Tax News
Tax Court: Fund Manager Gets Business Bad Debt Treatment for Loan to Advisor
April 04, 2011
Fund managers' compensation typically consists of two elements: a management fee--generally 1-2% of NAV (which in addition to paying the managers, is applied toward other operating expenses), and a performance fee--generally 20% of gains.  In addition, fund managers may receive an investment return from any capital they invest into the fund (typically, around 1% of the fund's capital).  The Tax Court's holding in Todd A. Dagres et ux. v. Commissioner; 136 T.C. No. 12 (March 28, 2011), indicates that the relative amouints of these components can be determinative of the issue of whether a bad debt deduction resulting from a loan made by a fund manager is (i) deductible as an ordinary loss as a business bad debt; (ii) deductible as and employee bad debt, which is a miscellaneous itemized deduction, subject to the 2-percent floor imposed by section 67 and is not deductible in computing alternative minimum tax under section 56(b)(1); or (iii) deductible only against capital losses as a bad debt relating to investment activity.

In this case, one of the managers of a fund invested primarily in internet and other technology companies made a loan to an advisor--a co-founder of internet service provider PSINet--following the bursting of the internet stock bubble in 2000, during which the advisor's holdings in PSINet and other internet companies who were customers of PSINet became almost worthless.  The IRS stipulated to the fact that the loan was made: "to preserve and strengthen his business relationship with [the advisor] in order to ensure his access to investment opportunities that [the advisor] might offer in the future. In other words, petitioner made the loan to get the first opportunity at investing in [the advisor's] next ventures, from which he would profit through a managing member interest in [the fund's general partner]."

Given this fact, after determining that the manager was involved in the trade or business of managing the investments of others for compensation, the Tax Court simply compared amounts of the three cash flows derived from the taxpayer's managing member interest in the fund GP to determine what the "dominant motivation" of the taxpayer in making the loan was, which would, in turn, determine the nature of the bad debt deduction.  

Clearly, the manager's share of the GP's 1% investment in the fund was dwarfed by his share of the GP's 20% carried interest.  As such, the IRS's argument that the "dominant motivation" for the loan was investment-related, and thus was a nonbusiness bad debt, failed.   Further, the court found that the manager's share of the carry significantly exceeded his share of the management fee, which was paid out to him as wages.  Therefore, the IRS's argument that the dominant motivation for the loan was preservation of the manager's employment likewise failed and the court held that the loan was made in connection with the manager's trade or business, and was thus deductible as an ordinary loss. 

Given the stipulation to which the IRS agreed, it seems the IRS was hanging its hat on the argument that managing a venture capital fund is an investment activity.  However, as alluded to above, the court easily rejected this argument, explaining that, "similar to any bank or brokerage firm that invests other people's money, the manager of venture capital funds provides a service that is an investment mechanism for the customer but that is a trade or business of the manager. In exchange for this service, the fund manager receives both service fees and a profits interest, but neither the contingent nature of that profits interest nor its treatment as capital gain makes it any less compensation for services."

The IRS also relied on the taxpayer's characterization of the activity to which the loan related, as shown on Schedule C to his 1040.   The taxpayer entered a code of 523900, meaning "Other financial investment activities (including investment advice)", however the court rejected this argument, noting that the taxpayer had indicated elsewhere on his return that he was in the "venture capital" business and that the IRS could not identify a more appropriate code for the business of managing venture capital funds.

Following this case, it seems clear that fund managers can benefit from business bad debt treatment with respect to loans that are motivated by a desire to protect or enhance management activities.  However, different facts, including a scenario where the manager's compensation from management fees exceeds his performance fee compensation, may result in a different outcome.
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Tags: bad debt, bad debt deduction, Dagres v. Commissioner, fund manager bad debt, Section 165, Section 166, Section 168, Section 212, Section 67