R. Lantz Co., 424 F.2d at 1333. Evaluating
this factor involves the question of whether the putative lender owns the
52
[*52] putative debtor. See, e.g., Segel v. Commissioner, 89 T.C. 816, 830
(1987); Gooding Amusement Co. v. Commissioner, 23 T.C. 408, 418
(1954), aff’d, 236 F.2d 159 (6th Cir. 1956); see also Moughon v.
Commissioner, T.C. Memo. 1963-25, 22 T.C.M. (CCH) 94, 99–100, aff’d,
329 F.2d 399 (6th Cir. 1964). If an advance is in proportion to the
lender’s ownership interest in the borrower, this indicates that the
advance is not debt. See Hardman, 827 F.2d at 1414; Am. Offshore, 97
T.C. at 604–05. A sole shareholder’s advance is more likely committed
to the risk of the business than an advance from a creditor who is not a
shareholder. Ga.-Pac. Corp. v. Commissioner, 63 T.C. 790, 797 (1975).
H&S Investments argues that this factor indicates the advances
are debt because AAM, which made all of the advances, has no
ownership interest in the Honda Center. We disagree. Although AAM
has no ownership stake in the Honda Center—the building is owned by
the City—AAM has an equity-like stake in the profits from the operation
of the Honda Center. AAM has a right to 100% of the residual profits up
to $12 million and 75% of the residual profits above $12 million. Under
the management agreement, therefore, AAM is committed to the risk of
the business conducted at the Honda Center.
debt.
We conclude that this factor does not indicate the advances are
J.
Payment of interest only out of “dividend” money
The tenth factor is “payment of interest only out of ‘dividend’
money.” See A.R. Lantz Co., 424 F.2d at 1333 (quoting O.H. Kruse Grain
& Milling v. Commissioner, 279 F.2d at 125–26). Part of AAM’s expected
investment return on the advances was the return stated in the notes
themselves: Interest accruals at prime plus 1% on the outstanding
balance of the advances. But AAM would not receive such payment
unless the Honda Center earned sufficient revenues. Cf. Hardman, 827
F.2d at 1414 (“The company was obligated to pay regardless of whether
it had accumulated earnings and profits.”). And part of AAM’s return
was its right to a portion of the Honda Center’s residual profits. The
latter portion of AAM’s return was a variable return that would also
depend on the residual profits earned by the Honda Center. For the
foregoing reasons, we conclude that this factor does not indicate that the
advances are debt.
53
[*53] K.
The ability to obtain loans from outside lenders on
substantially similar terms
The 11th and final factor is whether the alleged borrower could
have borrowed the advances from a third-party lender on substantially
similar terms. See A.R. Lantz Co., 424 F.2d at 1333; Segel, 89 T.C. at
832–34.
AAM would not have made the advances at the same interest rate
as a third-party lender. AAM was willing to make the advances at a
relatively low interest rate (prime plus 1%) because (1) it was required
to maintain the Honda Center as a functioning arena (and thus it made
the advances including the Cap Ex Loans), (2) it was required to make
up shortfalls in the finances of the Honda Center activity (and thus it
made the Operating Loans and the Debt Service Loans), and (3) it
received a share of the residual profits form the Honda Center activity.
We therefore conclude that this factor does not indicate the
advances are debt.
L.
Conclusion
None of the 11 factors indicates that the advances were debt. We
conclude that the advances are not debt. We therefore sustain the IRS’s
disallowance of AAM’s bad-debt deduction.
II.
An accuracy-related penalty is not applicable to AAM’s claim of a
bad-debt deduction because AAM had reasonable cause for and
acted in good faith in claiming the bad-debt deduction.
For 2015, the FPAA determined an accuracy-related penalty
under section 6662(a) and (b)(1) or (2) for an underpayment attributable
to substantial understatement of income tax or negligence or disregard
of rules or regulations. The accuracy-related penalty relates only to
AAM’s bad-debt deduction; the FPAA did not make any other
adjustments to partnership items for 2015.
Section 6221 provides that “the applicability of any penalty . . .
which relates to an adjustment to a partnership item . . . shall be
determined at the partnership level.” Section 6226(f) provides that a
court’s jurisdiction as to penalties in a partnership-level case such as
this one is limited to “the applicability of any penalty . . . which relates
to an adjustment to a partnership item.” Treasury Regulation
§ 301.6221-1(c) provides that “[p]artnership-level determinations
54
[*54] include all the legal and factual determinations that underlie the
determination of any penalty . . . other than partner-level defenses.”
“[T]he court has jurisdiction in the partnership-level proceeding to
determine any penalty . . . that relates to an adjustment to a partnership
item.” Treas. Reg. § 301.6226(f)-1(a). “However, the court does not have
jurisdiction in the partnership-level proceeding to consider any partnerlevel defenses to any penalty . . . that relates to an adjustment to a
partnership item.” Id.
A substantial understatement of income tax exists if the amount
of the understatement for the taxable year exceeds the greater of (1) 10%
of the tax required to be shown on the return for the taxable year or
(2) $5,000. § 6662(d)(1). An understatement is the amount of the tax
required to be shown on the return for the taxable year minus the
amount of the tax actually shown on the return. Id. para. (2). The
understatement is calculated at the partner level, not at the partnership
level. See Murfam Enters. LLC v. Commissioner, T.C. Memo. 2023-73,
at *33. “[T]he determination of an [understatement] cannot happen at
the partnership level . . . . We can, however, still determine the
applicability of the understatement . . . penalty, at the partnership
level.” VisionMonitor Software, LLC v. Commissioner, T.C. Memo. 2014182, at *16; see also United States v. Woods, 571 U.S. 31, 41 (2013).
Section 6662(d)(2)(B) provides that the amount of the
understatement is reduced by the portion of the understatement which
is attributable to (1) the tax treatment of any item by the taxpayer for
which there is or was substantial authority for such treatment or (2) an
item for which (a) the facts affecting the item’s tax treatment are
adequately disclosed on the return and (b) there is a reasonable basis
for the tax treatment of the item by the taxpayer.
Section 6662(c) provides that “[f]or purposes of [section 6662], the
term ‘negligence’ includes any failure to make a reasonable attempt to
comply with the provisions of this title, and the term ‘disregard’ includes
any careless, reckless, or intentional disregard.” See also Treas. Reg.
§ 1.6662-3(b)(1). A taxpayer is not negligent if the position taken on the
return has a reasonable basis. Id.
The existence of negligence is determined at the partnership
level. See Oakbrook Land Holdings, LLC v. Commissioner, T.C. Memo.
2020-54, at *41 (stating that the negligence penalty is applicable when
a partnership takes a return position that is negligent).
55
[*55] The section 6662(a) penalty is not imposed if it is shown that the
taxpayer had reasonable cause for and acted in good faith in claiming a
deduction. § 6664(c)(1). Whether AAM had reasonable cause and acted
in good faith is a partnership-level defense that can be determined in
this case. See Treas. Reg. §§ 301.6221-1(c), 301.6226(f)-1(a). In general,
we determine whether a partnership had reasonable cause by
evaluating the state of mind of its general partner or member-manager.
See Superior Trading, LLC v. Commissioner, 137 T.C. 70, 91 (2011),
aff’d, 728 F.3d 676 (7th Cir. 2013). In this case, however, the authority
to claim the bad-debt deduction on AAM’s return was delegated to
Schulman. Therefore, we must evaluate Schulman’s state of mind when
he decided that AAM should claim the bad-debt deduction. See New
Millenium Trading, LLC v. Commissioner, T.C. Memo. 2017-9, at *41.
The relevant regulations provide that “whether a taxpayer acted
with reasonable cause and in good faith is [determined] on a case-bycase basis, taking into account all pertinent facts and circumstances.”
Treas. Reg. § 1.6664-4(b)(1). “Generally, the most important factor is the
extent of the taxpayer’s effort to assess the taxpayer’s proper tax
liability.” Id. “Circumstances that may indicate reasonable cause and
good faith include an honest misunderstanding of fact or law that is
reasonable in light of all of the facts and circumstances, including the
experience, knowledge, and education of the taxpayer.” Id. Good faith
reliance on the advice of an independent, competent professional as to
the tax treatment of an item may also constitute reasonable cause.
Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98–99 (2000),
aff’d, 299 F.3d 221 (3d Cir. 2002); Treas. Reg. § 1.6664-4(c)(1); see also
United States v. Boyle, 469 U.S. 241, 250 (1985). Treasury Regulation
§ 1.6664-4(c)(2) provides:
Advice is any communication, including the opinion of a
professional tax advisor, setting forth the analysis or
conclusion of a person, other than the taxpayer, provided
to (or for the benefit of) the taxpayer and on which the
taxpayer relies, directly or indirectly, with respect to the
imposition of the section 6662 accuracy-related penalty.
Advice does not have to be in any particular form.
This Court has stated that reasonable cause and good faith are
present if “(1) [t]he adviser was a competent professional who had
sufficient expertise to justify reliance, (2) the taxpayer provided
necessary and accurate information to the adviser, and (3) the taxpayer
actually relied in good faith on the adviser’s judgment.” Neonatology
56
[*56] Assocs., 115 T.C. at 99. H&S Investments has the burden of
proving reasonable cause and good faith. See Higbee, 116 T.C. at 446–47.
Section 6751(b)(1) provides that “[n]o penalty under this title
shall be assessed unless the initial determination of such assessment is
personally approved (in writing) by the immediate supervisor of the
individual making such determination or such higher level official as the
Secretary may designate.” For cases appealable to the Ninth Circuit,
supervisory approval is timely if secured before the penalty is assessed
or “before the relevant supervisor loses discretion whether to approve
the penalty assessment.” Laidlaw’s Harley Davidson Sales, Inc. v.
Commissioner, 29 F.4th 1066, 1074 (9th Cir. 2022), rev’g and remanding
154 T.C. 68 (2020); see also Kraske v. Commissioner, 161 T.C. 104, 110–
11 (2023). H&S Investments has the burden of proving that the IRS did
not satisfy section 6751(b)(1). See supra OPINION Part I.
A.
The IRS satisfied section 6751(b)(1).
We will first address whether the IRS satisfied section 6751(b)(1).
H&S Investments contends that Senior Counsel Coy did not make
the initial determination to assert a penalty. Instead, H&S Investments
argues, Senior Counsel Coy merely recommended that RA Swann
consider asserting a penalty. We need not decide whether Senior
Counsel Coy made the initial determination to assert the penalty.
1.
If Senior Counsel Coy made the IRS’s initial
determination to
assert the
penalty,
his
determination was approved by his supervisor.
If Senior Counsel Coy did make the initial determination to assert
the penalty, then that initial determination was approved by Associate
Area Counsel Famularo, Senior Counsel Coy’s immediate supervisor,
while Associate Area Counsel Famularo still had discretion as to
whether to approve the penalty determination. See Laidlaw’s Harley
Davidson Sales, Inc. v. Commissioner, 29 F.4th at 1074; Kraske, 161 T.C.
at 110–11.
57
[*57]
2.
If Senior Counsel Coy did not make the initial
determination to assert the penalty, the initial
determination was made by RA Swann and
approved by his supervisor.
But if Senior Counsel Coy did not make the initial determination
to assert the penalty, then the initial determination to assert the penalty
was made later by RA Swann (and approved by RA Swann’s immediate
supervisor, Acting Group Manager Houston). Acting Group Manager
Houston signed the Civil Penalty Approval Form on June 3, 2019. On
that date, Acting Group Manager Houston still had discretion as to
whether to approve the penalty determination. See Laidlaw’s Harley
Davidson Sales, Inc. v. Commissioner, 29 F.4th at 1074; Kraske, 161 T.C.
at 110–11. Therefore, we conclude that the IRS satisfied section
6751(b)(1).
H&S Investments makes three arguments as to why RA Swann’s
determination and Acting Group Manager Houston’s approval do not
satisfy section 6751(b)(1). All are unavailing. First, H&S Investments
contends that RA Swann made the initial determination to not assert a
penalty because RA Swann’s RARs, which were sent to AAM in
February and April 2019, did not assert a penalty. But section 6751(b)(1)
requires only that the initial determination of a penalty be approved by
the immediate supervisor of the individual making the penalty
determination.
H&S Investments next argues that there is no evidence that RA
Swann was the person who completed the Civil Penalty Approval Form
determining a penalty should be asserted. H&S Investments contends
that Acting Group Manager Houston may have been the one who
completed the Civil Penalty Approval Form.
Both RA Swann and Acting Group Manager Houston credibly
testified that RA Swann was the person who completed the Civil Penalty
Approval Form determining a penalty should be asserted. Furthermore,
RA Swann’s name appears on the Civil Penalty Approval Form as the
“Examiner.” This is persuasive evidence that RA Swann completed the
Civil Penalty Approval Form.
Finally, H&S Investments argues that there is insufficient
evidence that Acting Group Manager Houston was RA Swann’s
immediate supervisor at the time RA Swann made his penalty
determination. We disagree. An “Internal Revenue Service Designation”
58
[*58] form designates Acting Group Manager Houston as “Acting Group
Manager” from March 3 to June 22, 2019. Furthermore, Acting Group
Manager Houston credibly testified that she was RA Swann’s immediate
supervisor when RA Swann made his penalty determination. Therefore,
we find that Acting Group Manager Houston was RA Swann’s
immediate supervisor.
For all the foregoing reasons, we conclude that the IRS has
complied with section 6751(b)(1).
B.
AAM had reasonable cause and acted in good faith because
Schulman reasonably relied on the advice of Bolar and
Bellew when claiming AAM’s bad-debt deduction.
H&S Investments next argues that AAM had reasonable cause
for and acted in good faith in claiming its bad-debt deduction because
Schulman reasonably relied on the advice of its accountants, Bolar and
Bellew, when claiming the bad-debt deduction on AAM’s return. We
agree. Both Bolar and Bellew had decades of experience as CPAs and
were competent professionals with sufficient expertise to justify
Schulman’s reliance. See Neonatology Assocs., 115 T.C. at 99.
Furthermore, Murphy, on behalf of Schulman and AAM, provided
relevant and accurate information related to the advances to Bolar and
Bellew. See id. Finally, after reviewing the information they received
from Murphy, Bellew’s memo advised Schulman that AAM could claim
the bad-debt deduction on its 2015 return. Murphy, Foltz, and Schulman
all credibly testified that AAM would not have claimed the bad-debt
deduction without Bolar’s and Bellew’s advice. We thus hold that
Schulman relied in good faith on Bolar’s and Bellew’s judgment that
AAM could claim the bad-debt deduction. See id.
The IRS argues that Bolar and Bellew did not give Schulman any
advice as to whether the advances were bona fide debts. Thus, the IRS
contends, Schulman cannot rely on the opinion of Bolar and Bellew as
reasonable cause for claiming the bad-debt deduction. We disagree.
Bellew’s memo does focus on whether the advances were worthless at
the end of 2015. Schulman, Bolar, and Bellew all believed that the close
legal question for claiming a bad-debt deduction was whether the
advances were worthless in 2015. That is why Bellew’s memo addressed
the worthlessness issue. But although Bellew’s memo focused mainly on
the worthlessness issue, Schulman had sought more general advice as
to whether the advances were deductible under section 166.
Furthermore, Bellew credibly testified that, as part of his analysis, he
59
[*59] considered whether AAM’s advances were debt and concluded that
the advances were debt. Bolar and Bellew concluded that the advances
were deductible under section 166, and we find that, as part of that
conclusion, Bolar and Bellew concluded that the advances were debt.
For all the foregoing reasons, we conclude that AAM had
reasonable cause for and acted in good faith in claiming its bad-debt
deduction. Therefore, a section 6662(a) penalty is not applicable to
AAM’s claim of a bad-debt deduction. 25
In reaching our holdings herein, we have considered all
arguments made, and, to the extent not mentioned above, we find them
to be moot, irrelevant, or without merit.
To reflect the foregoing,
Decision will be entered for respondent with respect to the bad-debt
deduction and for petitioner with respect to the section 6662(a) penalty.
25 In addition to arguing that AAM had reasonable cause for and acted in good
faith in claiming its bad-debt deduction, H&S Investments makes the following
arguments. H&S Investments argues that AAM was not negligent in claiming its baddebt deduction because AAM had a reasonable basis for claiming the bad-debt
deduction. See Treas. Reg. § 1.6662-3(b)(1). H&S Investments argues that a section
6662(a) penalty for a substantial understatement of income tax is not applicable to
AAM’s claim of a bad-debt deduction because AAM (1) had substantial authority for
claiming the bad-debt deduction, see § 6662(d)(2)(B)(i), and (2) had a reasonable basis
for claiming the bad-debt deduction and adequately disclosed the deduction on its
return, see id. cl. (ii). Because we conclude that AAM had reasonable cause for and
acted in good faith in claiming its bad-debt deduction, we need not address H&S
Investments’ other arguments as to why the section 6662(a) penalty should not apply.
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