The IRS may treat unreported income as taxable income even if a taxpayer claims the amounts represent repayments for a loan.
In a new case, Dufresne, TC Memo 2019-93, 7/25/19, the Tax Court ruled that purported loan repayments constitute taxable income based on eight factors, in a result the taxpayer probably should have seen coming.
The taxpayer was a resident of California and his mother was a well-known psychic who appeared on television, wrote books and gave lectures. During the tax years 2010 through 2013 the taxpayer worked full-time as a psychic counselor for his mother’s business, an S corporation. He performed as many as seven psychic readings a week. Clients were charged $200 for a 30-minute reading.
The taxpayer didn’t have access to the corporation’s books and records. Following his mother’s death, he became the sole heir of her estate and the corporation. The corporation was dissolved in 2015.
The IRS indicated that the taxpayer had unreported taxable cash deposits totaling more than $1.5 million for 2010-13. According to the taxpayer, these cash deposits represented repayments he received from his mother on loans for payment of past due federal taxes and the purchase of real estate properties.
Although she was in debt at the time of her death, the taxpayer claimed that he had not discussed his mother’s financial affairs with her and wasn’t aware of her net worth. From 1985 to 2007, the taxpayer purchased five real estate properties, including a timeshare in Mexico and four properties in California. He produced a letter, with his mother’s signature, dated January 1, 2008, which stated that she owed him more than $1.1 million for the five real estate purchases.
According to the taxpayer, he lent his mother money to pay a federal tax liability. He produced a letter dated February 1, 2010, with his mother’s signature, which attested that she owed him about $300,000 for past due federal taxes.
In 2010, he was not aware that his mother had tax liens against her or the amount of back taxes she owed. But the taxpayer didn’t draft any formal documents about the loans before the extension of the funds.
Both letters produced by him are addressed “To Whom It May Concern” and have only his mother’s signature. Also, the letters do not mention how or when repayment is to occur, a rate of interest or any collateral or a security.
The IRS reconstructed the taxpayer’s income for 2010-13 using the bank deposit method to determine taxable income of more than $1.5 million. The Tax Court examined the following factors to determine whether the cash deposits received were repayments of loans:
- The ability of the borrower to repay
- The existence or nonexistence of a debt instrument
- Security, interest, a fixed repayment date and a repayment schedule
- How the parties’ records and conduct reflect the transaction
- Whether the borrower has made repayments
- Whether the lender had demanded repayment
- The likelihood that the loans were disguised compensation for services
- The testimony of the purported borrower and lender
After analyzing these factors, the Court concluded that the purported loans do not withstand heightened scrutiny to be considered bona fide loans. The lack of records and substantiating evidence was particularly detrimental to the taxpayer’s claims.
Result: The cash deposits constitute unreported taxable income.