The matter that I thought was over and done with when I filed my 2005 personal taxes in 2006 resurfaced in 2008.  In a letter dated February 13, 2008 (the letter erroneously showed 2007) and postmarked February 15, 2008, the same IRS Revenue Agent from 2005 stated that he wished to visit me to see proof that the loans in the business bad debt deduction were actually loans and not capital contributions.  The letter included an Infor­mation Document Request for a few documents from the original corporation.  On March 17, 2008, the Agent visited me and reviewed the documents I provided, which included various sup­porting documents such as promissory notes, 1099-INT forms (interest paid on loans,) and check registers showing loan checks written and repayments made. 

After reviewing the docu­ments, the Agent stated that he could see that the funds were truly loans as claimed, but then informed me that he would research the timing of the deductions, and also might have to reclassify the loans as capital contri­butions.  Sur­prised by his response to what I thought was a simple issue, I reminded him of his very logical statement in 2005 that the bad debt could be recognized in the year it occurred, or in the year of a triggering event, which in this case was the audit.  He acknowledged that state­ment, and then indicated that the final determination had yet to be made, and that he would get back to me.

On June 4, 2008, the Agent came to my dealership and presented me with the audit conclusion.  Shockingly, he informed me that the bad debt deduction I had taken on my 2005 personal return was being disallowed, as the IRS had reclassified the funds I had loaned the original corporation as capital contributions.  The tax liability calculation for 2005 and 2006 came to $94,509 plus interest, for a total of $111,488.  No penal­ties were assessed.  The conclusion did not change the amount of the loss, only the fact that the IRS had reclassified it from a loan to “equity interest.”   I reacted with shock that the IRS would ignore the fact that the funds were clearly loans.  While the IRS acknowledged that the loans were truly just that, in order to disallow the deduction it took the position that corporation was “thinly capitalized,” and then chose to reclassify them. 

In the course of the conversation with the Revenue Agent concerning the seemingly illogical conclusion, I asked him to explain the conflicting events.  I stated my confusion that his current ruling was inconsistent with his 2005 statement that a bad debt could be recog­nized when it occurred or in the year of a triggering event.  As the bad debt occurred in 2005 when the IRS ended the consulting agreement and thus the old corporation’s ability to repay the debt it owed me personally, it appeared to be indisputable.  A notation of this statement was included in my 2005 tax return.  I also asked him why in 2008 I was asked to furnish proof that the funds were in fact loans, only to have the fact dis­regarded after I satisfied his request.  The Agent explained that at the time he had initially been assigned my 2005 tax return for review, he attempted to “survey” it.  He explained “survey” to mean that he determined that the return should stand as submitted with no changes or further action necessary.  He went on to say that his Manager wouldn’t accept that, and returned my tax return to him for further work. 

I asked the Agent how often his Manager overruled his con­clusions, to which he replied that it was a rare occurrence.  While he did his best to support the position, it was quite apparent by the Agent’s lack of conviction in his verbal explan­ation, as well as his seem­ingly embar­rassed manner, that he was not morally comfortable with the conclusion he was required to deliver as a result of his Manager’s decision.  It is unfor­tunate that the seemingly know­ledgeable, ethical, and professional Agent who met with me was thrust into this awkward position apparently against his will.  In light of the above, it clearly appeared that it was the Manager, not the Agent, who determined the disallowance of the deduction, and then asked the Agent to craft a supporting conclusion to attempt to justify his decision.  As will be discussed later, I later received IRS internal documents that substantiate the Agent’s statements and my observations. 

The Agent explained my payment and appeal options, to which I responded that I would discuss it with my CPA.  I later did so, and while my CPA felt we could successfully appeal the decision, I considered the many factors currently weighing on me, and in July 2008 reluc­tantly paid the tax.  I had also factored into my decision the fact that I had expected to reach an settlement in my lawsuit with GM in which it would pay me a fair price for my franchises, which would produce a long-term capital gain that would be partially offset by the capital loss that resulted from the Agent’s final determination.  While the tax savings would have only been 15% of the approximately $350,000 capital loss, as opposed to 33% if it were a bad debt deduction, it would at least salvage some tax benefit from the loss.   It is important to note that I strongly disagreed with the disal­lowance of the deduc­tion, but paid it only to avoid the additional time, stress, and expense of fighting it amid my lawsuit against GM and GMAC, and a severely deteriorating auto business that necessitated my running the sales department nearly singlehandedly.