MEMORANDUM FINDINGS OF FACT AND OPINION
William Owens has spent his career lending money for a profit, whether through business entities or out of his personal funds. One of his personal loans to a commercial laundry wound up mangled into a total loss. Owens claimed a bad-debt deduction, and the Commissioner objected. His primary argument is that Owens's private lending was not a trade or business. But he has a load of other contentions which we'll have to iron out here as well.
FINDINGS OF FACT
Owens lends money for a living now, but after he graduated from Westmount College in 1973 with a B.A. in literature he had hoped to pursue a career in property development. After college he headed in that direction and took a job with a company that harvested trees and sold timber. He spent about six months there before he took a job with a land-development company that sold campsites in the Sierra.
But his father was in the moneylending business and it wasn't long before he answered his family's call to assume his own place in the firm.
Owens's Lending Career
The call came because Owens's father had lent money to a cemetery that fell behind on its payments. He dispatched Owens to assess the situation, and it turned out that the borrower had stolen the cemetery's trust fund. It was routine for Owens's father to take over the day-to-day operations of a failed debtor to make the best of a bad deal. (The industry term for this is a "workout".) Owens was told to do just that. So for the next 2-1/2 years Owens ran the cemetery and tried to fix its problems. The Owenses eventually took a loss on the loan, but less of one than they might have. Owens soon took on a second workout and then "reluctantly" went to work for his father. Whatever reluctance he might have felt in his youth couldn't mask his skill in the business. It didn't work out horribly in the end: He, and what is now his company, have made billions from loans over the last 35 years. Here are the entities he uses.
Owens Financial Group
When Owens's father ran the moneylending business it was called Owens Mortgage Co., but under Owens's reign it became Owens Financial Group, Inc. (OFG). OFG is a mortgage-broker company that arranges commercial loans. Owens has been the president of OFG for more than 20 years and owns a majority interest in it. OFG sits in a niche corner of that market—it offers short-term bridge financing when long-term funding is unavailable or too expensive. OFG lends mostly to investors who want to buy (or sometimes sell) income-producing property and who need quick financing to close a deal. After they close, it's possible for them to spend several months looking for a better long-term deal from a more traditional lender. Loan terms at OFG are typically only around 18 months and earn an interest rate of between 7 and 11 percent.
Much of OFG's business originates from referrals—attorneys or accountants who have a client that needs to borrow money fast—but OFG also gets its fair share of cold calls. The firm has a reputation for both "performance" and speed. They can give borrowers a simple yes-or-no answer on their loan application within just a couple days. And if the answer is yes, OFG moves right ahead and closes the deal. Owens's personal reputation is impressive too—both colleagues and competitors testified credibly that he is regarded as one of the best in the business. One employee even compared Owens's likeness to that of a god—Plutus, perhaps.
OFG typically gets about ten inquiries for every one it considers, and of course it does not approve every application it considers. The number of inquiries, applications, and loans depends on the broader economy. In the early 2000s, when the real-estate market was strong, the lending business was strong too. But after the crash in 2008, OFG was "practically out of business." It had several projects that were under water and it didn't have the capital to make new loans. The firm survived and began to thrive again after 2013, and Owens estimates that since then, it's made about 40 loans a year. This kind of bridge financing has always been a risky proposition, and Owens estimates that since he started working for OFG, the firm has made more than $2.5 billion in loans and had to foreclose on about $225 million of them.
The Investment Fund
During the years at issue, loans brokered by OFG were funded by the Owens Mortgage Investment Fund (Investment Fund). The Investment Fund is a publicly registered limited partnership that OFG manages as its general partner. The Investment Fund's portfolio includes both loans and real property nationwide.
Owens's Personal Lending
In addition to his responsibilities at OFG and the Investment Fund, Owens also makes loans from his personal assets, and he has done so since at least 1986. He explained during trial that the return on a personal loan was higher than any return that he'd see at a bank and that because his lack of experience made him uncomfortable investing in the stock market, he instead invested his assets by way of loans. Owens credibly explained that these personal loans typically were to borrowers too risky for OFG, and his willingness to make them depended less on the value of any assets they might be backed by than it did on his belief in the borrower and his business model. He testified that "they're very talented people in the world doing things, and they have stories tied to real estate. They're going to transform a property or develop something or do something with a property [and] there's a captivating story that goes with it."
Funds for Owens's personal lending came from his trust,
Owens does not, and did not during the years at issue, keep a separate office for business related to his personal lending ventures. He instead conducted his personal business out of OFG. OFG staff handled all correspondence, documentation, and legal issues arising from Owens's personal lending. OFG staff also managed loan servicing throughout the duration of a loan. There was a file for each loan that included the underwriting documentation, legal documentation, and any security agreements. At the end of the day, the only difference between Owens's loans and OFG's loans is that the money goes into a different "bucket". Owens believes that because he's been the president of OFG since 1996, there would have been "no point" in having a separate office. He views OFG employees as his employees.
In 2002 Owens began a series of loan transactions with a businessman named David Lohrey. Lohrey was in the laundry business. He'd started a laundry company in 1971 with his two older brothers called West Coast Linen, and together they grew it to become the largest commercial laundry in the San Francisco Bay Area. They serviced all the major hotel chains—Hyatt, Marriott, and even Hilton. They also serviced hospitals throughout northern California. But in the early '80s, Lohrey's brothers wanted to retire and he bought their shares of the company.
By that point Lohrey's largest corporate customer was Marriott—his company serviced several of its hotels in the Bay Area. They had a longstanding relationship, and it wasn't long before Marriott approached Lohrey with a deal: Marriott would buy a 50% stake in Lohrey's laundry and start a company called Marriott Services that would bundle laundry with other services such as housekeeping and janitorial work. The business grew and became successful. Marriott bought Lohrey's stake, though he kept a finger if not a hand in the old business by continuing to own a commercial site in Gilroy (the Garlic Capital of the World and a thriving town south of the Bay Area) through Lohrey Investments, LLC. He leased this site to Marriott as a giant commercial laundry and he also worked as a consultant for the chain until about 2002. That was the year Marriott sold Marriott Services to a French company named Sodexo. Sodexo then downsized and decided to close the Gilroy laundry. Before it did so, however, Sodexo offered Lohrey an option to buy back the business. Lohrey exercised that option and in 2003 opened Lohrey Enterprises, d/b/a West Coast Linen.
He at first thought he would resell the operation or at least find someone else to lease it to.
Owens's Loans to Lohrey Investments
Owens reviewed the Gilroy property as well as Lohrey Investments' newly purchased laundry equipment and determined that they were worth $20 million. He also determined that OFG would be able to lend Lohrey Investments $7.5 million. Because that wouldn't be enough to pay off the current loan with Bank of America, Owens agreed to personally advance Lohrey Investments additional funds to "bridge the gap." Owens had appraisals of Lohrey Investments' equipment drawn up and gathered Bank of America's appraisals of the Gilroy property before he issued the advances.
Everything checked out, and in July 2003 OFG made a $7.5 million loan to Lohrey Investments secured by a first deed of trust on the Gilroy property. A month later Owens made a personal loan to Lohrey Investments for $2.75 million. The loan was funded by Owens Trust and the FLP and had a 15% interest rate, required monthly payments, and had a maturity date of September 2005. This loan was secured by a second deed of trust on the Gilroy property, and unlike OFG's loan to Lohrey Investments, it was a "participating" loan. It gave Owens the right to participate in income over a certain threshold—something Owens explained is fairly typical when a lender takes a junior position in a transaction. "[T]here's more risk and you want a greater reward." Owens credibly testified that he forecasted Lohrey Investments would be in "growth mode" for at least the next two years. West Coast Linen did begin to grow rapidly and won more contracts from the San Francisco hotel industry. Lohrey Investments soon needed more equipment, and Owens was happy to keep the funds flowing. Everything went as planned with the first several loans, and Lohrey Investments kept up with its monthly payments, but that changed when it fell behind. Owens's business relationship with Lohrey Investments was about to get a lot more personal.
The Operating Agreement
Lohrey hit a point with West Coast Linen where he needed cashflow to expand the business, to increase profit margins, and ultimately to pay off his creditors. Owens understood this, so when Lohrey Investments fell behind on its payments, he remained patient. Owens was willing to wait for payments on his personal loans, especially because it meant Lohrey Investments would at least be making payments on the OFG loan. The economy was stable, and Owens didn't think he had cause for concern. Believing Lohrey was the best solution to his own problem, Owens deferred to his judgment for some time until he decided to exercise his option to acquire ownership in the company.
In December 2005, on the advice of an attorney, Owens entered into an operating agreement with Lohrey himself. The operating agreement—which was admitted into evidence—made Owens Trust a member of Lohrey Investments with a 30% share of profit, 99% share of loss, and 30% of capital. We find based on this agreement that it was a workout—Owens did not contribute any fresh money. Owens was named the tax matters partner
The K-1s reported net rental-real-estate losses of almost $4 million for 2006 and $2.8 million for 2007. Owens deducted each of these losses against the debt basis of the $16 million in loans he'd made to Lohrey Investments.
Owens's and Lohrey's new arrangement, however, didn't sate Lohrey's hunger for additional capital, and later in 2005 Lohrey approached Owens for a $20 million loan to pay off old debt and expand the laundry again. But Owens and OFG were tapped out. That's when Owens recommended that Lohrey talk to Vestin Mortgage, Inc. Lending funds to Lohrey Investments at this point though was risky business, and the only way Vestin would do it was if Owens subordinated his own loans to Vestin. Owens agreed, but he didn't do so lightly.
Owens still believed in Lohrey's ability to run the laundry and thought that with Vestin's capital Lohrey would be able to get the business somewhere. He credibly explained that he had concerns. Owens felt his investment might be in "a dire situation" but even so, there was a glimmer of hope: Lohrey had begun negotiating a deal with Kaiser Industries to take over the laundry for 16 of their hospitals. Commercial laundering on this scale has low marginal costs and Owens took a calculated risk to subordinate his loans to Vestin so that Lohrey might succeed, and in turn, Owens would see a higher return. We specifically find that even though this business strategy failed in the end, it was nonetheless reasonable at the start.
In June 2006 Vestin lent $16 million to Lohrey Investments secured by the Gilroy property and the equipment within it. Lohrey Investments used part of the Vestin loan to fully repay OFG, but not Owens's personal loan. In anticipation of a deal with Kaiser, Lohrey Investments also used Vestin's money to buy more equipment to handle more laundry.
West Coast Linen Folds
Lohrey did win the Kaiser contract. But in hindsight Owens believed that Lohrey had underbid the contract and that it was costing West Coast Linen more to process the laundry than the contract was bringing in. The end was near. Owens believed Lohrey ignored professional advice to cut off the hotel business and get things under control when the problem came to light. Lohrey Investments became delinquent on the Vestin loan. In August 2008 Vestin recorded a notice of default to protect its security interest in the Gilroy property. Lohrey was still not convinced that the contract price was the problem; he focused instead on Kaiser's taking 60-90 days to pay its invoices and tried to work out a deal for immediate debit that he thought would increase his cashflow. It didn't work. Even though Lohrey Investments was processing about 150-175 tons of laundry a day, there's no making up on volume when one loses money on every sale, and the business couldn't make the $500,000 bi-weekly payroll for its 700 employees.
It was October 2008, the start of the Great Recession, and Lohrey was out of options. Owens had made many personal loans to Lohrey Investments, all memorialized in promissory notes. We summarize them here:
West Coast Linen
West Coast Linen filed for chapter 11 bankruptcy that month. It was meant only as a delay tactic until Lohrey could get an automatic-debit system in place, but it ended in disaster. After meeting with the acting chapter 11 trustee,
Lohrey solemnly described his memory of that morning. The trustee had padlocked the gate to West Coast Linen around midnight. By about 4 or 5 a.m. that morning, Lohrey's phone started ringing off the hook—hotels, hospitals, employees—no one could get in the building, and no one knew what was going on. This was devastating: Hospitals and hotels typically have only three to four sets of linens—one on the bed, one on the shelves, and at least one being washed. And both industries rely on their laundry services. Lohrey said that as a result of the padlock, "you now have thousands and thousands of sick people in hospitals literally laying on mattresses with no sheets, no gowns, no operating * * * literally overnight you had 25,000 people with no towels, no sheets, and no surgeries."
This was the end of West Coast Linen. In late November 2008 its chapter 11 bankruptcy was converted to a chapter 7 bankruptcy, and when it was, the company—though it couldn't operate—still listed $4,835,000 in assets and only $1,255,000 in liabilities. In January 2009 the Owens Trust and Vestin each began an adversary proceeding in bankruptcy court to determine the nature and extent of their respective interests in machinery, equipment, and fixtures. Neither recovered anything by the time the bankruptcy case closed in December 2010.
As we noted above, Vestin recorded a notice of default on the Gilroy property in August 2008. Owens, as trustee of Owens Trust and member of the FLP, filed a notice of default for a portion of his loan by October. He filed another, as trustee of Owens Trust, a week later. Vestin then filed a notice of trustee sale on the Gilroy property. The amount owed to Vestin at the time was almost $23 million.
The Gilroy property was Lohrey Investments' major asset, and by January 2009 it followed West Coast Linen into bankruptcy. According to the filing, Lohrey Investments had liabilities of $44 million and assets of $14.5 million. An operating report filed in March of that year revised these numbers—it showed assets worth $31 million and liabilities of $43 million. That still meant insolvency, and maybe Owens had some hope of some recovery—the parties stipulated that he filed proofs of claim as the trustee of Owens Trust and as a member of the FLP.
In the end the Gilroy property, water rights, and laundry equipment were sold for only $4.1 million—the proceeds of which were distributed pursuant to a settlement between the secured creditors. This bankruptcy closed in May 2012 and Owens recovered nothing.
For Lohrey, the end of the story came early in 2009. He had signed personal guaranties on all his loans, and he and his wife were forced into filing for bankruptcy themselves. Their assets totaled $2.8 million, but their liabilities exceeded $50 million. This bankruptcy proceeding also became a liquidation and led to their discharge a few months later. Lohrey—with a mispriced contract and a business hungry for capital at the worst possible time—became an example that not all entrepreneurial risks pay off, even with 35 years of hard work. Owens recovered nothing from this bankruptcy either. He didn't recover a penny.
We return to Owens—despite having some interest in these three related bankruptcy cases, he recovered not a cent through them. But they did at least generate a deduction. He turned to a CPA to prepare his returns for the 2008, 2009, and 2010 tax years. The same CPA also prepared amended returns for his 2003, 2004, and 2005 tax years. This CPA advised Owens that his loss on the loan with Lohrey Investments entitled him to a bad-debt deduction under section 166. Owens took this advice and claimed a $9.5 million bad-debt loss expense on his 2008 tax return. On the advice of his CPA, he also claimed an NOL carryforward for the 2009 and 2010 tax years and amended his 2003, 2004, and 2005 tax years to claim a carryback for those years. Owens also claimed a multitude of Schedule C deductions related to his personal lending business for the 2008 and 2009 tax years. The Commissioner determined to deny the bad-debt deduction and associated carrybacks and carryforwards in a single notice of deficiency. He also denied Owens the Schedule C deductions that he claimed. The total of the deficiencies is more than $3 million.
Owens was a California resident when he timely filed a petition. We tried the case in San Francisco.
OPINION We have three issues:
Owens argues that he has been in the business of making personal loans on a continual and regular basis for years. He also argues that the loans he made to Lohrey Investments created bona fide debts and that those debts then became wholly worthless in 2008 when West Coast Linen filed for bankruptcy after the trustee padlocked the building in Gilroy. The Commissioner doesn't think that Owens's lending activity amounted to a trade or business and even if it did, the Lohrey loans were more equity than debt. Even if they were debts, they didn't become worthless in the 2008 tax year.
These arguments all mirror section 166. That section allows a deduction for a bona fide debt that becomes worthless within a taxable year. Sec. 166(a); sec. 1.166-1(c), Income Tax Regs. It requires that:
We will discuss each requirement in turn.
Trade or Business
For Owens's moneylending activity to be considered a trade or business he must have been involved in the activity with continuity and regularity—with the primary purpose of earning income or making a profit.
The Commissioner first argues that even if Owens made enough loans over the years, his source of funds was the FLP and not himself personally. We find that Owens's personal lending activities were continuous and regular by themselves.
From 2003 through 2008—the most crucial years in this case—Owens made approximately 33 loans totaling over $21 million, including $17 million in Lohrey loans. This period was not unusual—money had been Owens's stock in trade since the first days of his career, and lending had long since become his vocation. We are convinced that, over the years, he had fallen into the understandable and prudent habit of lending money raised from the public through OFG to more secured and better risks; the riskier-but-still-promising loans he took on for himself.
The Commissioner reasonably points out that Owens did not personally maintain records regarding the loans he made—staff at OFG did that for him. OFG treated documentation related to Owens's lending the same as it did its own: It kept a file for each loan that included the underwriting documentation, legal documentation, and any security agreements. OFG kept additional documentation when a borrower was in default, including correspondence, notices, and forbearance agreements. OFG also kept records of existing loans reflecting the balances, summary of payments, and due dates.
Should any of this count against Owens? We don't think so. Remember that the question we're asking is whether his personal lending was a trade or business. The answer to this question is more probably "yes" the more his personal-lending activity looks like the activity of a traditional lender—in contrast, say, to the activity of someone who writes a personal check to his brother-in-law and then bugs him about repaying it every so often. That Owens kept good records of his loans in exactly the same way OFG kept records on its loans very much suggests that Owens was treating his personal lending as a continual and regular activity.
We've addressed this issue before. For example, in
The Commissioner next asserts that Owens failed to prove how much time he spent making personal loans. Owens testified that he generally spent an average of 50 hours at work each week and did not distinguish the time he spent on lending from his personal funds from the time he spent on lending from OFG's funds. We recognize this as an officially approved factor-to-be-considered but also find that the toilsome drudgery of measuring out one's days in six-minute increments is rarely found among our more entrepreneurial countrymen—they are more inclined to focus on getting the chore in front of them done as efficiently as possible than on keeping detailed time sheets. And on the facts of this case, we find, as we have in similar cases, that Owens had no need to bill specific hours on his personal lending while managing OFG.
The Commissioner argues, and we do not disagree, that Owens did not advertise his availability to make personal loans. But we also find that he didn't need to any more than the taxpayers in
The Commissioner's final argument focuses on Owens's relationship with Lohrey. He claims that a reasonable businessman in the lending business would not subordinate his loans to a third-party lender, especially when the borrower is underwater. But we've already found that given his options, Owens did act reasonably. We're being consistent here: In
We find that Owens lent from his personal funds continuously and regularly and did so with the purpose of making a profit. He was therefore in the trade or business of lending money during the years at issue.
Bona Fide Debt
That Owens was in the moneylending business is not by itself enough to make his failed loans to Lohrey deductible. He must also show that they were bona fide debt. A bona fide debt is one that "arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money."
Each of Owens's purported loans to Lohrey Investments—both before and after the 2005 operating agreement between the parties—was evidenced by "promissory notes." This shows a general intent between Owens and Lohrey to form a genuine debt.
"The presence of a fixed maturity date indicates a fixed obligation to repay, a characteristic of debt obligation."
Source of Payments
If the source of repayment is dependent on earnings, it is indicative of equity.
Right to Enforcement
An enforceable and definite obligation to repay an advance indicates the existence of a bona fide debt.
Participation in Management
When a taxpayer receives a right to participate in management, or some increase in ownership interest, in exchange for an advance, that participation tends to demonstrate that the advance was an equity investment—not a bona fide debt.
We specifically do not find that Owens received an ownership interest in Lohrey Investments in exchange for his previous advances. By that point it had been a year since Owens advanced any money to Lohrey Investments. After he acquired his interest, he didn't advance further funds until 2007—two years later. And the operating agreement does not indicate that Owens made a contribution at the time or note previous loans. Other cases show a more direct correlation. For example, in
Status Equal or Inferior to Other Creditors
It is commonplace practice that equity participants take subordinate positions to creditors regarding rights to payments upon liquidation.
Owens unequivocally subordinated his advances to Vestin, but he did so only in an effort to recover his initial advances. While this factor does favor the Commissioner, it is not determinative.
The Parties' Intent
"[T]he inquiry of a court in resolving the debt-equity issue is primarily directed at ascertaining the intent of the parties".
We find credible both Owens's and Lohrey's testimony on this issue. Lohrey testified that he wanted a lender for Lohrey Investments. Owens treated Lohrey like a potential debtor from their first meeting: He reviewed Lohrey's laundry business and had appraisals drawn up for the Gilroy property and business equipment. The Commissioner argues that Owens didn't act like a regular lender when he later helped Lohrey Investments find additional funding, but we see nothing necessarily investor-like, and not creditor-like, here. Lohrey Investments had become distressed; distressed debtors need more capital or some other refinancing help to survive. And it's often in the creditor's interest to help find a solution lest his existing debt become even more distressed.
"Thin" or Adequate Capitalization
There is caselaw that says advances to meet the daily needs of a corporation are indicative of bona fide indebtedness,
Identity of Interest
Advances in proportion to the stockholder's capital interest will lead to a finding that the advance was an equity investment.
Payment of Interest Out of "Dividend" Money
Similarly to factor 3 of this analysis, we look to the source of the payments. We focus though, on how the parties treated interest.
The Ability of the Corporation To Obtain Loans From Outside Lending Institutions
If a corporation is able to borrow funds from an outside source at the time of the advance, the transaction looks more like a bona fide debt.
After looking at all these factors, we find that Owens's advances to Lohrey Investments created bona fide debts.
Owens has only one more hurdle to clear.
We've found that Owens was in the trade or business of lending money during the years at issue, and we've found that his advances to Lohrey Investments were bona fide debts. Owens may therefore deduct these as worthless debt, but for what year? Owens says 2008.
The Commissioner disagrees. This is also a question of fact.
Lohrey's laundry business had been struggling for many years despite promising opportunities. Once West Coast Linen filed for bankruptcy, and Lohrey was hung out to dry by the trustee, Owens knew Lohrey was doomed. The padlock on the door meant Lohrey was going to lose his primary client, and his reputation, with little hope for a comeback. Lohrey even told Owens that Lohrey Investments was going to file for bankruptcy in 2008. We find that this showed Lohrey Investments was not going to be able to repay its debt. And in a battle over collateral, Owens was going to lose to Vestin.
The Commissioner asserts that Lohrey still believed in 2008 that Lohrey Investments' equipment and property were worth more than its liabilities, and that without proof that Lohrey's subjective belief was not true, Owens's belief that he would not recover anything on his loan to Lohrey Investments has no weight. We can think of no reason why we would give Lohrey's subjective belief at the time more merit than the facts and circumstances surrounding Owens's belief that the value of the property was "very small relative to the debt." In fact, we can take into consideration subsequent events to prove the reasonableness of this belief.
Finally, the Commissioner argues that because Owens filed a proof of claim, he must have expected at least some recovery. While a proof of claim may indicate that a taxpayer had some hope for recovery, we are reluctant to determine the outcome of this case based on Owens's steps to secure his place in the order of distribution. "No single factor is conclusive as there are no absolutes in this area."
Because Owens was involved in the trade of business of lending money during the years at issue and his advances to Lohrey Investments during the years constitute bona fide debt that became worthless in 2008, he is entitled to the claimed bad-debt deduction. The Commissioner had additionally asserted section 6662 penalties for the 2008 and 2010 tax years, but we've found for Owens and thus this issue is moot.