Comptroller of the Treasury v. Jalali (Ct. of Special Appeals)

Filed: January 31, 2018

Opinion by: Judge James A. Kenney III

Holding: The Court of Special Appeals held that: (1) the question of whether advances of money to a business are considered debt or equity (the “debt-equity” question) is a mixed question of law and fact; (2) in deciding the debt-equity question, the Maryland Tax Court applied correct legal principles and properly evaluated the relevant facts and circumstances when it found that a taxpayer’s advances of money to business entities were advances of debt; and (3) the Court of Special Appeals would not consider an issue not raised by the Comptroller before the Tax Court because, on judicial review of administrative agency decisions, the Court of Special Appeals is restricted to the record before the agency and generally does not consider issues not encompassed in the agency’s final decision (although the Court went on to find that a taxpayer’s advances constituted bad business debt because the record supported a finding that the taxpayer’s dominant motivation for making the advances was to protect his employment).

Facts: Taxpayer made several advances to businesses he owned or in which he had an ownership interest. Each advance was documented by a written promissory note containing a loan amount, loan period, interest rate, and other repayment terms. The interest and repayment terms of the notes were not strictly complied with or enforced. None of the advances were secured. Ultimately, the businesses failed and the advances were not repaid. Taxpayer filed amended tax returns with the Maryland Revenue Administration division and the Internal Revenue Service for the relevant tax year. The amended returns reported the unpaid advances as unreimbursed business expenses and sought a resulting carried-back net operating loss and tax refund. The Comptroller rejected the returns. Taxpayer requested a final determination, and the Comptroller issued a Notice of Final Determination denying the requested refunds, in part, because (i) proof of acceptance of one applicable return by the IRS had not been provided; and (ii) the advances were not bona fide loans. Taxpayer appealed to the Maryland Tax Court, which reversed the Comptroller’s determination and granted the requested refunds. The Comptroller filed a petition for judicial review, and the Circuit Court for Anne Arundel County affirmed the Tax Court. On appeal by the Comptroller, the Court of Special Appeals affirmed the Tax Court’s decision.

Analysis:  The Court of Special Appeals first held (in contrast to Fourth Circuit precedent) that the debt-equity question is a mixed question of fact and law. Therefore, the Court limited its review of the Tax Court decision to determining whether “a reasoning mind reasonably could have reached the factual conclusion that the Tax Court reached”. Applying this standard, the Court found that, in addressing the debt-equity question, the Tax Court properly evaluated the facts of the case in light of many of the factors deemed relevant by applicable case law, including the adequacy of capitalization of the businesses, availability of outside financing, the presence of written promissory notes, the presence of stated loan terms, the unsecured position of the advances, the failure of the businesses to comply with interest and repayment terms, the taxpayer’s subjective intent, and the source of repayments. The Court then addressed the Comptroller’s claim that, even if the advances at issue were debt, the advances were non-business bad debt and therefore not deductible. The Court held that it would not consider the argument because it had not been raised before the Tax Court, noting that “[o]n judicial review of administrative agency decisions, we do not ordinarily ‘pass upon issues presented to us for the first time on judicial review.’” Nevertheless, the Court went on to find that there was sufficient evidence in the record that the taxpayer’s “dominant motivation” in making the advances at issue was to protect his employment, and, as such, the advances constituted deductible bad business debt.

The full opinion is available in PDF.