There is little doubt that successfully funding biotech start-ups is a question of numbers. First, it is important to invest in a variety of strategies because it goes without saying that only a few will achieve home-run success. Second, it is imperative to be able to see forward and be able to determine when a strategy turns down a rabbit hole and additional funding should be stopped. Careful US tax planning also is important so that, if and when this happens, usable tax losses result. In Rutter v. Commissioner, 2 a worldrenowned biochemist learned this lesson the hard way as good money followed bad in chasing a technology that unfortunately did not result in a viable product. This Legal Update examines the results in that case and considers how better tax planning could have made the losses more palatable and less susceptible to the imposition of tax penalties. Analysis of the Rutter Case In 1999, Dr. Rutter began funding iMetrikus (“IM”), a biotechnology start-up company engaged in developing technology to improve patient treatment compliance and monitoring. Dr. Rutter, over his initial two years of involvement with IM, made 39 separate cash advances totaling $10.6 million. Interestingly, Dr. Rutter did not receive any IM common stock, which constituted only a de minimis portion of IM’s capital structure, in exchange for these advances. Each advance was evidenced by a convertible promissory note and bore interest at 7 percent. IM paid the interest on a current basis. Over the succeeding three years, Dr. Rutter advanced another $22 million to IM. IM issued promissory notes for only $3.4 million of these advances. Although no documentation was issued with respect to the remaining $18.6 million, IM recorded these advances as loans bearing 7 percent interest. IM did not pay interest on these advances. By May 2005, Dr. Rutter had made additional advances, and the balance had grown to $43.4 million. At that time, IM undertook a recapitalization and converted the entire amount advanced by Dr. Rutter into preferred stock. Dr. Rutter advanced another $43.04 million to IM between May 2005 and the end of 2009. These advances were made monthly to enable IM to meet operating expenses. IM executed 7 percent promissory notes for these advances but, again, never paid any interest on the advances. By the end of 2009, the preferred stock and the subsequent advances made by Dr. Rutter constituted 92 percent of IM’s capital structure. In 2009, IM was working with a major internet company to develop a strategic partnership for IM’s nascent technology. An expert later testified that IM was worth only $14.3 million by year- 2 Mayer Brown | Biotech Start-up Funding: An Ounce of Prevention Is Worth a Pound of Cure end 2009. A US Internal Revenue Service (“IRS”) expert opined that IM had a higher value, but even that value was significantly below the amount advanced by Dr. Rutter. The internet company opportunity completely fizzled out in June 2010. Dr. Rutter, however, continued to advance money through 2013. None of these $37.75 million of additional advances were evidenced by promissory notes. As the funding story suggests, IM never developed a sufficient revenue stream to become self-sufficient. By the end of 2008, IM had incurred in excess of $75 million in losses, and without the additional cash advances from Dr. Rutter, the company would likely have folded. The losses grew to $83 million by 2011. In December 2009, Dr. Rutter forgave $8.55 million of the IM debt that he held and claimed a bad debt deduction for the loss. The amount chosen as a bad debt was equal to the income that Dr. Rutter had realized from other investments. An ordinary bad debt deduction is permitted only for advances “incurred in the taxpayer’s trade or business.”3 The Code bad debt rules treat non-business bad debts incurred by individuals as short-term capital losses.4 The IRS challenged the ordinary loss claimed by Dr. Rutter and asserted a 20 percent understatement penalty. The first issue considered by the court was whether the advances made by Dr. Rutter should be considered debt (potentially eligible to be treated as bad debts) or stock (which could not be treated as a bad debt). The court, citing a litany of cases, noted that advances to closely held corporations are subject to a high degree of scrutiny and will not be respected as debt if, based upon all the facts and circumstances, are more properly treated as contributions to capital. The court set the standard by asking whether an outside lender would have provided the advance as a loan on the same terms and conditions as the taxpayer did. In order to answer this question, the court looked to an 11 factor (non-exclusive) test: 1. the labels on the documents evidencing the alleged indebtedness; 2. the presence or absence of a maturity date; 3. the source of payment; 4. the right of the alleged lender to enforce payment; 5. whether the alleged lender participates in management of the alleged borrower; 6. whether the alleged lender’s status is equal to or inferior to that of regular corporate creditors; 7. the intent of the parties; 8. the adequacy of the alleged borrower’s capitalization; 9. if the advances are made by shareholders, whether the advances are made ratably to their shareholdings; 10. whether interest is paid out of “dividend money;” and 11. the alleged borrower’s ability to obtain loans from outside lenders. The court found IM’s failure to document the latter advances supported the treatment of such advances as equity. Dr. Rutter testified that it would have been futile for the notes to have fixed maturity dates. This testimony hurt his cause because the court interpreted these statements as showing Dr. Rutter’s indifference to the treatment of the advances as debt or equity. Since IM could only pay interest by way of additional advances from Dr. Rutter (essentially paying himself interest), the third factor supported the treatment of the advances as equity. The fact that principal on the debt could have been paid only if the company was sold reinforced this conclusion. Since the advances were not evidenced by promissory notes, Dr. Rutter’s right to receive repayment was open- 3 Mayer Brown | Biotech Start-up Funding: An Ounce of Prevention Is Worth a Pound of Cure ended and not fixed. The court further found that if Dr. Rutter had forced repayment, he would have simply been required to make a higher advance in the next month (assuming IM did not fold). The fact that Dr. Rutter could not realistically obtain a repayment of his advances from IM’s operations supported treating the advances as equity. Dr. Rutter held no common stock or other voting securities in IM. Ostensibly then Dr. Rutter did not exercise management control over IM, which supported the treatment of the advances as debt. The court, however, employed a substance-overform approach and noted that Dr. Rutter exercised de facto control over IM and accordingly found Dr. Rutter did exercise control over IM for purposes of the debt-equity test. This conclusion further supported the treatment of the advances as equity. Although IM did not have any creditors other than Dr. Rutter, the facts that there “was no promissory note, no maturity date, no collateral, no protective covenant, no personal guaranty and no payment of interest” meant that Dr. Rutter’s advances would not have enjoyed priority to any other creditor. The court considered Dr. Rutter’s failure to receive promissory notes as evidence of his intent to treat the advances as equity. The fact that no interest was paid on the advances “strongly” supported the treatment of the advances as equity. On the question as to whether a third party would have advance funds on similar terms to those advanced by Dr. Rutter, the court again noted that no third party would have advanced so much money without promissory notes. Again, the failure to properly document the advances caused another factor to weigh in favor of equity treatment. Two factors weighed in favor of Dr. Rutter’s claim that the advances should be treated as loans. First, the court found that the preferred stock investment of Dr. Rutter supplied a strong equity base in IM. Second, the existence of the IM common shareholders meant that there was not a complete identity between shareholders and creditors. Unfortunately, these factors were not strong enough to outweigh the factors discussed above that supported treating the advances as equity. Although the court’s conclusion that the advances made by Dr. Rutter were equity, and not debt, foreclosed any possibility of a bad debt deduction, the court continued to evaluate whether Dr. Rutter would have been entitled to a deduction if the advances had been held to be debt. (Presumably, the court was backstopping its conclusion that Dr. Rutter was not entitled to an ordinary loss even if, on appeal, Dr. Rutter prevails on the issue as to whether the advances should be treated as debt.) A debt is treated as a business bad debt only if the debt was created or acquired in connection with a trade or business.5 A taxpayer is considered to be engaged in the conduct of a trade or business only if he pursues the activity with continuity and regularity and with a profit motive.6 Investment activities never constituted trade or business activities.7 Dr. Rutter asserted that the advances were made in the trade or business of being a promoter of start-ups or as a lender. The court found that Dr. Rutter’s failure to receive promissory notes or collect interest was evidence that Dr. Rutter was not in a lending trade or business. The facts belied the conclusion that Dr. Rutter made the advances with a view toward making a profit on the loans. The court noted that lenders do not make money by waiving interest and not collecting principal. The court cited numerous cases in which other courts had held that being a promoter is not different than being an investor, and, as noted above, being an investor is not being in a trade or business. The next issue considered by the court was whether, if the advances were properly treated as indebtedness, Dr. Rutter made a single loan with multiple fundings or whether each advance was a separate advance. The court held that the advances could be treated as separate advances 4 Mayer Brown | Biotech Start-up Funding: An Ounce of Prevention Is Worth a Pound of Cure only if they had been evidenced by “promissory notes that had different maturities, different interest rates, or different levels of creditor protection in terms of covenants or collateral.” Since all advances had the same terms, the court considered them to be part of the same openended loan. This conclusion disadvantaged Dr. Rutter because the court then considered whether the advances were worthless in part rather than a simpler worthless bed debt. The former is a higher standard. Dr. Rutter had asserted that the collapse of the talks with the internet company was an identifiable event that permitted the loss. The IRS successfully countered that the talks with the internet company did not end until 2010, a year after the claimed loss. The fact that the amount of the debt written off was equal to the amount of income that Dr. Rutter earned in 2009 clearly created a negative inference in the mind of the court. Accordingly, the court held that even if the advances were debt, they did not become worthless in part in 2009. The Documentation Rules In April 2016, the IRS proposed regulations under Section 385 of the Internal Revenue Code of 1986, as amended (“Code”), governing when an instrument issued to a related party will be treated as indebtedness for federal income tax purposes.8 The IRS subsequently amended the proposed regulations.9 These regulations contained rules, often referred to as the “Documentation Rules,” that the IRS would require to be met in order for a debt instrument issued to a related party to be treated as indebtedness for federal income tax purposes. The Treasury Department has announced that the revised Documentation Rules will not be promulgated as final regulations, and substantially simpler regulations will be issued instead.10 Nonetheless, certain aspects of the Documentation Regulations are worth considering when a taxpayer desires for an advance to a start-up company to be treated as indebtedness for federal income tax purposes. The Documentation Rules contain four broad mandates for related party indebtedness to be respected as indebtedness for federal income tax purposes. First, the advance must be evidenced by a written instrument establishing an “unconditional and legally binding obligation to pay a fixed or determinable sum certain on demand or at one or more fixed dates.”11 Second, the documentation must establish that the person making the advances has creditor rights.12 Although the Documentation Rules do not require the specification of creditors’ rights if such rights are available under local law, it seems prudent to include some specification of such rights in the promissory note. Third, the creditor must have documentation that there is a reasonable expectation of repayment and that the debtor’s financial position supports a conclusion that the advance can be repaid in accordance with its terms.13 The Documentation Regulations allow this requirement to be satisfied on an annual basis in situations in which the debtor will be issuing multiple obligations to the creditor (as occurred in Rutter, supra). This documentation requirement can be satisfied by cash flow projections, financial statements, business forecasts and asset appraisals.14 The fourth requirement of the Documentation Rules is an ongoing monitoring and payment requirement. If the instrument has been paid in accordance with its terms, documentation establishing this fact should be maintained.15 If the debtor defaults, documentation of the creditor’s exercise of creditor rights must be maintained.16 Conversely, if the creditor decides not to exercise creditor rights in connection with a default, the creditor must document its “decision to refrain from pursuing any actions to enforce payment as being consistent with the reasonable exercise of the diligence and judgment of a creditor.”17 5 Mayer Brown | Biotech Start-up Funding: An Ounce of Prevention Is Worth a Pound of Cure Ensuring Debt Treatment When Funding Biotech Start-ups The old saw “hope for the best and prepare for the worst” is particularly apt for taxpayers funding biotechnology start-ups. These ventures frequently require significant cash infusions and cannot be depended upon to turn a profit. In these unfortunate cases, proper tax planning could significantly reduce the impact of the losses. On the other hand, as the Rutter case demonstrates, ignoring tax considerations until the loss occurs could result in no tax benefits and significant penalty exposure. The Rutter case makes clear that if the advances had been documented by robust written promissory notes at the time that the advances had been made, the taxpayer would have had a much stronger case for arguing that the advances represented indebtedness. The court cited to the lack of documentation in evaluating a significant number of the debt-equity factors as proof that such factors supported the treatment of the advances as equity. Specifically, the lack of documentation prevented the taxpayer from establishing that the advances had a fixed maturity date, rights vis-à-vis other creditors and an intent to not treat the advances as equity and that third parties would have extended money on similar conditions. Although the tax bar has decried the Documentation Rules and Treasury will now substantially scale back such rules, these rules provide a useful set of guideposts in the startup arena for ensuring that advances should be treated as indebtedness for federal income tax purposes. The use of written promissory notes will address a multitude of potential challenges that could be made to the treatment of an advance as indebtedness, including the establishment of creditor rights and the existence of a fixed maturity date. Careful documentation of the ability of the debtor to repay the debt, even if based upon reasonable projections, will ensure that the creditor thought through the ability of the debtor to satisfy the debt. In those instances in which the debtor cannot meet its obligations (potentially giving rise to the ability to claim a bad debt deduction), careful documentation of the actions of the creditor will help support the fact that the advance was indebtedness for federal income tax purposes. Documentation alone will not solve the challenge faced by the taxpayer in Rutter, supra, as to whether the character of the loss as ordinary or capital. Some forethought here, too, however, could have created a stronger case for an ordinary deduction. The taxpayer, instead of making the advances directly, should consider the formation of a pass-through entity, such as an S corporation or partnership, that will make the loans. If this entity is solely engaged in a lending business, the taxpayer will have a much stronger case in defending against the assertion that any particular advance is a non-business bad debt. Of course, the pass-through entity will have to observe corporate (or partnership) formalities and conduct a robust lending business in order for this strategy to be successful. In any event, strong documentation and the use of a lending vehicle, when properly implemented, should also serve as a basis to avoid the imposition of penalties if an ordinary loss deduction is successfully challenged by the IRS. For more information about this topic, please contact the following lawyer. Mark H. Leeds +1 212 506 2499 email@example.com Endnotes 1 Mark is a tax partner in the New York office of Mayer Brown. Mark’s professional practice includes working with biotech start-up companies, including intellectual property 6 Mayer Brown | Biotech Start-up Funding: An Ounce of Prevention Is Worth a Pound of Cure tax planning and structuring to make efficient use of tax attributes. 2 T.C. Mem. 2017-174 (September 7, 2017). 3 Code § 166(d)(2). 4 Section 166(d)(1) of the Internal Revenue Code of 1986, as amended (the “Code”); Treas. Reg. § 1.166-5(a)(2). 5 Code § 166(d)(2). 6 See Comm’r v. Groetzinger, 480 U.S. 23 (1987). 7 Higgins v. Comm’r, 61 S.Ct. 475 (1941); Steffler v. Comm’r, 69 T.C.M. ¶ 2940 (1995); Rothbart v. Comm’r, 26 T.C. 680 (1956); Abegg, 50 T.C. 145 (1968), acq. 1968-2 C.B. 1, aff’d 429 F.2d 1209 (2nd Cir. 1970), cert. den. 400 U.S. 1008 (1971); Mayer v. Comm’r, 67 T.C.M. ¶ 2949 (1994); Moller v. U.S., 721 F.2d 810 (Fed. Cir. 1983), rev’g 553 F. Supp. 1071 (1982). 8 REG-108060-15 (April 8, 2016). 9 TD 9790 (October 2016). 10 Second Report to the President on Identifying and Reducing Tax Regulatory Burdens (Executive Order 13789), Department of the Treasury (October 2, 2017), Reference No. 2018-03004 (Rev. 1). 11 Prop. Treas. Reg. § 1.385-2(c)(2)(i). 12 Prop. Treas. Reg. § 1.385-2(c)(2)(ii). 13 Prop. Treas. Reg. § 1.385-2(c)(2)(iii). 14 Prop. Treas. Reg. § 1.385-2(c)(2)(iii)(E). 15 Prop. Treas. Reg. § 1.385-2(c)(2)(iv)(A). 16 Prop. Treas. Reg. § 1.385-2(c)(2)(iv)(B)(1). 17 Prop. Treas. Reg. § 1.385-2(c)(2)(iv)(B)(2). Mayer Brown is a global legal services organization advising clients across the Americas, Asia, Europe and the Middle East. Our presence in the world’s leading markets enables us to offer clients access to local market knowledge combined with global reach. We are noted for our commitment to client service and our ability to assist clients with their most complex and demanding legal and business challenges worldwide. We serve many of the world’s largest companies, including a significant proportion of the Fortune 100, FTSE 100, CAC 40, DAX, Hang Seng and Nikkei index companies and more than half of the world’s largest banks. 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