Fussell, Fake Debt and Deduction Rollover Failure

In Fussell v. Commissioner, T.C. Memo. 2025-131, the U.S. Tax Court addressed two critical issues that have significant implications for taxpayers claiming bad debt deductions and net operating loss carryovers. The case, docketed as No. 9700-23 and decided on December 18, 2025, involved Mark L. Fussell's 2018 tax year, where the IRS determined a deficiency of $38,662 plus additions to tax. The court's opinion, written by Judge Jenkins, provides important guidance on what constitutes a bona fide debt for deduction purposes and how net operating loss deductions must be applied across multiple tax years.

The Velidom Transaction and Alleged Bad Debt

The case centered on a business venture extending back approximately 20 years, involving a company called Velidom. In December 2004, Fussell entered into a Purchase Agreement with an effective date of December 16, 2004, to purchase Velidom. The purchase was partially funded through what Fussell claimed was debt—specifically, amounts that he characterized as loans to Velidom that became worthless, giving rise to bad debt deductions.

The fundamental problem with Fussell's bad debt claim was the complete absence of evidence that a bona fide debt actually existed. For a bad debt deduction to be allowable under Section 166, the taxpayer must establish that a valid, enforceable debt existed that became worthless during the tax year. The court found that Fussell failed to meet this basic requirement.

Lack of Debt Characteristics

The court's analysis revealed multiple failures in establishing the existence of a bona fide debt. First, there were no payments made on the alleged debt. A genuine debt typically involves some form of repayment obligation, whether through periodic payments, a maturity date, or other repayment terms. The absence of any payments—or even evidence of an obligation to make payments—strongly suggested that no true debtor-creditor relationship existed.

Second, there was no interest charged or paid on the alleged debt. Interest is a hallmark of a bona fide debt, as it represents compensation for the use of borrowed funds and reflects the economic reality of a lending transaction. The complete absence of interest terms, interest payments, or even interest accrual indicated that the transaction lacked the essential characteristics of a debt.

Third, the court found other critical failures that undermined the debt's legitimacy. There was no promissory note, loan agreement, or other documentation establishing the terms of the alleged debt. Without written evidence of the debt's terms, maturity date, interest rate, or repayment schedule, the court could not conclude that a legally enforceable obligation existed.

Additionally, the timing and structure of the transaction raised questions. The alleged debt arose in connection with Fussell's purchase of Velidom, suggesting it might have been part of the purchase price rather than a separate loan. The court noted that capital contributions or equity investments are not deductible as bad debts, even if they become worthless. The line between debt and equity is critical, and the absence of debt characteristics pointed toward an equity investment rather than a loan.

The IRS's Prior Treatment and Estoppel

Fussell argued that the IRS had previously accepted the bad debt treatment in an earlier tax year, and that this should bind the IRS in subsequent years. This argument raised an important question about whether the IRS is estopped from taking inconsistent positions across different tax years.

The court firmly rejected this argument, establishing a clear principle: every tax year must stand on its own accord and be proven separately. The IRS is not held to one treatment of a transaction across multiple years. This principle reflects the fundamental nature of tax administration, where each tax year is a separate accounting period requiring independent substantiation.

The court explained that the IRS's acceptance or rejection of a position in one year does not create an estoppel that prevents the IRS from challenging the same position in another year. Taxpayers cannot rely on the IRS's prior treatment as evidence that their position is correct in subsequent years. Each year requires its own proof, its own documentation, and its own analysis.

This holding is significant because it prevents taxpayers from using prior IRS acceptance as a shield against current challenges. It also prevents the IRS from being locked into positions that may have been accepted in error or without full examination. The principle ensures that both taxpayers and the IRS can properly evaluate each year's tax liability based on the facts and law applicable to that specific year.

The court's reasoning aligns with the general principle that tax estoppel is disfavored in tax law. Unlike some areas of law where parties may be bound by prior positions, tax administration requires flexibility to correct errors and apply the law correctly to each tax year. This principle protects both the government's revenue interests and ensures that taxpayers receive proper treatment based on the actual facts of each year.

Net Operating Loss Rollover Rules

The second major issue in the case involved Fussell's attempt to claim net operating loss (NOL) deductions from earlier years. Even if the bad debt loss had been valid in an earlier year, creating an NOL, Fussell sought to allocate those losses across future years as he desired. The court rejected this approach, establishing a clear rule about how NOL deductions must be applied.

Chronological Application Requirement

The court explained that loss deductions cannot be spread out over rollover years as desired by the taxpayer. Rather, they must be applied to the years in chronological order, wiping out all income in the first rollover years if possible. The taxpayer cannot allocate them across future years as desired—they must apply to the earliest rollover years as possible by the income available.

This rule is grounded in Section 172, which governs net operating loss carrybacks and carryforwards. The statute provides specific rules about the order in which NOLs must be applied. Generally, NOLs are first carried back to the earliest available year, then forward to subsequent years in chronological order. Taxpayers cannot cherry-pick which years to apply losses to maximize their tax benefits.

The court's holding reinforces that NOL application is not elective—it follows a mandatory chronological sequence. If a taxpayer has an NOL from 2015, for example, and wants to carry it forward, the NOL must first be applied to 2016 (if income exists), then 2017, then 2018, and so on. The taxpayer cannot skip years or allocate portions of the loss to later years while leaving earlier years with taxable income.

Income Absorption Rules

The court further explained that NOLs must be applied to wipe out income in the earliest available years. If a taxpayer has $50,000 of NOL from 2015 and $30,000 of income in 2016, the entire $30,000 of 2016 income is offset by the NOL, leaving $20,000 of NOL to carry forward to 2017. The taxpayer cannot choose to apply only $10,000 to 2016 and save $40,000 for later years.

This income absorption requirement ensures that NOLs are used as soon as possible, preventing taxpayers from strategically timing their loss utilization. The rule prevents manipulation where taxpayers might want to preserve losses for high-income years while paying tax in lower-income years.

The chronological application rule also serves administrative efficiency. It provides a clear, predictable method for applying NOLs that both taxpayers and the IRS can follow without dispute. The mandatory sequence eliminates questions about which years losses should be applied to, reducing complexity and potential abuse.

Interaction with Bad Debt Timing

In Fussell's case, the chronological application rule interacted with the bad debt deduction issue. Even if Fussell had been able to establish a valid bad debt loss in an earlier year, that loss would have had to be applied chronologically to subsequent years. Fussell could not have chosen to apply it to 2018 while leaving earlier years with income.

This interaction highlights an important planning consideration: taxpayers must understand not only whether a loss is valid, but also how it will be applied across multiple years. The mandatory chronological application can affect the timing of tax benefits and may not always align with a taxpayer's preferences.

Implications for Taxpayers

The Fussell case provides several important lessons for taxpayers claiming bad debt deductions and NOL carryovers.

Establishing Bona Fide Debt

For taxpayers seeking bad debt deductions, the case emphasizes the importance of proper documentation and debt characteristics. To establish a bona fide debt, taxpayers should:

1. Create written loan agreements with clear terms, including principal amount, interest rate, maturity date, and repayment schedule
2. Charge and collect interest at a market rate, demonstrating the economic reality of a lending transaction
3. Make and document payments on the debt, showing that both parties treated it as a debt
4. Maintain separate accounting for the debt, distinguishing it from equity investments or capital contributions
5. Establish debtor-creditor relationship through documentation showing the borrower's obligation to repay

The absence of these characteristics will likely result in denial of the bad debt deduction, as it did in Fussell's case.

NOL Application Planning

For taxpayers with net operating losses, the case reinforces that NOL application is not elective. Taxpayers must:

1. Apply losses chronologically to the earliest available years first
2. Absorb income completely in each year before moving to the next
3. Plan accordingly understanding that they cannot strategically allocate losses to preferred years
4. Document the application showing the chronological sequence and income absorption

Taxpayers should not assume they can choose which years to apply losses to or allocate portions of losses across multiple years simultaneously.

Year-by-Year Substantiation

The case's rejection of estoppel arguments emphasizes that each tax year requires independent substantiation. Taxpayers cannot rely on:

• Prior IRS acceptance of a position
• Prior audit results
• Prior tax return treatments

Each year must be proven on its own merits with current documentation and evidence. This principle applies broadly, not just to bad debt deductions, but to all tax positions that span multiple years.

Legal Analysis and Precedent

The court's analysis in Fussell builds on established precedent regarding bad debt deductions and NOL applications.

Bad Debt Precedent

The requirement for bona fide debt has been consistently applied in tax cases. Courts have long required evidence of a genuine debtor-creditor relationship, including enforceable obligations, repayment terms, and economic reality. Fussell's case reinforces that mere characterization of a transaction as debt is insufficient—the transaction must have the actual characteristics of debt.

The court's emphasis on the absence of payments and interest aligns with cases like Commissioner v. Tufts, which emphasized economic substance over form. The transaction must function as a debt in practice, not just in name.

NOL Application Precedent

The chronological application rule for NOLs is well-established in the Code and regulations. Section 172 provides specific ordering rules, and the regulations under that section detail how losses must be carried back and forward. Fussell's case reinforces that these rules are mandatory, not elective.

Cases like Alumax Inc. v. Commissioner have previously established that taxpayers cannot electively apply NOLs to preferred years. The chronological requirement ensures consistent application and prevents manipulation.

Estoppel Precedent

The court's rejection of estoppel arguments aligns with the general principle that tax estoppel is disfavored. The Supreme Court has consistently held that the IRS is not bound by prior positions, allowing for correction of errors and proper application of the law. This principle protects both government revenue and ensures correct tax treatment.

Conclusion

The Fussell case serves as an important reminder of the strict requirements for bad debt deductions and the mandatory nature of NOL application rules. Taxpayers claiming bad debt deductions must establish that a bona fide debt existed, with proper documentation, payment terms, interest, and other debt characteristics. The absence of these elements will result in denial of the deduction.

The case also establishes that the IRS is not bound by prior treatment of transactions across multiple years. Each tax year stands independently, requiring its own proof and substantiation. Taxpayers cannot rely on prior IRS acceptance as a defense in subsequent years.

Finally, the case reinforces that NOL deductions must be applied chronologically to the earliest available years, with losses absorbing income in order. Taxpayers cannot strategically allocate losses to preferred years or spread them across multiple years simultaneously.

These principles ensure proper tax administration, prevent abuse, and provide clear guidance for taxpayers and practitioners navigating bad debt deductions and NOL carryovers. The Fussell decision will likely be cited in future cases involving similar issues, particularly where taxpayers attempt to claim deductions for transactions lacking debt characteristics or seek to manipulate the timing of loss utilization.