Even psychics need to document bona fide loans: Lessons from a recent tax court case

Even psychics need to document bona fide loans: Lessons from a recent tax court case

You might think that of all people, psychics would have an advantage when dealing with the IRS. But, perhapsChristopher Dufresne, the son of the late renowned psychic Sylvia Browne, should have also consulted a tax advisor in their financial arrangements instead of relying on his and his mother’s psychic abilities.

Unfortunately for Mr. Dufresne, the tax court needed actual documentation – not just psychic intent – that the $1.5 million in payments he received from his mother were payments on a bona fide loan. He had to pay more than $500,000 in tax and another $100,000 in penalties. 

What makes a loan bona fide?

At a minimum, both parties must have the intention that the debt will be repaid and that the creditor has the ability to enforce repayment. While intra-family financial transactions may be a bit more casual than bank loans, it always helps if there’s documentation that records, at a minimum, the names of parties, the date, and the amount of the loan and the repayment terms, including an interest rate.

What does the IRS look for?

When the IRS looks at a transaction to determine whether it was a bona fide loan, they consider eight factors:

  1. The ability of the borrower to repay.
  2. The existence or nonexistence of a debt instrument.
  3. Documentation of a related security, interest, a fixed repayment date, and a repayment schedule.
  4. How the parties’ records and conduct reflect the transaction.
  5. Whether the borrower has made repayments.
  6. Whether the lender had demanded repayment.
  7. The likelihood that the loans were disguised compensation for services.
  8. The testimony of the purported borrower and lender.

Unfortunately, the judge in Mr. Dufresne’s tax court case was not a psychic, so when he evaluated these factors, there was not enough evidence to confirm the existence of a bona fide loan.

Even psychics can have money problems

Mr. Dufresne worked as a psychic counselor for his mother Sylvia Browne’s company, Sylvia Browne Corporation. The business paid him very well, so between 1985 and 2007, Mr. Dufresne purchased five properties, which were all titled in his name, and which he treated as his own.

Between 2010 and 2013 – the years of interest to the IRS – an IRS auditor tallied up unreported cash deposits to Mr. Dufresne’s bank account totaling $1.5 million. According to Mr. Dufresne, these were repayments of loans he had made to his mother when she was facing financial distress.

According to two letters signed by Ms. Browne, Mr. Dufresne had lent his mother $1,182,670 in 2008 to purchase five properties, and another $307,718 in 2010 to pay Federal taxes. These letters did not include repayment terms, or any further details beyond the date, the amount, the general purpose of the loans, and Ms. Browne’s signature. At the time of these loans, Mr. Dufresne knew only that his mother and her corporation were having financial difficulties. He did not ask for any evidence that she would be able to repay him.

Ms. Browne lived in one of the five properties that her son had reportedly purchased for her, and, until her death in 2013, paid him rent to live there, which he duly reported on his tax returns. It’s not clear why she paid rent if she was also paying off a loan to buy the house.

At trial, Mr. Dufresne produced a document prepared by an employee of his mother’s corporation that listed payments he received from the corporation. Ms. Browne wrote checks payable to cash, which an employee cashed. A portion of the cash proceeds were given to Mr. Dufresne, reportedly as loan payments. This seems like an odd way to pay off a loan.

Mr. Dufresne also claimed that when he asked his mother for payments against her outstanding loans, she complied. However, he provided no corroborating evidence to confirm this.

Between 2010 and 2014, Mr. Dufresne, who was a 0.01 percent shareholder in his mother’s corporation, took a drastic cut in his salary, reportedly because the corporation was struggling financially. However, the unreported cash deposits, plus his salary, were similar in amount to the salary he had received in prior years.

In the end, the tax court judge had only Mr. Dufresne’s assertions that the $1.5 million in unreported deposits to his bank account were payments on a bona fide loan, so he was liable for income tax and penalties on the entire amount.

This case serves as a potent reminder that advisors should encourage clients to make sure that loans to family members are carefully documented and treated as bona fide loans!