In the recent Tax Court Memorandum decision Fussell v. Commissioner, T.C. Memo. 2025-131, the Tax Court offered a stark reminder regarding the stringent substantiation requirements for business bad debts under Internal Revenue Code (IRC) Section 166 and the mechanical application of Net Operating Loss (NOL) carryovers under Section 172. For tax professionals, this case serves as a critical case study on the distinction between capital contributions and bona fide debt, as well as the burden of proof required to sustain NOL deductions in years subsequent to the alleged loss.

Factual Background

The petitioner’s tax controversy originated from a business venture dating back to 2004 involving Velidom, Inc. (Velidom), a software development company. The petitioner, serving as CEO, purchased 20 million shares of common stock for $80,000. Between 2005 and 2015, the petitioner claimed to have lent Velidom $420,000 through his separate sole proprietorship. To support these advances, the petitioner produced checks with memo lines reading "Note Record" and an undated spreadsheet, but notably failed to produce executed promissory notes or loan agreements.

Velidom effectively dissolved around 2008 or 2013, with a formal Notice of Dissolution issued in January 2014 stating "there are no assets of any value, cash or otherwise".

In 2015, the petitioner filed amended returns (Forms 1040X) for tax years 2012, 2013, and 2014, attempting to apply the "loss on loans" against his business income for those years. While the IRS processed a refund for 2012, it audited the 2013 and 2014 returns, ultimately disallowing the bad debt deductions. The petitioner and the IRS settled the 2013–2014 dispute via a stipulated decision in 2018 which established no deficiencies or overpayments for those years.

For the tax year at issue, 2018, the petitioner failed to file a return. The IRS prepared a Substitute for Return (SFR) pursuant to Section 6020(b) based on third-party reporting of $130,052 in gross income. The IRS issued a Notice of Deficiency determining a tax liability of $38,662 plus additions to tax. The petitioner argued that unused business bad debt losses from the Velidom loans should carry forward to offset his 2018 income.

The Court’s Analysis of Bad Debt Deductions Under Section 166

The Tax Court first addressed whether the petitioner was entitled to a bad debt deduction. The Court emphasized that "deductions are a matter of legislative grace," placing the burden of proof squarely on the taxpayer.

To qualify under Section 166(a)(1), a debt must be "bona fide," defined as a debt that "arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money". The Court reiterated that "[a] contribution to capital is not considered to give rise to a debt for purposes of section 166".

In distinguishing debt from equity, the Court looked to the taxpayer’s actual intent, noting that "[t]he outward form of the transaction is not controlling". The Court referenced the eleven factors established by the Ninth Circuit in Hardman v. United States, which include the presence of a maturity date, the source of repayment, the right to enforce payment, and capitalization ratios.

Applying these factors, the Court found the petitioner’s evidence lacking. The petitioner failed to provide loan agreements, promissory notes, or details regarding interest or maturity terms. As the Court observed, "[t]he absence of loan agreements and notes or other instruments favors respondent". Furthermore, the lack of repayment over a decade suggested that repayment was contingent solely on earnings, which "indicates that the transfers did not constitute bona fide loans".

The Court concluded that "petitioner has not established that there was bona fide debt," treating the advances instead as likely capital contributions.

Analysis of Net Operating Loss Carryovers

A pivotal technical aspect of the opinion involves the application of Section 172. Even assuming arguendo that the advances were bona fide debts that became worthless, the Court analyzed whether any resulting NOL could survive to the 2018 tax year.

The petitioner seemingly argued that because he did not fully utilize the deductions in prior years, they remained available. The Court rejected this, citing the absorption rules of Section 172(b)(2). This section mandates that the portion of a loss carried to a subsequent year "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 petitioner’s own reporting showed aggregate taxable income exceeding $300,000 for the years 2012 through 2014. Consequently, even if a $420,000 deduction had been allowed in 2014 (or earlier), the required carrybacks and offsets against prior year income would have fully absorbed the loss long before 2018. The Court noted, "Given the mandate of section 172(b)(2), it would have been irrelevant that petitioner did not claim the full amount to which he was purportedly entitled for the relevant years".

Thus, the Court held that "even if petitioner could persuade this Court that he was entitled to a $420,000 section 166(a) deduction... he would not, as a result thereof, be entitled to an NOL deduction for his 2018 tax year".

Additions to Tax

The Court upheld additions to tax under Section 6651(a)(1) (failure to file), Section 6651(a)(2) (failure to pay), and Section 6654 (failure to pay estimated tax).

The petitioner argued that his failure to file the 2018 return was due to "delays in the IRS reviewing 1040 & 1040x filing information for years 2013-2015". The Court dismissed this argument, citing established precedent that "ongoing audits or other actions before the IRS did not provide petitioner with justification to delay the filing of his 2018 income tax return". Consequently, the petitioner failed to demonstrate reasonable cause.

Conclusions and Takeaways

The Tax Court entered a decision for the respondent, sustaining the deficiency and all additions to tax.

For tax practitioners, Fussell underscores two fundamental principles:

Documentation is Paramount: A taxpayer’s subjective intent to create a loan is insufficient without objective indicia of debt, such as promissory notes, fixed maturity dates, and enforcement of repayment rights,.
NOL Ordering Rules are Mandatory: A taxpayer cannot "save" a deduction for a future year. Section 172(b)(2) mechanically absorbs losses against the taxable income of intervening carryback and carryover years, regardless of whether the taxpayer actually claimed the deduction on returns for those years.

This case serves as a warning against relying on informal financing arrangements in closely held corporations and highlights the importance of timely filing, regardless of pending disputes with the IRS.

Prepared with assistance from NotebookLM.