Business Advances in Revenue-Sharing Deals Not Deductible – Houston Tax Attorneys

Government agencies and non-profits often enter into business arrangements with private companies that, ultimately, are structured as a percentage of revenue. This approach frequently replaces traditional fixed payments like rent or management fees.

The typical example involves a building that a business owns and leases to a government agency or non-profit. The business collects a percentage of the fees or other revenues collected from the end users of the building in lieu of receiving traditional rent payments. The arrangement may also be structured as a management fee or labeled some other way.

There are also instances where the parties’ roles are switched, with the business being the tenant and the government or non-profit being the landlord. The central aspect of these arrangements is typically a type of revenue-sharing agreement. The rent or other payments may look more like business income to the business rather than rental income.

But what if the parties do not negotiate a fair deal or a deal that turns out to work economically? For example, what happens when the end users do not generate enough money to pay for the ongoing expenses of the business operationand the business advances funds to cover the shortfall? If this advancement is not paid back, is this a bad business debt and deductible as such? Or is it a capital contribution that adds to the business basis and cannot be immediately deducted?

The case of Anaheim Arena Management

The case of Anaheim Arena Management, LLC v. Commissioner, T.C. Memo. 2025-68, addresses this debt-versus-equity distinction and provides guidance on when business advances in revenue-sharing arrangements qualify for immediate tax relief.

Facts & Procedural History

AAM is a limited liability company that manages the Honda Center arena in Anaheim, California. It operates under an exclusive management agreement with the City of Anaheim.

The Samueli family owns AAM through a network of related entities. AAM’s management contract granted it the right to operate the arena and receive a share of residual profits. The agreement also imposed obligations to maintain the facility and cover operational shortfalls.

Between 2004 and 2015, the Honda Center consistently struggled to generate sufficient revenue to cover its expenses. The management agreement required AAM to make advances when the arena faced funding shortfalls. AAM ultimately advanced approximately $51.5 million in three categories: Operating Loans to cover day-to-day expenses, Debt Service Loans to meet bond obligations, and Capital Expenditure Loans for facility improvements.

Each advance was documented with promissory notes bearing interest at prime plus one percent. The notes designated “the Honda Center” as the borrower, even though the arena was merely a building owned by the City with no legal capacity to borrow money. Under the management agreement’s waterfall provision, AAM was to be repaid from arena revenues only if sufficient funds remained after paying higher-priority obligations.

By 2015

By 2015, it became clear that the Honda Center would never generate enough revenue to repay the advances. AAM claimed a $51.5 million bad debt deduction on its 2015 partnership return. The IRS conducted an audit and disallowed the deduction. The IRS also imposed accuracy-related penalties under Section 6662. AAM petitioned the U.S. Tax Court to challenge both the deduction disallowance and the penalties.

What Qualifies as a Bad Debt Under Section 166?

The tax code provides a deduction for business bad debts under Section 166. This allows taxpayers to deduct debts that become wholly or partially worthless during the taxable year.

The deduction is based on the economic reality that businesses sometimes extend credit or make loans that cannot be collected. The idea is that the tax system should not penalize taxpayers for such legitimate business losses by having the business pay tax on all of its income, given the financial loss that it incurred.

As with every deduction, there are nuances. Section 166 has requirements that taxpayers have to satisfy to claim bad debt deductions. The main requirements is that the debt has to become worthless during the tax year. For business debts, the deduction is treated as an ordinary loss rather than a capital loss. This treatment typically provides more favorable tax treatment since ordinary losses can offset ordinary income without limitation.

The regulations under Section 166 define the scope of deductible debts–adding more explanation. Treasury Regulation Section 1.166-1(c) states that “only a bona fide debt qualifies for the purposes of section 166.” The regulation defines a bona fide debt as “a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.”

This regulatory definition requires more than just docume…

This regulatory definition requires more than just documentation labeled as a loan or promissory note. The substance of the relationship must reflect the characteristics typically associated with arm’s length debt transactions. Based on this, the courts examine whether the parties intended to create a genuine creditor-debtor relationship or whether the advance served other business purposes.

When Must a True Debtor-Creditor Relationship Exist?

When is there a true debtor-creditor relationship? According to the courts, this relationship must be based on a valid and enforceable obligation to repay a specific amount. The obligation cannot be contingent on business success or dependent on factors beyond the borrower’s control.

A valid debtor-creditor relationship requires several elements. The debtor must have legal capacity to incur the obligation. There must be consideration for the debt–meaning the debtor received something of value in exchange for the repayment obligation. The terms must be sufficiently definite to allow enforcement through legal proceedings if necessary.

The enforceability requirement means that the creditor must have realistic legal remedies available if the debtor defaults. If the purported creditor cannot pursue collection through normal legal channels, courts may question whether a true debt relationship was intended. This is particularly problematic when the purported debtor lacks assets or legal capacity to be sued.

Courts also examine whether the parties treated the arrangement as a genuine debt relationship. If the creditor repeatedly waives payment obligations, extends maturity dates without penalty, or subordinates repayment to all other business obligations, these actions may indicate that no true debt was intended. The behavior of both parties has to be consistent with a genuine lending relationship.

How Do Courts Distinguish Debt from Equity in Tax Cases?

Federal tax law has long grappled with distinguishing debt from equity in various contexts. The characterization affects not only bad debt deductions but also interest deductibility, dividend treatment, and numerous other tax consequences. Courts have developed multi-factor tests to analyze the economic substance of purported debt relationships.

The Ninth Circuit applies an eleven-factor test to determine debt versus equity status. These factors include the names given to the instruments, the presence of a maturity date, the source of payments, the right to enforce payment, participation in management, subordination to other creditors, the parties’ intent, capitalization adequacy, identity of interest between creditor and debtor, payment of interest only from earnings, and the ability to obtain third-party financing on similar terms. As it is a factor analysis, no single factor is determinative in this analysis. Courts examine the totality of circumstances to determine whether the advance represents a genuine arm’s length debt transaction or an investment in the business.

With that said, the more an advance resembles typical commercial lending practices, the more likely it will be characterized as debt. Conversely, advances that are subordinated to other creditors, lack enforcement mechanisms, or depend entirely on business success for repayment tend to be characterized as equity investments.

This type of debt-versus-equity analysis recognizes that business owners sometimes provide funding to their enterprises that, despite formal documentation as loans, function economically as capital contributions. The tax consequences differ based on whether the arrangement is debt or equity.

Tax Conseuqnces of Debt vs. Equity

The distinction between debt and equity can result in dramatically different tax consequences for both the advancing party and the recipient.

When an advance is characterized as debt, the advancing party can potentially claim a bad debt deduction under Section 166 if the debt becomes worthless. This deduction is available in the year the debt becomes worthless. Business debts receive ordinary loss treatment. Ordinary loss treatment allows the deduction to offset ordinary income without limitation. This can provide an immediate tax benefit.

For the recipient of debt financing, interest payments are generally deductible business expenses under Section 162. The principal amount of the debt does not create taxable income when received. This is because borrowed funds must be repaid. Upon repayment, the principal amount is not deductible. This represents return of borrowed capital.

When an advance is characterized as equity, the advancing party cannot claim an immediate deduction when the investment becomes worthless. Instead, the loss is generally recognized only when the equity interest is sold, exchanged, or becomes completely worthless under Section 165. This can delay the tax benefit for quite some time.

For partnerships and limited liability companies treated as partnerships, equity contributions increase the partner’s outside basis in their partnership interest. Losses from the entity can flow through to partners, but only to the extent of their basis in the partnership. This basis limitation can prevent immediate recognition of losses even when the business fails.

When the partnership or LLC is ultimately dissolved or th…

When the partnership or LLC is ultimately dissolved or the partner’s interest becomes worthless, the partner may recognize a capital loss equal to their remaining basis. However, capital losses are subject to significant limitations. Individual taxpayers can only deduct $3,000 of net capital losses per year against ordinary income, with excess losses carried forward to future years.

Corporate taxpayers face even more restrictive rules for …

Corporate taxpayers face even more restrictive rules for capital losses. Capital losses can only offset capital gains, with no deduction against ordinary income. Unused capital losses can be carried back three years and forward five years, but many corporations lack sufficient capital gains to absorb large capital losses.

Suffice it to say that this is an area where advance tax planning can help avoid unexpected tax liabilities.

How Did the Tax Court Analyze AAM’s Advances?

The tax court applied the eleven-factor test to AAM’s advances and found that none of the factors supported debt characterization. While the promissory notes were labeled as debt instruments, the court noted that the Honda Center had no legal capacity to borrow money. This made the notes largely ceremonial documents rather than enforceable obligations.

The court found that the maturity dates in the notes were meaningless because AAM could extend them at will and actually did so repeatedly. The source of payments was limited to arena revenues, creating uncertainty about repayment that differed from typical commercial debt. AAM had limited ability to enforce collection since repayment depended entirely on the arena’s financial performance.

Regarding management and participation, the court determined that AAM made the advances to fulfill its contractual obligations as arena manager and to preserve its profit-sharing rights. The advances were subordinated to most other arena obligations. AAM’s return included both interest payments and a share of residual profits. The court found this profit participation particularly significant in distinguishing the advances from arm’s length debt.

According to the court, the parties’ intent analysis revealed that the advances served AAM’s broader business interests rather than representing pure lending transactions. AAM needed to maintain the arena’s operations to preserve its lucrative management contract and profit-sharing arrangement. The court concluded that AAM made the advances as equity-like investments in the arena business rather than as a disinterested creditor seeking fixed returns.

The Takeaway

This decision explains the risks one takes in revenue-sharing arrangements and in advancing funds to cover operational shortfalls. Courts will look beyond formal loan documentation to examine the economic substance of these advances, particularly when the advancing party has contractual obligations to provide funding or receives profit participation beyond fixed interest rates. The case shows that advances made to preserve existing business interests or management rights could to be characterized as equity investments rather than deductible debt. This characterization can transform what appears to be an immediate ordinary loss deduction into a capital contribution that provides no immediate tax benefit and may only be recoverable as a limited capital loss upon disposition of the business interest.

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Stephan Dorsey

Stephan is the sports journalist for the Maple Grove Report.

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Recent Reviews

Sidestep Tax Court Review by Applying Overpayments – Houston Tax Attorneys

What happens when a taxpayer properly invokes their right to challenge the underlying tax liability through the CDP process, but the IRS then uses subsequent overpayments to zero out the disputed balance?

Can the IRS effectively eliminate tax court jurisdiction by manipulating these overpayments mid-process, leaving the taxpayer without any forum to resolve their legitimate dispute?

We previously covered this when the tax court considered the case. The case was appealed, and reversed. Now the U.S. Supreme Court has weighed in. The Court’s Commissioner v. Zuch, 605 U.S. ___ (2025), warrants further consideration of this issue.

Facts & Procedural History

The case involved a married couple who filed untimely 2010 federal tax returns in fall 2012. The wife’s return showed no outstanding obligations, while the husband’s reflected substantial unpaid taxes.

The husband submitted an IRS offer in compromise to resolve his balance. There were $50,000 in estimated tax payments the couple had previously made. The IRS applied these payments to the husband’s account as a married-filing-separate taxpayer, settling his debt.

The wife later amended her 2010 return to report additional income from a retirement distribution. This resulted in an approx. $28,000 in tax liability. However, the spouse maintained that the $50,000 in estimated payments should have been credited to her account, entitling her to a $22,000 refund. The IRS disagreed and threatened to levy her property to collect what it deemed unpaid tax debts.

The taxpayer requested a CDP hearing to contest both the proposed IRS levy and the underlying tax liability allocation. This was her first opportunity to dispute the liability, as no notice of deficiency had been issued since she self-assessed the additional tax on her amended return. The appeals officer rejected her arguments and issued a Notice of Determination sustaining the levy action. The taxpayer appealed to the Tax Court under section 6330(d)(1).

During the multi-year proceedings, the taxpayer filed several annual returns showing overpayments. Each time, rather than issuing refunds, the IRS applied these overpayments against her disputed 2010 liability. Once the balance reached zero, the IRS moved to dismiss the Tax Court case as moot, arguing it lacked jurisdiction without an ongoing levy. The Tax Court agreed and dismissed the case. The Third Circuit reversed, but the Supreme Court granted certiorari to review the Third Circuit decision.

Understanding Collection Due Process Rights

The collection due process hearing represents Congress’s attempt to balance the IRS’s need for efficient collection with taxpayers’ due process rights. Before the IRS can make a levy, Section 6330 requires written notice to the taxpayer and an opportunity for a hearing before an independent appeals officer within the IRS Office of Appeals.

The CDP statute serves dual purposes in the broader landscape of IRS tax collections. First, it provides procedural protections against improper collection actions. The appeals officer must verify that the IRS followed applicable law and procedures before sustaining a proposed levy. Second, it offers a limited exception to the general rule requiring taxpayers to pay disputed taxes first and seek refunds later.

The hearing process allows taxpayers to raise various issues relating to the proposed levy. These include challenges to collection procedures, offers of collection alternatives like IRS installment agreements or currently not collectible status, and appropriate spousal defenses. The appeals officer must consider whether the proposed collection action balances efficient tax collection against the taxpayer’s legitimate concern that collection be no more intrusive than necessary.

When Can Underlying Tax Liability Be Challenged in CDP Proceedings?

The most important aspect of CDP proceedings for many taxpayers involves the ability to challenge the underlying tax liability itself. Under section 6330(c)(2)(B), taxpayers may challenge “the existence or amount of the underlying tax liability for any tax period if the person did not receive any statutory notice of deficiency for such tax liability or did not otherwise have an opportunity to dispute such tax liability.”

This provision recognizes that the normal deficiency procedures don’t cover all situations. Some taxpayers never receive proper notice or opportunity to contest their liability through the usual IRS notice of deficiency process. For these taxpayers, the CDP hearing provides their first meaningful chance to dispute the underlying debt.

The regulations clarify the boundaries of this exception. Taxpayers qualify if they didn’t receive a notice of deficiency in time to petition the tax court, or if they didn’t have a prior opportunity for an appeals conference regarding the liability. However, taxpayers who previously had a chance to dispute the liability through deficiency procedures or prior appeals conferences cannot relitigate those issues in CDP proceedings.

The underlying liability challenge must be properly raised during the CDP hearing to preserve it for Tax Court review. Simply disagreeing with the tax assessment isn’t sufficient. The taxpayer must present a substantive challenge to the existence or amount of the liability, supported by relevant facts and legal arguments.

What Determines Tax Court Jurisdiction in CDP Cases?

The Tax Court system operates as a court of limited jurisdiction, meaning it can only hear cases that Congress specifically authorizes. In CDP cases, jurisdiction flows from section 6330(d)(1), which grants the Tax Court authority to “review” an appeals officer’s “determination.”

The scope of this jurisdiction depends on what issues the appeals officer addressed in the determination. When taxpayers only challenge collection procedures or seek collection alternatives, the tax court’s review is limited to whether the appeals officer abused discretion in sustaining the proposed levy. The court applies a deferential standard, looking for determinations that are arbitrary, capricious, or without sound basis in fact or law.

However, when taxpayers properly raise underlying liability challenges, the tax court’s jurisdiction expands significantly. The court can conduct de novo review of the tax liability itself, making independent findings about the correct amount of tax owed. This represents a major exception to the usual rule requiring pre-payment of disputed taxes.

The determination of jurisdiction can be complicated when multiple issues are raised. Appeals officers must address each issue the taxpayer properly presents, and their determination may include findings on collection procedures, collection alternatives, and underlying liability. The tax court’s jurisdiction extends to reviewing all aspects of the determination that are properly before it.

How Did the Supreme Court Interpret CDP Jurisdiction?

The Supreme Court adopted a narrow interpretation of tax court jurisdiction under section 6330. It did so by focusing heavily on the statutory text and structure.

Justice Barrett’s majority opinion emphasized that the Tax Court’s jurisdiction depends on reviewing an appeals officer’s “determination,” which the Court defined as the binary decision of whether a levy may proceed.

The Court distinguished between the “considerations” that inform an appeals officer’s determination and the “determination” itself. Under this interpretation, disputes about underlying tax liability are merely inputs into the determination, not part of what the tax court can review once the levy is no longer viable. The Court reasoned that section 6330’s focus on levies means that without an ongoing threat of collection action, there’s no relevant determination for the tax court to review.

The majority opinion also emphasized the general rule that taxpayers must pay disputed taxes before seeking judicial review. The Court viewed CDP proceedings as a narrow exception to this pay-first rule, triggered specifically by proposed levy actions. Once the IRS abandons the levy, the exception no longer applies, and taxpayers must pursue traditional refund suits.

The Court expressed additional skepticism about the tax court’s remedial authority under Section 6330(e). The majority suggested that this provision only authorizes injunctions against levies, not broader declaratory relief about tax liability disputes. Without an ongoing levy to enjoin, the tax court lacks meaningful remedial power.

Justice Gorsuch’s Dissent

Justice Gorsuch’s lone dissent highlighted significant problems with the majority’s approach. He argued that Section 6330(d)(1)’s grant of jurisdiction over “such matter” refers back to the appeals officer’s full determination–including resolution of underlying liability challenges properly raised by the taxpayer.

The dissent emphasized that Congress chose the word “determination” rather than “levy” in the jurisdictional provision. As noted in the dissent, this suggests broader review authority than the majority recognized. Gorsuch noted that Congress used “levy” almost 30 times elsewhere in Section 6330 and that this shows that it knew how to limit jurisdiction to levy-related issues if that was the legislative intent.

More importantly, the dissent recognized the practical trap the majority’s rule creates for taxpayers. Those who properly invoke CDP procedures to challenge underlying liability can find themselves without any forum for resolution if the IRS manipulates overpayments to eliminate the basis for collection. This effectively allows the IRS to avoid judicial review of potentially incorrect determinations.

Justice Gorsuch also noted that the majority’s interpretation conflicts with the IRS’s own prior positions. The IRS had previously taken the view that motions to dismiss CDP cases were inappropriate as long as taxpayers still contested the existence or amount of their tax liability, regardless of whether collection was still necessary.

The Procedural Trap for Taxpayers

This decision creates several interconnected problems that trap taxpayers who legitimately attempt to use CDP procedures for their intended purpose.

The most obvious issue involves taxpayers who properly raise underlying liability challenges but find their cases dismissed mid-stream when the IRS eliminates the levy basis through overpayment applications.

This timing problem is compounded by administrative claim requirements for refund suits. Taxpayers must file administrative refund claims within specific time limits –generally within three years of filing the return or two years of paying the tax, whichever is later. Those pursuing CDP proceedings may not realize they need to file protective refund claims until these deadlines have passed.

The case itself illustrates this problem perfectly. The taxpayer could not seek refunds for all the years in question because she missed the administrative claim deadlines while pursuing the CDP process. The IRS’s apparent failure to notify her promptly about the overpayment applications compounded this procedural disadvantage.

The decision also allows the IRS to avoid accountability for determinations that may be incorrect. Appeals officers who reject underlying liability challenges can have their determinations insulated from review simply by the IRS’s strategic use of overpayments. This creates odd incentives for both the appeals process and collection decisions.

This case changes the landscape for appealing IRS collection actions. It signals that CDP proceedings are primarily about levy mechanics rather than substantive tax disputes, even when Congress explicitly authorized underlying liability challenges in appropriate circumstances.

Given this case, taxpayers have to consider whether the IRS might manipulate overpayments to eliminate jurisdiction and develop strategies to preserve their rights to meaningful review. This might include seeking expedited hearings, challenging overpayment applications, or pursuing parallel proceedings in other forums.

The Takeaway

This case provides administrative convenience for the IRS at the expense of taxpayer due process rights. The practical effect creates a procedural trap that undermines Congress’s clear intent to provide meaningful protections for taxpayers facing collection actions. The decision allows the IRS to evade judicial review of potentially incorrect determinations simply by manipulating overpayments to eliminate levy justifications, leaving taxpayers who properly invoke their statutory rights without any meaningful recourse. This outcome is particularly troubling because the CDP statute explicitly contemplates underlying liability challenges in appropriate circumstances. This makes requesting a CDP hearing more challenging than it should be.