On June 30, 2025, the U.S. Tax Court issued its decision in Anaheim Arena Management, LLC, et al. v. Commissioner, addressing whether a taxpayer could claim a $51,465,228 bad debt deduction for advances made in connection with its management of a sports arena in Anaheim, California.¹ Given the difficulty taxpayers typically have in claiming bad debt deductions, this case is instructive of what factors courts look to when a bad debt deduction is challenged by a taxing agency.

Background and Facts

The taxpayer managed the sports arena under a facility management agreement with the city. The agreement required the taxpayer to make advances to fund the arena and cover operational shortfalls. Failure to do so would result in the forfeiture of the taxpayer’s exclusive management rights and share of residual profits. Over several years, the taxpayer made substantial advances to fund the arena’s operations, maintenance, and capital improvements. These advances were documented by promissory notes naming the arena as borrower, with repayment intended to come from the arena’s revenues.

By the end of 2015, the taxpayer determined that repayment was unlikely due to the arena’s financial performance and based on advice from its financial and legal advisors. Relying on its accountants’ opinion, the taxpayer claimed a bad debt deduction for the full amount of outstanding advances on its 2015 partnership return. The IRS disallowed the deduction, asserting that the advances did not constitute debt for tax purposes.

Tax Court’s Analysis: Debt vs. Equity Factors

The Internal Revenue Code does not define “debt” or “equity.” In the Ninth Circuit, where an appeal of this case would lie, courts apply an 11-factor test to determine whether the parties intended the advance to be debt or equity.

Here, the Tax Court determined that all factors weighed against treating the advances as debt:
 

The court found the arena was a physical structure owned by the city and not a legal entity capable of entering into enforceable contracts or incurring debt. The promissory notes were signed by the taxpayer’s officers, not by any city representative, so they lacked the legal force of a true debtor-creditor instrument and did not support a finding of debt.
 

While the promissory notes included maturity dates, the taxpayer retained sole discretion to extend them, and in practice, dates were routinely extended or ignored. The court found these dates were not meaningful and did not support a finding of debt.
 

The management agreement established a “waterfall” of payment priorities, with the taxpayer’s advances subordinated to other obligations. Repayment would occur only if sufficient funds remained after higher-priority expenses were paid. The court determined this was more characteristic of an equity investment.
 

Since the promissory notes were not legally enforceable, the court looked to the management agreement to determine the enforceability of repayment. The agreement did not provide the taxpayer with the right to pursue collection through legal action, so the taxpayer’s only remedy was to wait for future revenues to become available. The court found that the taxpayer’s inability to enforce repayment weighed heavily against debt characterization.
 

The advances were not made at arm’s length but served to preserve the taxpayer’s business interests and contractual position. This factor suggested that the advances were more like capital contributions or equity investments.
 

The taxpayer’s position was inferior to typical creditors because: (1) the management agreement provided that it was junior to most other advances, operating expenses, certain fees, and other debts, and (2) the advances could be repaid after higher priority claims. The taxpayer’s inferior status indicated these investments were not debt.
 

The advances were made as part of the taxpayer’s duties as manager – to fulfill contractual obligations –with repayment contingent on the arena’s financial success. Therefore, the court found that the parties did not intend to create a traditional lending relationship.
 

The taxpayer’s advances were necessary to keep the business running, but the lack of adequate capitalization meant there was little realistic prospect of full repayment. The low likelihood of full repayment indicated the advances were not debt.
 

Although the taxpayer did not own the sports arena, it had a right to a share of residual profits under the management agreement. The court noted that this identity of interest further blurred the line between debt and equity, supporting the conclusion that the advances were not debt.
 

Because interest of principal on the advances was payable only if the sports arena generated sufficient revenues, the court concluded that it resembled a dividend or profit-sharing mechanism.
 

The taxpayer made the advances because it was contractually obligated to do so as manager and it stood to benefit from the arena’s success. The court determined that no third-party lender would make the advances because of the low interest rate, lack of enforceability, and high risk.

After weighing all 11 factors, the court concluded that the advances did not constitute debt for tax purposes. Accordingly, the IRS’s disallowance of the bad debt deduction was sustained.

Key Takeaways for Taxpayers: Debt vs. Equity in Tax Treatment

This decision underscores the importance of substance over form when determining the tax treatment of advances between related parties, particularly where repayment is contingent and the advances serve a business purpose beyond that of a typical loan. While the Tax Court denied the bad debt deduction, it declined to impose penalties, recognizing the taxpayer’s good faith reliance on professional advice. Taxpayers involved in complex financing arrangements and management agreements should consult a tax professional to ensure compliance with the debt versus equity rules.