Mark L. Fussell v. Commissioner

Decades-Old Startup Losses Fail to Offset 2018 Income

At stake for Mark L. Fussell is a determined deficiency of $38,662, plus penalties, for the 2018 tax year. The core issue: whether Fussell could offset his 2018 income with losses stemming from a failed tech startup, Velidom, which he founded in 2004. Fussell contended that 'bad debt' losses from Velidom effectively reduced his 2018 tax liability to zero. However, the Tax Court disagreed, finding that Fussell's advances to Velidom constituted equity contributions rather than debt. Furthermore, even if the advances had been debt, any potential net operating losses (NOLs) arising from their worthlessness would have been fully absorbed in prior years, precluding their use to offset 2018 income.

A 'Tightly-Held' Tech Venture and Missing Notes

The case centered on Fussell's involvement with a tech startup, Velidom, which he founded in 2004. Fussell contended that 'bad debt' losses from Velidom effectively reduced his 2018 tax liability to zero. However, the Tax Court disagreed, finding that Fussell's advances to Velidom constituted equity contributions rather than debt. Furthermore, even if the advances had been debt, any potential net operating losses (NOLs) arising from their worthlessness would have been fully absorbed in prior years, precluding their use to offset 2018 income.

Velidom, Inc., was incorporated in December 2004 to develop computer software products. Fussell, as the chief executive officer, agreed to purchase 20 million shares of Velidom's common stock for $80,000 under a Common Stock Purchase Agreement effective December 16, 2004. He characterized Velidom as a “tightly-held” corporation. Fussell claimed that after the initial stock purchase, Velidom was partially funded through purported debt financing. He alleged that he, operating as a computer software development consultant through a sole proprietorship, lent Velidom $420,000.

To support his claim, Fussell presented four checks drawn on a bank account in his name, which he asserted was a separate business account for his sole proprietorship. The checks, totaling $60,000, $40,000, $20,000, and $30,000, were payable to Velidom on various dates in the third and fourth quarters of 2005. Critically, the memo line of each check contained the notation “Note Record.” However, no actual promissory notes were ever produced. Fussell also provided an undated document with payment instructions "on account of the Notes," referencing a $150,000 note amount and a $37,500 warrant amount. An undated letter referencing a Note and Warrant Purchase Agreement with an attached spreadsheet showed the $150,000 note amount corresponding to Fussell and listed four additional investors who wrote checks to Velidom in November 2005 totaling approximately $225,000.

According to Fussell, Velidom functionally dissolved around 2008 because its "product failed and investment activities ended," and it lacked significant other income sources. A Notice of Dissolution and Winding Up of Velidom, Inc., issued on January 14, 2014, indicated that Velidom had dissolved on June 5, 2013. The notice instructed creditors to submit claims by February 28, 2014, and stated that "there are no assets of any value, cash or otherwise.”

In November 2015, Fussell and his spouse filed amended tax returns (Forms 1040X) for the 2012, 2013, and 2014 tax years. Each Form 1040X included an explanation stating that Velidom had received "$420K" in loans, which were now worthless due to the corporation's dissolution. The amended returns sought to apply these losses to the current and three previous years, proportional to the business income for each year. The IRS issued a Notice CP21B in April 2016, indicating that the adjustments to business income requested for 2012 had been made, resulting in a refund. Fussell assumed that similar changes would be allowed for 2013 and 2014.

However, instead of issuing further Notices CP21B, the IRS initiated an examination of Fussell's 2013 and 2014 income tax returns, which led to a prior Tax Court case (Docket No. 7877-17). The IRS determined income tax deficiencies for those years but, while auditing Fussell's Schedule C items, the IRS did not address the claimed bad debt from Velidom. Fussell then raised the "new issue of bad debt" in his petition to Tax Court, arguing that the loans to Velidom became unrecoverable due to its bankruptcy, and thus were deductible under Section 166, which allows a deduction for bad debts that become worthless during the tax year. The IRS contended that Fussell had not provided sufficient documentation to support the claimed additional deductions, offering only "a few letters allegedly showing loans were made and showing that petitioners purchased stock in Velidom Inc." The parties eventually settled, and the Tax Court entered a stipulated decision on March 9, 2018, stating that "there are no deficiencies in income tax due from, nor overpayments due to, petitioners for the taxable years 2013 and 2014."

The 'Zero Net Income' Defense

Fussell's primary defense against the IRS's deficiency determination centered on his belief that he owed no taxes for 2018. He argued that delays in the IRS's review of his filings for 2013 through 2015 justified his failure to file a 2018 return. Fussell contended that he was "waiting" on the IRS to process these older returns and believed that net operating loss (NOL) carryforwards would offset any income he earned in 2018, resulting in a "zero net income."

The IRS countered that Fussell's justification lacked merit. The IRS prepared a Substitute for Return (SFR) for Fussell's 2018 tax year under Section 6020(b). Section 6020(b) allows the IRS to create a return on behalf of a taxpayer who fails to file, using information from third parties like W-2s and 1099s. This SFR indicated that Fussell had gross income of $130,052. The IRS argued that Fussell conceded to receiving all income items reported for the 2018 tax year. The IRS also argued that any unreviewed acceptance of a deduction on the 2012 amended return didn't bind the agency to accept similar deductions for 2018.

Capital Contributions Disguised as Debt

The IRS, in disallowing the bad debt deduction, contended that Fussell's advances to Velidom were not bona fide debt, but rather capital contributions. The Tax Court examined this issue under Section 166, which allows a deduction for a bona fide debt that becomes worthless during the tax year. A bona fide debt, the court explained, arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money. By contrast, contributions to capital do not give rise to a debt for Section 166 purposes.

The court found that Fussell had failed to establish that the transfers to Velidom constituted bona fide debt. Fussell offered an undated letter referencing a "Note and Warrant Purchase Agreement," memo lines on checks payable to Velidom referencing a "Note," and documents related to payments. However, he did not provide copies of any loan agreements or promissory notes specifying interest or maturity terms. Moreover, he failed to provide documentation confirming the checks were deposited by Velidom, supporting loan advances exceeding $150,000, or documenting any subsequent history of the purported loans, such as interest payments or principal repayments.

The Tax Court cited precedent establishing that the absence of loan agreements or notes favored the IRS's position. The court noted Fussell's admission that Velidom lacked significant funding sources besides the alleged loans, suggesting repayment depended solely on Velidom's earnings. The court then cited the Ninth Circuit's Hardman factors which are used to distinguish debt from equity. The Hardman factors consider: (1) the names given to certificates of debt; (2) the presence of a maturity date; (3) the source of payments; (4) the right to enforce payment; (5) increased participation in management; (6) lender status relative to creditors; (7) the parties’ intent; (8) borrower capitalization; (9) proportionality of funds advanced to capital interest; (10) the extent to which interest payments come from dividend money; and (11) the borrower's ability to obtain outside loans.

The court found it implausible that Fussell would fail to retain any loan agreement, promissory note, or payment documentation over the decade that the loans were supposedly outstanding. The court concluded that Fussell failed to prove a bona fide debt existed. Because the court found no bona fide debt existed, it did not analyze the additional requirements for a bad debt deduction, such as worthlessness, or business vs. non-business nature of the debt.

The Unforgiving Math of Section 172

Even if the court had found that a bona fide debt existed, the taxpayer's net operating loss (NOL) argument would still fail under Section 172. The court explained that Section 172(a) allows a deduction for the aggregate of NOL carrybacks and carryovers to a taxable year. Generally, an NOL is the excess of allowable deductions over gross income for a given tax year, computed with certain modifications as specified in Section 172(c). To carry over or carry back an NOL, a taxpayer must prove the amount of the NOL and the amount of the NOL carryover or carryback to a particular year, taking into account its potential use for another year.

Absent an election to the contrary, under Section 172(b)(3), an NOL for a taxable year must first be carried back two years and then may be carried forward up to 20 years, according to Section 172(b)(1)(A), (2). The court observed that the taxpayer seemed to be arguing that he was entitled to first carry back and then carry over an NOL arising from the claimed bad debt deduction. However, because the court already determined that he was not entitled to a bad debt deduction, he consequently failed to establish that he had an NOL with respect to which he might be entitled to carrybacks and carryovers.

The court went on to explain that even if the taxpayer had been entitled to a bad debt deduction, his own reporting indicated that he would not have been entitled to an NOL deduction for the 2018 tax year. Section 172(b)(2) provides that “[t]he portion of [the NOL] which shall be carried to each of the other taxable years shall be the excess, if any, of the amount of such loss over the sum of the taxable income for each of the prior taxable years to which such loss may be carried.” The taxpayer's own reporting reflected more than $300,000 of aggregate taxable income remaining for the 2012 through 2014 tax years after aggregate claimed deductions for bad debts or NOLs of $370,000. Thus, the $50,000 NOL hypothetically remaining would nevertheless clearly have been required to be used for such years. Therefore, if the taxpayer had actually been entitled to a $420,000 bad debt deduction as a result of the loans in 2014, consistent with his carrying back an NOL to 2012, no deductions stemming from the purported loan worthlessness should have been available to carry to future tax years. Even if the NOL had arisen in 2015, the taxpayer’s reporting with respect to 2015 and 2017 indicates that none of the NOL would have remained to be carried to 2018.

Additions to Tax

The court then addressed additions to tax. Under Section 6651(a)(1), an addition to tax is imposed for the failure to file an income tax return by the due date (including extensions). Section 6651(a)(2) imposes an addition to tax for failing to pay taxes when due. The Commissioner bears the burden of production with respect to the liability of any individual for any addition to tax under Section 7491(c).

The court noted that the taxpayer conceded that he did not file an income tax return for the 2018 tax year, and that the IRS consequently prepared a Substitute for Return (SFR) under the authority of Section 6020(b). The SFR showed unreported gross income, which the taxpayer conceded he received, and the taxpayer’s tax liability for the 2018 tax year. Accordingly, the IRS satisfied the burden of production with respect to the Section 6651(a)(1) and (2) additions to tax.

To avoid the penalties, the taxpayer argued that the IRS had not yet processed his amended returns for the 2013 and 2014 tax years, indicating that the failure to file was a result of "delays in the IRS reviewing 1040 & 1040x filing information for years 2013-2015.” He also argued that any amount owed for the 2018 tax year could be satisfied with the refunds he claimed to be owed related to his 2013 and 2014 tax years. The court found that ongoing audits or other actions before the IRS did not provide the taxpayer with justification to delay the filing of his 2018 income tax return. Accordingly, the court concluded that the taxpayer’s filing and payment failures were not due to reasonable cause.

Finally, the court addressed the addition to tax under Section 6654(a), which imposes an addition to tax on an individual for failure to make required estimated tax payments. The court found that the IRS established that the taxpayer filed an income tax return for the 2017 tax year, that he failed to file an income tax return for the 2018 tax year, and that he had an actual tax liability for 2018 but failed to make the required payments. Because the taxpayer filed for the prior year, the court concluded that the required annual payment for 2018 is 90% of the tax owed for that year. The court noted that Section 6654 has no general exception for reasonable cause. Accordingly, the court held that the taxpayer is liable for the addition to tax under Section 6654(a) for tax year 2018.