Dagres v. Commissioner

TODD A. AND CAROLYN D. DAGRES, PETITIONERS v.

COMMISSIONER OF INTERNAL REVENUE,

RESPONDENT

Docket No. 15523–08. Filed March 28, 2011.

P, a manager of venture capital funds, lent $5 million in

2000 to S, a business associate who provided leads on compa-

nies in which the venture capital funds might invest. P and

S renegotiated the loan in 2002, and S stopped making pay-

ments in 2003. In settlement of the debt, S transferred some

securities to P in 2003. On P’s 2003 income tax return, he

claimed a $3,635,218 deduction for bad debt under I.R.C. sec.

166(a). R issued a notice of deficiency for 2003, which dis-

allowed the deduction as a business bad debt. Held: P was in

the trade or business of managing venture capital funds. His

bad debt loss was proximately related to that trade or busi-

ness, and it is deductible under I.R.C. sec. 166(a).

Joel R. Carpenter, David J. Nagle, and Barry S. Pollack,

for petitioners.

Carina J. Campobasso, for respondent.

GUSTAFSON, Judge: On March 21, 2008, the Internal Rev-

enue Service (IRS) issued to petitioners Todd and Carolyn

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264 136 UNITED STATES TAX COURT REPORTS (263)

Dagres 1 a notice of deficiency pursuant to section 6212, 2

determining a deficiency of $981,980 in income tax for 2003

and an accompanying accuracy-related penalty of $196,369

under section 6662(a). After Mr. Dagres’s concession that the

$30,000 of interest he received in 2003 constitutes taxable

income, the issues for decision are whether: (1) Mr. Dagres

is entitled to a $3,635,218 business bad debt deduction for

2003 pursuant to section 166(a); and (2) Mr. Dagres is liable

for the accuracy-related penalty under section 6662(a).

On the facts proved at trial, we find that Mr. Dagres was

in the trade or business of managing venture capital funds;

and we hold that he suffered a bad debt loss in connection

with that business in 2003, and that it was a business bad

debt loss. As a result, he is entitled to deduct the loss under

section 166(a). Because the bad debt deduction offsets all of

Mr. Dagres’s taxable income, he is not liable for the

accuracy-related penalty.

FINDINGS OF FACT

We incorporate by this reference the parties’ stipulation of

facts with attached exhibits. At the time Mr. and Mrs.

Dagres filed their petition, they resided in Massachusetts.

Mr. Dagres’s background

Mr. Dagres holds a master of science degree in economics

and a master in business administration degree. Early in his

career he held positions in various firms involved in

financing and investing in developing technology companies.

In 1994 Mr. Dagres worked as an analyst for Montgomery

Securities, an investment bank based in San Francisco, and

he focused on the computer networking industry.

Meeting Mr. Schrader

In 1994 Mr. Dagres met with William L. Schrader, who in

1989 had co-founded Performance Systems International, Inc.

That company provided Internet connectivity to commercial

customers and eventually changed its name to PSINet, Inc.

1 Ms. Dagres is a party to this case because she filed a joint Federal income tax return with

Mr. Dagres. See sec. 6013(d)(3).

2 Unless otherwise indicated, all citations of sections are to the Internal Revenue Code of 1986

(26 U.S.C.), as amended, and all citations of Rules are to the Tax Court Rules of Practice and

Procedure.

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(263) DAGRES v. COMMISSIONER 265

(PSINet). Because Mr. Dagres made a favorable impression on

Mr. Schrader as someone who was bright and knowledgeable,

Mr. Schrader selected Montgomery Securities to take PSINet

public. The initial public offering succeeded, and PSINet

traded on the NASDAQ Exchange under the symbol PSIX. Mr.

Dagres served as the lead investment banker for PSINet’s ini-

tial public offering in 1995 and 1996, and throughout that

period Mr. Dagres and Mr. Schrader had many opportunities

to discuss technologies, companies, and the development of

the Internet.

Joining Battery Ventures

In 1996, after PSINet’s public offering, Mr. Dagres left

Montgomery Securities to engage in venture capital activities

in Boston with a group of associated entities generally

referred to as Battery Ventures. When Mr. Dagres joined

Battery Ventures, four funds had already been established.

Mr. Dagres stayed with Battery Ventures for 9 years (and at

the time of trial in 2009 he worked at Spark Capital, another

venture capital firm).

Battery Ventures’ organization 3

During the relevant years, Battery Ventures was a group

of entities that consisted of the following three types:

(1) Specific venture capital funds. Each of Battery Ven-

tures’ venture capital funds 4 was organized as a limited

partnership, 5 and each was governed by a limited partner-

3 The following narrative description of Battery Ventures’ organization and operation and Mr.

Dagres’s place and function therein is depicted in the chart appended to this Opinion.

4 One commentator gives the following general description of a venture capital fund:

A PE/VC [private equity and venture capital] fund generally raises its capital from a limited

number of sophisticated investors in a private placement (including public and private employee

benefit plans, university endowment funds, wealthy families, bank holding companies, and in-

surance companies) and splits the profits achieved by the fund between the PE/VC professionals

and the capital providers/investors on a pre-negotiated basis (typically with 20% of the net prof-

its allocated among the PE/VC professionals as a carried interest and the remaining 80% of the

profits allocated among the PE/VC professionals and the capital providers in proportion to the

capital supplied).

PE/VC professions generally plan and execute PE/VC transactions, including start-ups,

growth-equity investments, leveraged and management buyouts, leveraged recapitalizations, in-

dustry consolidations, and troubled-company turn-arounds.

Jack S. Levin, Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions,

para. 102 (2009 ed.).

5 A limited partnership is a partnership that has one or more limited partners (who are ‘‘lim-

ited’’ in the sense that their liability for partnership debts is limited to their investment in the

Continued

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266 136 UNITED STATES TAX COURT REPORTS (263)

ship agreement. Important in the relevant period were funds

named Battery Ventures IV, L.P. (organized in January

1997), Battery Ventures V, L.P. (organized in March 1999),

and Battery Ventures VI, L.P. (apparently organized in

2000), which we refer to individually as Fund IV, Fund V,

and Fund VI and collectively as the Venture Fund L.P.s. 6

Funds IV, V, and VI were formed during Mr. Dagres’s tenure

at Battery Ventures. Each Venture Fund L.P. had limited

partners (who were its principal investors) and a single gen-

eral partner.

(2) Limited liability companies (L.L.C.s). 7 Battery Ven-

tures’ L.L.C.s served as the general partners of the Venture

Fund L.P.s, responsible for management and investment.

Important in the relevant period were Battery Partners IV,

L.L.C. (the general partner of Fund IV), Battery Partners V,

L.L.C. (the general partner of Fund V), and Battery Partners

VI, L.L.C. (the general partner of Fund VI), which we refer

to individually as Partners IV, Partners V, and Partners VI

and collectively as the General Partner L.L.C.s. The General

Partner L.L.C.s were governed by limited liability company

agreements that provided for several types of members

(‘‘Member Managers’’, ‘‘Special Members’’, and ‘‘Limited

Members’’) and that set out the members’ entitlement to

share in the profits of the L.L.C. The members of the General

Partner L.L.C.s were Battery Ventures personnel. Mr.

Dagres was a Member Manager of Partners IV, V, and VI

and was entitled to a 12- to 14-percent share of their profits.

(3) Management companies. The Battery Ventures manage-

ment companies provided services to assist the operation of

the Venture Fund L.P.s and their General Partner L.L.C.s.

Relevant in this suit is Battery Management Co. (BMC), an

S corporation that served as a management company in rel-

partnership and they do not have management authority) in addition to one or more general

partners (who are liable for the debts of the partnership and who have management authority).

6 The facts about Fund VI (and its related limited liability company) are limited on the record

before us (which does not include the limited partnership agreement or the limited liability com-

pany agreement), but Fund VI appears to be organized similarly to Fund IV and Fund V. The

facts about Fund IV and Fund V are adequate to explain Mr. Dagres’s involvement with Battery

Ventures. Mr. Dagres also evidently owned interests in Battery Ventures entities with the

Roman numeral ‘‘III’’ in their names, but the record does not show the details of their operations

or his work in connection with these other entities.

7 A limited liability company (L.L.C.) is an entity created under State statute. Its owners are

called ‘‘members’’. An L.L.C. is like a corporation is some respects (e.g., its owners bear only

limited personal liability for the debts and actions of the entity) and is like a partnership in

other respects (e.g., the incidents of taxation can pass through to the members).

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(263) DAGRES v. COMMISSIONER 267

evant years. 8 Battery Ventures personnel, including Mr.

Dagres, were salaried employees of BMC. BMC’s shares were

owned by the Member Managers of the General Partner

L.L.C.s, including Mr. Dagres. 9 At the end of each year, the

management company paid unspent service fees to its share-

holders, in proportion to their ownership interest in the

management company (though the record does not show the

fact or amount of actual payments in any particular year).

Mr. Dagres contends that, in addition to these specific enti-

ties, ‘‘ ‘Battery Ventures’ * * * likely constituted an oral

partnership or partnership by estoppel under state law’’ and

that this partnership was engaged in a venture capital busi-

ness that should be attributed to him as a partner. It is true

that Mr. Dagres held himself out as a ‘‘General Partner’’ of

‘‘Battery Ventures’’, and literature evidently published by

Battery Ventures entities did the same. However, in view of

our finding that the General Partner L.L.C.s were engaged

in the business of managing venture capital funds, and our

holding that this activity is attributed to Mr. Dagres as a

Member Manager of those L.L.C.s, we need not and do not

resolve the factual and legal issues prompted by this conten-

tion of partnership by estoppel.

8 BMC was initially a C corporation, but it elected S corporation status for taxable year 2003.

The parties stipulated that BMC provided management services to Fund V and Partners V but

stipulated that those services were provided to Fund IV and Partners IV by a different entity—

Battery Capital Corp. (BCC), a C corporation. However, the role of BCC is unclear on the record

before the Court. Mr. Dagres’s testimony about management services addressed only BMC, and

BMC received management fees from and provided administrative services to not only Battery

Ventures V and its General Partner L.L.C. but also Battery Ventures IV and its General Part-

ner L.L.C. Moreover, BMC was the only management company for the Battery Venture Funds

in the year 2000, and during the relevant years BMC was the only Battery Ventures manage-

ment entity from which Mr. Dagres reported income (specifically, income on Form W–2, Wage

and Tax Statement). Consequently, we assume that BMC was the successor to BCC, and this

Opinion will speak of BMC as the sole management company of the Battery Ventures group.

Any imprecision in the identity of the management company—whether in the stipulation or in

the other evidence—does not affect the outcome of any issue in this case.

9 Mr. Dagres acquired 70 shares of BMC in 1999, and in December 2002 he purchased an ad-

ditional 11 shares. At all relevant times, BMC had 350 shares outstanding; thus, Mr. Dagres

was a 20-percent shareholder from 1999 through 2002, and he owned 23.1 percent of BMC as

of December 2002 and throughout 2003.

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268 136 UNITED STATES TAX COURT REPORTS (263)

Services and fees

Under the limited partnership agreement of each Venture

Fund L.P., its General Partner L.L.C. was responsible for

managing the fund and making its investments, in return for

a fee. The General Partner L.L.C. in turn entered into a

service agreement with BMC, pursuant to which—in return

for the General Partner L.L.C.’s promise of an equivalent fee

to BMC—Mr. Dagres and other Battery Ventures personnel

actually performed the necessary work of managing and

investing for the Venture Fund L.P.

Under the service agreement, BMC assumed all the normal

operating expenses of the General Partner L.L.C.s, including

all routine expenses incident to serving the venture capital

activities of the General Partner L.L.C.s. These included the

expenses for investigating investment opportunities, compen-

sating the officers and employees of BMC, paying the salaries

of the Member Managers of the General Partner L.L.C.s, and

paying the fees and expenses for administrative, accounting,

bookkeeping, and legal services, office space, utilities, travel,

liability insurance, and other related expenses. BMC provided

the facilities and staff needed to perform the venture capital

business of Battery Ventures, including staff who helped

with identifying and researching potential investment tar-

gets, staff who helped perform due diligence on those pros-

pects, staff who helped to manage the investments (by pro-

viding management assistance to the target companies them-

selves), and other support staff, such as receptionists, secre-

taries, accounting personnel, etc.

Each Venture Fund L.P. paid service fees annually of 2 to

2.5 percent of the partners’ total committed capital in the

fund. The limited partnership agreements obligated each

Venture Fund L.P. to pay these service fees to its respective

General Partner L.L.C., but each General Partner L.L.C. in

turn agreed to reimburse BMC for organizational expenses

incurred in setting up the General Partner L.L.C. and the

Venture Fund L.P., and agreed to pay a service fee to BMC

equal to the service fee described in the limited partnership

agreement. Consequently, each Venture Fund L.P. remitted

the service fees directly to BMC, by-passing the General

Partner L.L.C. that was immediately obligated to perform

the management services and entitled to receive the fees.

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(263) DAGRES v. COMMISSIONER 269

Those service fees were the revenue source from which BMC

paid salaries to its employees.

Investment and return

Each Venture Fund L.P. solicited investors to invest (as

limited partners) in ‘‘developmental and emerging companies

primarily in the software, communications and information

systems industries primarily in the United States’’. The total

maximum subscription or aggregate investment amount for

Fund IV was $200 million, and the maximum for Fund V

was $400 million. The aggregate investment amount is also

called the amount of pledged funds or the ‘‘committed cap-

ital’’ of the fund. Each Venture Fund L.P. had a 10-year life,

and each limited partnership agreement provided that the

General Partner L.L.C. could not make additional calls for

capital contributions by the limited partners after the fifth

anniversary of the date of the agreement. 10

The limited partner investors included insurance compa-

nies, pension funds, foundations, and high-net-worth individ-

uals. Each limited partnership agreement required its Gen-

eral Partner L.L.C. to use its best efforts to conduct the part-

nership’s affairs: (1) in a manner to avoid any classification

for Federal income tax purposes that the partnership was

engaged in the conduct of a trade or business, and (2) in a

manner to avoid generating any unrelated business taxable

income for any tax-exempt limited partner. The parties

therefore agree that the activity of the Venture Fund L.P.s

themselves was investment, and not the conduct of a trade

or business.

The limited partners contributed 99 percent of each fund’s

capital. The remaining 1 percent of the funds in the Venture

Fund L.P. came from the General Partner L.L.C. The mem-

bers of that General Partner L.L.C. personally contributed

the money to fund that 1 percent, presumably in proportion

to their ownership interests in the General Partner L.L.C.

(though the record does not show the proportions).

10 The limited partnership agreements provided that Fund IV began on January 22, 1997, and

would end December 31, 2007, and that Fund V began March 31, 1999, and would end Decem-

ber 31, 2009. At the end of that time, each Venture Fund L.P. was to be liquidated and its cash

and securities distributed. Thus a capital call could occur for Fund IV as late as January 22,

2002, and for Fund V as late as March 31, 2004. Consequently, at the time he made the loan

to Mr. Schrader, Mr. Dagres still had an interest in finding companies in which to invest the

funds of Funds IV and V and (since it was organized even later) Fund VI.

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270 136 UNITED STATES TAX COURT REPORTS (263)

The General Partner L.L.C. was entitled to additional com-

pensation for the management and investment services that

it was obliged to provide (with support from the management

company): Each Venture Fund L.P. granted a 20-percent

profits interest to its General Partner L.L.C. This profits

interest is called ‘‘carried interest’’ or ‘‘carry’’. As is explained

above, this ‘‘carry’’ is an important feature of the venture

capital arrangement. Though the venture capital firm makes

only a relatively modest 1-percent contribution to the capital

of the fund, it obtains an additional 20-percent interest in

the profits. 11 It therefore has a very substantial opportunity

for gain—and, from the point of view of the other investors,

it has a very substantial incentive to maximize the fund’s

success.

Mr. Dagres’s functions at Battery Ventures

In the period 2000 (the year of the loan at issue) through

2003 (the taxable year at issue), Mr. Dagres was (1) an

employee of BMC, (2) an owner of BMC shares, and (3) a

Member Manager of General Partner L.L.C.s. Mr. Dagres’s

responsibilities included finding investment opportunities for

the funds; researching, analyzing, and investigating the

products, services, and financials of the companies (per-

forming due diligence on the target companies); calling cap-

ital (i.e., requesting from limited partners that they fund

more of their commitment to the fund so that the fund could

invest in the target company); then working with each com-

pany (often on its board of directors) to help it achieve the

growth or acquisition potential that made it an attractive

investment prospect; and finally liquidating the investments

before the termination date of the Battery Fund at issue. The

BMC staff included researchers who would attend trade con-

ferences and read industry periodicals to identify investment

opportunities, and Mr. Dagres also developed and mined his

11 Strictly speaking, it appears that the General Partner L.L.C. obtains slightly less than 21

percent (20 percent plus 1 percent) of the profits. After the investors’ capital has been returned

to them, 20 percent of the profits is paid to the General Partner L.L.C. in its capacity as man-

ager of the Venture Fund L.P., and then the remaining 80 percent of the profits is distributed

to the investors in proportion to their investment. Since the General Partner L.L.C. invested

1 percent of the capital, it receives 1 percent of the investors’ share—i.e., 1-percent of 80 percent

of the profits. Thus, the General Partner L.L.C. as a 1 percent investor receives 0.8 percent of

the profits. For the sake of simplicity, we refer in this Opinion to the 20-percent and 1-percent

interests without making this correction.

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(263) DAGRES v. COMMISSIONER 271

own network of contacts (including computer and networking

industry professionals, attorneys, and investment bankers).

Mr. Dagres’s income from Battery Ventures

Mr. Dagres earned income through Battery Ventures in

three different ways: (1) As an employee of BMC he received

a salary, which he called a draw. This salary totaled more

than $10 million over the five years 1999 to 2003, as is

shown on the chart below. (2) As a stockholder of BMC, he

was entitled to receive his proportionate share of any service

fees paid to BMC by the Venture Fund L.P.s that remained

unused at the end of the year. 12 (3) As a Member Manager

of the General Partner L.L.C.s, he was entitled to (and was

paid directly by the Venture Fund L.P.s) a proportionate

share of the carried interest—the 20-percent profits interest

that each Venture Fund L.P. paid to its General Partner

L.L.C. 13 In the years 1999 to 2003, this profit interest

yielded Mr. Dagres more than $43 million in capital gains,

as is shown on the chart below, which summarizes Mr.

Dagres’s wages and capital gains as reported on his Federal

income tax returns:

Year Wages & salary Capital gain

1999 $917,248 $2,640,198

2000 2,578,416 40,579,415

2001 3,640,916 –3,000

2002 2,104,276 161,568

2003 1,628,012 –3,000

Total 10,868,868 43,375,181

Thus, in the year 2000—the year in which he made the loan

at issue (discussed below) and, on this record, clearly his best

year—Mr. Dagres earned $2.6 million in his capacity as a

BMC employee and $40.6 million in his capacity as a Member

Manager. Subjectively, Mr. Dagres’s greatest interest was in

his ‘‘carry’’ and in his opportunity to maximize it by identi-

fying profitable leads for the Venture Fund L.P.s. That

12 The record does not disclose the precise nature or amount of any excess service fees that

BMC paid to Mr. Dagres.

13 The Venture Fund L.P. also returned to the General Partner L.L.C. its 1-percent capital

contribution (i.e., a return of principal) along with the gain on that investment, and Mr. Dagres

received his proportionate share of those funds as well.

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272 136 UNITED STATES TAX COURT REPORTS (263)

interest was never greater than when Mr. Dagres was flush

with success in late 2000.

PSINet relationship

Following PSINet’s 1996 public stock offering that Mr.

Dagres had managed for his previous employer, PSINet grew

and prospered, and Mr. Schrader, as chairman and chief

executive officer, prospered with it. By 1999 PSINet had

become one of the largest independent Internet service pro-

viders in the United States.

When Mr. Schrader learned that Mr. Dagres had moved

from Montgomery Securities to Battery Ventures, he got back

in touch with him. Mr. Dagres and Mr. Schrader were busi-

ness acquaintances and not personal friends. Rather, Mr.

Dagres recognized Mr. Schrader as an early pioneer of the

commercial Internet and a shrewd businessman who had

built a very successful company. Mr. Dagres found Mr.

Schrader to be an influential and useful contact, part of Mr.

Dagres’s network of leaders and executives in the industry.

Because of PSINet’s dominant role connecting companies to

the Internet, its management learned of promising young

Internet and technology companies very early in their

development. Many of these companies sought advice and

possibly investment from PSINet, and Mr. Schrader passed

some of these entrepreneurial contacts on to various invest-

ment bankers and venture capitalists he knew, including Mr.

Dagres. PSINet had a venture capital investment branch

called PSINet Ventures through which it profitably co-

invested with Battery Ventures in Akamai Technologies and

Predictive Networks, among others.

PSINet Ventures also used various venture capital funds to

vet companies that it was considering investing in. PSINet

Ventures primarily focused its investing on PSINet’s cus-

tomers and on companies that could supply PSINet with tech-

nology. PSINet would screen the companies for compatibility

with PSINet’s systems, and then PSINet Ventures would con-

tact outside venture capitalists to investigate the company,

doing the thorough ‘‘due diligence’’ on finances, ownership,

funding, and other attributes, a function that was outside

PSINet’s expertise but that was one of the venture capitalist’s

core competencies. PSINet’s goal was to co-invest in the com-

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(263) DAGRES v. COMMISSIONER 273

pany, using some money from PSINet Ventures and some

from an outside venture capital fund (such as Battery Ven-

tures’ funds).

Mr. Schrader was therefore an important source of leads

on promising companies for Mr. Dagres to consider inves-

tigating as potential investments for the venture funds for

which he worked, a source of information on prospective

investment targets, and (through PSINet) a source of help for

some of the companies in which Mr. Dagres’s venture funds

invested. In addition, Mr. Schrader and PSINet also invested

in Battery Ventures IV and V.

Making the loan

When the Internet stock bubble burst in 2000, PSINet’s

stock was particularly hard hit. Not only was PSINet a major

Internet company, but most of its customers were also Inter-

net firms, and the combination of pressure on its stock and

weakening revenues from customers with decreasing abilities

to pay their bills drove PSINet’s stock from $20 per share in

August 2000 to $5 per share in October 2000 and to less than

$3 per share in November 2000.

Mr. Schrader owned PSINet stock; but he had pledged his

stock as collateral for loans and had invested the loan pro-

ceeds in various privately held companies and in several ven-

ture capital funds. With the value of his PSINet stock plum-

meting and the value of many of the investments he made

with borrowed funds falling, his bankers began demanding

additional security or repayment. After exhausting his per-

sonal funds and the money he could obtain from family and

friends, Mr. Schrader asked Mr. Dagres to lend him $5 mil-

lion.

With an eye toward strengthening his relationship with

Mr. Schrader and PSINet, Mr. Dagres made the loan on

November 7, 2000. The $5 million loan was unsecured, evi-

denced by a demand note, and included interest at the rate

of 8 percent annually (at a time when the applicable Federal

rate was 6.15 percent). It was understood that, in return for

the loan, whenever Mr. Schrader thereafter learned about

any promising new companies, Mr. Dagres would be the first

he would tell about any opportunities. The parties stipulated

that Mr. Dagres—

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274 136 UNITED STATES TAX COURT REPORTS (263)

ultimately decided to make the loan to preserve and strengthen his busi-

ness relationship with Schrader in order to ensure his access to investment

opportunities that Schrader might offer in the future. In other words, peti-

tioner made the loan to get the first opportunity at investing in Schrader’s

next ventures, from which he would profit through a managing member

interest in an LLC general partner of a limited partnership [i.e., a Venture

Fund L.P.].

However, PSINet continued to founder, and by the end of

November 2000, PSINet traded at $1.13 per share. In April

2001 PSINet fired Mr. Schrader, and on April 27, 2001,

NASDAQ delisted PSINet. In 2002 Mr. Schrader repaid

$800,000 to Mr. Dagres. Mr. Schrader’s financial situation

worsened, and to avoid Mr. Schrader’s filing for bankruptcy

protection, on December 31, 2002, Mr. Dagres forgave the

original loan in exchange for a new non-demand promissory

note for $4 million, with 1.84-percent interest (when the

short-term applicable Federal rate was 1.84 percent),

maturing December 31, 2005, and with required monthly

payments of $5,000.

Mr. Schrader made six payments of $5,000 in 2003; but on

May 31, 2003, he notified Mr. Dagres that he would not be

able to make any further monthly payments on the note. At

Mr. Dagres’s request, Mr. Schrader negotiated with a cer-

tified public accountant who worked at Battery Ventures,

John O’Connor, and during the negotiations Mr. Schrader

stated:

[F]or the record I would like him [Mr. Dagres] to know that which he

already knows. I will always give him first opportunity to invest in any

and all businesses where there is even the slightest fit between Battery’s

focus and my future.

Mr. Dagres and Mr. Schrader executed a settlement agree-

ment on December 31, 2003, pursuant to which Mr. Dagres

accepted $364,782 in securities 14 from Mr. Schrader and for-

gave the balance of the $4 million loan as restructured on

December 31, 2002.

Reporting the losses

Upon the advice of Mr. O’Connor, who worked for BMC (and

who in turn consulted with tax counsel at the law firm of

14 These securities included Mr. Schrader’s interests in Fund IV and Fund V. The IRS did not

challenge the value placed on the securities Mr. Dagres received.

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(263) DAGRES v. COMMISSIONER 275

Holland & Knight and with tax specialists at the accounting

firm that handled Mr. Dagres’s tax return preparation), 15

Mr. Dagres claimed business bad debt losses on his Forms

1040, U.S. Individual Income Tax Return, for 2002 and 2003.

In the block next to his name on page 2 of those returns (as

on prior returns), Mr. Dagres indicated his ‘‘occupation’’ as

‘‘VENTURE CAPITALIST’’. To the 2002 and 2003 returns Mr.

Dagres attached Schedules C, Profit or Loss From Business,

that reported a sole proprietorship for which the principal

business or profession in line A was ‘‘Loan and Business Pro-

motions’’ and for which the code entered in line B was

523900, which stood for ‘‘Other financial investment activi-

ties (including investment advice)’’.

The IRS did not examine Mr. and Mrs. Dagres’s 2002

return, and we therefore do not discuss it further.

Although he had received $30,000 in payments and

$364,782 in securities from Mr. Schrader in 2003, Mr. Dagres

reported no business income on his Schedule C for 2003. 16

He reported one expense, labeled ‘‘Bad Debt Loss’’, in the

amount of $3,635,218—the difference between the $4 million

principal amount of the loan as renegotiated in 2002 and the

agreed value of the $364,782 in securities he received from

Mr. Schrader in December 2003.

Notice of deficiency

The IRS examined Mr. and Mrs. Dagres’s 2003 return and

issued a timely notice of deficiency on March 21, 2008. The

notice of deficiency stated:

The deduction of $3,635,218 shown on your 2003 return as a business bad

debt is disallowed. The debt was a non-business bad debt because it was

a personal loan and not created in connection with your trade or business.

In the latter event, the [loss on the] loan is subject to the limitations of

15 Mr. Dagres contends that his reliance on professional advice supports a claim of ‘‘reasonable

cause and good faith’’ under 26 C.F.R. sec. 1.6664–4(b)(1), Income Tax Regs., that would relieve

him of the liability for an accuracy-related penalty under section 6662 on the business bad debt

deduction if the deduction were not upheld. Since we uphold his deduction, we do not reach this

issue.

16 The parties agree that Mr. Dagres should have reported the six $5,000 payments he re-

ceived from Mr. Schrader in 2003 as interest income on his 2003 return. It appears, however,

that interest that Mr. Dagres accrued on the $4 million debt substantially exceeded $30,000 and

that some of the $364,782 that Mr. Schrader paid in the form of securities should have been

characterized as interest and not principal. However, the IRS proposed no such adjustment, and

we accept the parties’ agreement that the amount of unreported interest income was $30,000.

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276 136 UNITED STATES TAX COURT REPORTS (263)

Section 1211 of the Internal Revenue Code. Accordingly, taxable income is

increased $3,635,218.00. [Emphasis added.]

The 2003 notice of deficiency determined a tax deficiency of

$981,980 and an accuracy-related penalty of $196,396. 17

Pleadings and pretrial motion

Mr. Dagres timely petitioned for redetermination of the

deficiency.

In an amended answer filed May 15, 2009, the IRS seeks

an increased deficiency based on Mr. Dagres’s failing to

report the $30,000 received in 2003. In the amended answer,

the IRS also asserts two alternative positions with respect to

disallowance of the bad debt loss deduction determined in the

notice of deficiency.

On June 18, 2009, Mr. Dagres filed a ‘‘Motion to Shift the

Burden of Proof to Respondent Under Rule 142(a)’’, asserting

that the IRS changed its theory of the case and should bear

the burden of proving whether Mr. Dagres was engaged in a

trade or business when working as a venture capitalist. At

trial we took Mr. Dagres’s motion under advisement; and as

we explain below in part I of this Opinion, we will deny the

motion as moot, since in this case the burden of proof does

not affect the outcome.

ULTIMATE FINDINGS OF FACT

Mr. Dagres was in the trade or business of working as an

employee of BMC, to which trade or business his wage income

relates. However, he was also a Member Manager of the

General Partner L.L.C.s, each of which was in the trade or

business of managing venture capital funds, not mere invest-

ment. That venture capital management business is attrib-

utable to Mr. Dagres. When he made the $5 million loan to

Mr. Schrader in 2000, Mr. Dagres’s dominant motivation for

lending $5 million to Mr. Schrader was to gain preferential

access to companies and deals to which Mr. Schrader might

refer him, so that Mr. Dagres could use that information in

the venture capital activities that he undertook as a Member

Manager of the General Partner L.L.C.s. His loan to Mr.

Schrader was proximately related to those venture capital

17 Additional adjustments in the notice of deficiency are computational, and their resolution

will depend upon our resolution of the bad debt deduction issue.

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(263) DAGRES v. COMMISSIONER 277

management activities and to his personal intention to

obtain ‘‘carried interest’’ from the General Partner L.L.C.s;

and thus he made the loan in connection with his trade or

business. Therefore, we find that he suffered a business bad

debt loss in 2003.

OPINION

The IRS contends that Mr. Dagres’s loan to Mr. Schrader

was personal and that Mr. Dagres’s 2003 loss is a nonbusi-

ness bad debt, deductible only as a short-term capital loss

under section 166(d)(1) and subject to the limitations

imposed by section 1211(b). Mr. Dagres contends that he was

in the trade or business of venture capital (either personally

or by imputation from entities he participated in), that he

properly claimed a business bad debt deduction, and that it

is fully deductible under section 166(a)(1). The question

whether the debt was business or nonbusiness is principally

an issue of fact. See 26 C.F.R. sec. 1.166–5(b), Income Tax

Regs.

I. Whether the burden of proof affects this case

A. The general rule

As a general rule, the Commissioner’s determinations are

presumed correct, and the taxpayer has the burden of estab-

lishing that the determinations in the notice of deficiency are

erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Similarly, the taxpayer bears the burden of proving

he is entitled to any disallowed deductions that would reduce

his deficiency. INDOPCO, Inc. v. Commissioner, 503 U.S. 79,

84 (1992). 18 With respect to a taxpayer’s liability for pen-

alties, section 7491(c) places the burden of production on the

Commissioner.

B. The effect of new matter

However, Rule 142(a) places the burden of proof on the

Commissioner ‘‘in respect of any new matter’’—i.e., ‘‘new’’ in

the Commissioner’s answer. Section 7522(a) requires the

Commissioner to ‘‘describe the basis for’’ any increase in tax

18 Under certain circumstances the burden can shift to respondent with respect to factual dis-

putes pursuant to section 7491(a). However, Mr. Dagres does not contend that the burden has

shifted under this section.

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278 136 UNITED STATES TAX COURT REPORTS (263)

due in the notice of deficiency. ‘‘A new theory that is pre-

sented to sustain a deficiency is treated as a new matter

when it either alters the original deficiency or requires the

presentation of different evidence.’’ Wayne Bolt & Nut Co. v.

Commissioner, 93 T.C. 500, 507 (1989). However, a ‘‘new

theory which merely clarifies or develops the original deter-

mination is not a new matter in respect of which respondent

bears the burden of proof.’’ Id.

C. The arguably new matter in this case

The notice of deficiency identified the loan deduction dis-

allowance as ‘‘Schedule C—Bad Debts from Sales and Serv-

ices’’, and explained that ‘‘The debt was a non-business bad

debt because it was a personal loan and not created in

connection with your trade or business.’’ In its motion for

leave to amend his answer, however, the IRS described the

amended answer as asserting two theories that were alter-

natives to disallowing the bad debt deduction as a nonbusi-

ness bad debt: (i) that the deduction should be allowed as an

unreimbursed employee business expense, or (ii) that the loss

should be allowed as an expense under section 212(1). 19

Mr. Dagres’s motion to shift the burden of proof to

respondent therefore focuses on the IRS’s alternative argu-

ments. He asserts that the IRS implicitly conceded that he

was in a trade or business by denying the deduction because

the loan ‘‘was not created in connection with your business’’,

and he argues that respondent’s counsel’s asserting at trial

that he was not in a trade or business is a new matter

requiring him to adduce proof different from that required by

the notice of deficiency.

The notice of deficiency did disallow the loss on the

grounds that the loan was personal rather than business

related, whereas we have found that the loan was not

personally motivated. This brings into focus Mr. Dagres’s

contention that any other theory by which the IRS might jus-

tify disallowance must be ‘‘new’’. It is true, as Mr. Dagres

points out, that the evidence that disproved any personal

19 The amended answer also asserted an increased deficiency due to unreported interest in-

come in 2003. This additional deficiency is clearly a new matter as to which the IRS would have

the burden of proof. However, Mr. Dagres has conceded that he failed to report the $30,000 that

Mr. Schrader paid in 2003 on his 2003 return, and therefore nothing remains to be proved with

respect to that portion of the deficiency.

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(263) DAGRES v. COMMISSIONER 279

motivation for the loan to Mr. Schrader is completely dif-

ferent from evidence that would prove that the loan was

proximately related to venture capital activity. However, the

IRS counters that, even to challenge the notice of deficiency,

Mr. Dagres must show not only that the loan was not per-

sonal but also that it was proximately related to a trade or

business. That is, the IRS contends, even to rebut the original

notice of deficiency, Mr. Dagres must prove the existence of

a trade or business to which the loan was related.

D. The non-effect of a burden shift in this case

Resolving these competing contentions in order to assign

the burden of proof on the various sub-issues might require

Solomonic and subtle distinctions—but on this record we can

avoid that difficulty, since the preponderance of the evidence

resolves these issues no matter which party has the burden

of proof. Plainly Mr. Dagres was in the trade or business of

being an employee of BMC, and both parties effectively admit

as much. The disputed issue is whether Mr. Dagres was also

in the trade or business of managing venture capital funds

(or whether such a business of a Battery Ventures entity

could be imputed to him), but the evidence relevant to the

various factual questions subsidiary to that issue is not in

equipoise. Rather, those questions are answered by the evi-

dence in the record, particularly the limited partnership

agreements of the Venture Fund L.P.s and the limited

liability company agreements of the General Partner

L.L.C.s. 20

20 The IRS apparently contends that the agreements are not enough to prove the actual ar-

rangements among the Battery Ventures entities. The General Partner L.L.C.s’ tax returns are

not in evidence, and the IRS contends that Mr. Dagres did not show that administrative fee

income was actually paid by the Venture Fund L.P.s to the General Partner L.L.C.s, rather than

being paid straight to BMC. We conclude, however, that the arrangement was the same no mat-

ter which of the entities was the payee on the Venture Fund L.P.s checks for administrative

services. The record plainly shows that the General Partner L.L.C.s contracted out their man-

agement service obligations (and their right to management service fees) to BMC. If the General

Partner L.L.C. had received the fees, it would have included them in income but then deducted

them when it paid them out to BMC—a wash. The IRS does not contend that anyone avoided

tax on the fee income. Nor does the IRS contend that an L.L.C. ceases to be in a trade or busi-

ness because it employs contractors to perform its business functions. Our finding that the Gen-

eral Partner L.L.C.s were engaged in the trade or business of managing venture capital funds

is unaffected by any instruction to the Venture Fund L.P.s to pay the administrative fees di-

rectly to BMC.

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280 136 UNITED STATES TAX COURT REPORTS (263)

II. When bad debt losses are deductible

A. Business and nonbusiness bad debts in general

Section 166(a)(1) provides the general rule permitting full

deduction of worthless debts. Mr. Dagres invokes that provi-

sion. However, two circumstances may limit that deduction,

and the IRS invokes those limits:

First, the IRS points to section 166(d)(1), which provides

that ‘‘nonbusiness’’ debts are deductible only as short-term

capital losses. Section 166(d)(2) defines a ‘‘nonbusiness debt’’

by exclusion; i.e., it is ‘‘a debt other than—(A) a debt created

or acquired (as the case may be) in connection with a trade

or business of the taxpayer, or (B) a debt the loss from the

worthlessness of which is incurred in the taxpayer’s trade or

business.’’ Classifying a taxpayer’s debt as business or non-

business therefore requires a determination of whether he

incurred the bad debt loss in a trade or business rather than

in some other activity. Section 1211(b) provides that an indi-

vidual taxpayer like Mr. Dagres may deduct capital losses

only to offset capital gains (plus no more than $3,000 on a

joint return). Thus, in general, the capital loss deduction for

nonbusiness bad debts is much less advantageous than the

ordinary deduction for business bad debts. The IRS’s primary

contention here is that Mr. Dagres’s loan to Mr. Schrader

was a personal loan that, when it became uncollectible,

yielded a nonbusiness bad debt deduction.

Second, the IRS observes that if a debt is incurred in the

trade or business of being an employee, then a loss arising

from the worthlessness of that debt is deductible as an

employee business expense—i.e., as a miscellaneous itemized

deduction as defined in sections 63 and 67. As a miscella-

neous itemized deduction, an employee business bad debt

deduction is subject to the 2-percent floor imposed by section

67 and is not deductible in computing alternative minimum

tax under section 56(b)(1). The IRS’s alternative contention is

that Mr. Dagres’s loan to Mr. Schrader was proximately

related to his status as an employee of BMC (rather than to

a trade or business of managing venture capital funds), so

that it yielded a business bad debt deduction that was sub-

ject to those strictures. 21

21 As an additional alternative, the IRS contends that the loss should be allowed as an ex-

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(263) DAGRES v. COMMISSIONER 281

B. Investment activity as a nonbusiness

Investing one’s money and managing one’s investments do

not amount to a trade or business. Whipple v. Commissioner,

373 U.S. 193, 200, 202 (1963). Investors who invest their own

funds in public companies or in privately held companies

earn investment returns; they are investing, not conducting

a trade or business, even when they make their entire living

by investing. ‘‘No matter how extensive his activities may be,

an investor is never considered to be engaged in a trade or

business with respect to his investment activities.’’ King v.

Commissioner, 89 T.C. 445, 459 (1987) (citing Higgins v.

Commissioner, 312 U.S. 212, 216, 218 (1941)).

However, an activity that would otherwise be a business

does not necessarily lose that status because it includes an

investment function. Rather, the activity of ‘‘promoting, orga-

nizing, financing, and/or dealing in corporations * * * for a

fee or commission or with the immediate purpose of selling

the corporations at a profit in the ordinary course of that

business’’ is a business, Deely v. Commissioner, 73 T.C. 1081,

1093 (1980) (citing Whipple v. Commissioner, 373 U.S. at

202–203), supplemented by T.C. Memo. 1981–229, as is

‘‘developing * * * corporations as going businesses for sale to

customers’’, Whipple v. Commissioner, 373 U.S. at 203.

Bankers, investment bankers, financial planners, and stock-

brokers all earn fees and commissions for work that includes

investing or facilitating the investing of their clients’

funds. 22 Selling one’s investment expertise to others is as

much a business as selling one’s legal expertise or medical

expertise.

In cases where business promotion activities are found to

rise to the level of a trade or business, a common factor for

distinguishing mere investment from conduct of a trade or

business has been compensation other than the normal

investor’s return: ‘‘income received directly for his own serv-

ices rather than indirectly through the corporate enterprise’’.

Id. That is, if the taxpayer receives not just a return on his

own investment but compensation attributable to his serv-

pense paid or incurred for the production or collection of income under section 212(1). We need

not reach this argument because we find that the loss is deductible as a business bad debt.

22 Cf. InverWorld, Inc. v. Commissioner, T.C. Memo. 1996–301 (holding that the taxpayer was

in a trade or business pursuant to section 864(b); distinguishing ‘‘cases [that] did not address

taxpayers who managed the investments of others’’).

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282 136 UNITED STATES TAX COURT REPORTS (263)

ices, then that fact tends to show that he is in a trade or

business. Although fee, commission, or other non-investor

compensation is a common element, it is not a necessary ele-

ment, provided the facts support the conclusion that the tax-

payer is more than a passive investor. Farrar v. Commis-

sioner, T.C. Memo. 1988–385; see also Deely v. Commissioner,

73 T.C. at 1093. Notably, in such business promotion cases,

the trade-or-business characterization applies even though

the taxpayer invests his own funds in, lends funds to, or

guarantees the debts of the businesses he promotes. See

Farrar v. Commissioner, supra.

C. Proximate relation of loan to business

A taxpayer may pursue more than one trade or business

during a taxable year, see Commissioner v. Groetzinger, 480

U.S. 23, 35 (1987); and where he does so, any bad debt loss

that he suffers will be characterized according to the activity

that gave rise to the debt. That is, a bad debt loss may be

deductible if the taxpayer was in a trade or business and the

bad debt loss was proximately related to such trade or busi-

ness (rather than some other activity of the taxpayer).

United States v. Generes, 405 U.S. 93, 96 (1972). To deter-

mine whether a particular bad debt loss is proximately

related to the taxpayer’s trade or business, we evaluate the

taxpayer’s dominant motive for making the loan. Id. at 104.

The business nexus required for deducting a bad debt

under section 166(a) exists where the dominant motive in

incurring the debt was protecting or enhancing the tax-

payer’s trade or business. In the case of an employee, where

the dominant purpose of a loan was protecting or enhancing

his employment, then the loan will be deductible as an

employee business expense. Id. In contrast, if the taxpayer’s

dominant motive was to protect his investment in a corpora-

tion—even if it was a corporation by which he was also

employed—then the loss is a nonbusiness bad debt. Id. at

100–101. How a taxpayer would have benefited from the loan

if it had not gone bad can be instructive. Tenn. Sec., Inc. v.

Commissioner, 674 F.2d 570, 575 (6th Cir. 1982), affg. T.C.

Memo. 1978–434. If the goal of the loan was to increase the

value of the taxpayer’s stock in the company, then the loan

is a nonbusiness investment; but if the taxpayer’s dominant

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(263) DAGRES v. COMMISSIONER 283

motive was to increase his salary or compensation, then the

debt is a business debt related to his employment. Where

both motives are found, then we must consider all the rel-

evant facts, emphasizing the objective factors and not giving

disproportionate weight to any single factor. Smith v.

Commissioner, T.C. Memo. 1994–640.

III. Whether Mr. Dagres engaged in venture capital manage-

ment as a trade or business

A. Managing others’ investments as a trade or business

Mr. Dagres contends that, for purposes of section 166(d),

the Battery Ventures activity of identifying, developing, and

pursuing investment opportunities for other investors in

return for compensation is a trade or business, an amalgam

of investment banking, stock picking, management con-

sulting, and other disciplines. As that activity is shown on

the record, we agree with Mr. Dagres and hold that the Gen-

eral Partner L.L.C.s are in the trade or business of managing

venture capital funds. The fact that the subject matter of the

activity is (other persons’) investments does not dictate that

the activity is mere investment. Rather, similar to any bank

or brokerage firm that invests other people’s money, the

manager of venture capital funds provides a service that is

an investment mechanism for the customer but that is a

trade or business of the manager. In exchange for this

service, the fund manager receives both service fees and a

profits interest, but neither the contingent nature of that

profits interest nor its treatment as capital gain makes it any

less compensation for services.

Neither the Code, the regulations, nor the caselaw has

defined ‘‘trade or business’’ for all purposes, see Commis-

sioner v. Groetzinger, 480 U.S. at 27, but the Supreme Court

gave instructive analysis when it considered whether a tax-

payer’s gambling activity constituted a ‘‘trade or business’’

for purposes of the alternative minimum tax, id. ‘‘We accept

the fact that to be engaged in a trade or business, the tax-

payer must be involved in the activity with continuity and

regularity and that the taxpayer’s primary purpose for

engaging in the activity must be for income or profit.’’ Id. at

35. The Supreme Court underscored the distinction between

trade or business on the one hand and profit-motivated

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284 136 UNITED STATES TAX COURT REPORTS (263)

transactions that are disconnected from a trade or business

on the other, reiterated that an examination of all the facts

in each case is required, and held that because Mr.

Groetzinger applied skill in a constant effort to earn a liveli-

hood, his gambling activity was a trade or business, and his

deduction of losses was not limited by the alternative min-

imum tax. Id. at 35–36.

There is no dispute that Battery Ventures personnel

worked continuously and regularly in investing fund money

and growing companies, nor is there doubt that their motiva-

tion was income and profit. Like stockbrokers, financial plan-

ners, investment bankers, business promoters, and dealers,

Mr. Dagres and his colleagues undertook a business by which

they made money from other persons’ investments.

The General Partner L.L.C.s were thus different from an

investor (whose nonbusiness activity involves buying and

selling securities for his own account) and were more like a

broker (whose business is to buy and sell securities as inven-

tory for commissions), cf. King v. Commissioner, 89 T.C. at

457–459 (distinguishing investors and dealers), or more like

one who ‘‘promot[es] corporations for a fee’’ or ‘‘develop[s]

* * * corporations as going businesses for sale to customers’’,

Whipple v. Commissioner, 373 U.S. at 202–203. The General

Partner L.L.C.s did not vend companies or corporate stock to

customers as inventory but nevertheless, like dealers, did

earn compensation (in their case, fees and a significant

profits interest) for the services they provided in managing

and directing the investment of the venture capital entrusted

to the Venture Fund L.P.s. The General Partner L.L.C.s pro-

vided early-stage funding to companies, primarily with

money belonging to others. They actively participated in the

growth and development of the portfolio companies and

designed and implemented exit strategies for the recovery of

the private equity and any profit. Like a stockbroker or a

financial planner, the General Partner L.L.C.s received com-

pensation for services they rendered to clients. Accordingly,

we are satisfied that the General Partner L.L.C.s’ manage-

ment of the Venture Fund L.P.s has the characteristics of a

trade or business.

However, two features of Battery Ventures’ arrangements

prompt the IRS to dispute the business character of the

activity—first, the fact that the General Partner L.L.C. is

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(263) DAGRES v. COMMISSIONER 285

itself a 1-percent investor in the investment vehicle (the Ven-

ture Fund L.P.); and second, the fact that part of (and if the

fund performs well, most of) the General Partner L.L.C.’s

return from the activity is capital gain rather than ordinary

income. For the reasons we now explain, these facts do not

change the business character of the venture capital manage-

ment activity.

B. The 1-percent investment

In the deals that Battery Ventures arranges, the General

Partner L.L.C. is an investor in the Venture Fund L.P. That

is, the General Partner L.L.C. contributes 1 percent of the

total capital, and the other investors invest 99 percent. The

IRS contends that the General Partner L.L.C.’s character in

the activity is governed by this 1-percent investment. As a

factual matter, however, this contention fails.

The General Partner L.L.C.’s incentive for its work was not

the 1-percent return it would otherwise get for its 1-percent

investment but rather the promised 20 percent of the Ven-

ture Fund L.P.’s profit. And the Venture Fund’s motive for

offering that 20-percent return was not the General Partner

L.L.C.’s very modest investment but rather its undertaking

to manage the venture capital fund. The extreme dispropor-

tion between the 1-percent investment and the 20-percent

profit interest yields the conclusion that the overwhelmingly

predominant activity of the General Partner L.L.C.—and the

activity that characterized it—was its management of the

fund.

It cannot be denied that the General Partner L.L.C. has an

investment (a 1-percent investment) in the Venture Fund

L.P. and is therefore a (1-percent) investor in the Venture

Fund L.P. And we do not hold that the 1-percent investment

was de minimis (since it amounted to the hardly negligible

sums of as much as $2 million for Fund IV and as much as

$4 million for Fund V), or that it was nonessential to the

arrangement.

But the Venture Fund L.P.’s agreement to pay 20 percent

of its profit to the General Partner L.L.C. is inexplicable—

and would be absurd—apart from the General Partner

L.L.C.’s serving as a venture capitalist. The 99-percent inves-

tors were not looking for a 1-percent co-investor; they were

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286 136 UNITED STATES TAX COURT REPORTS (263)

looking for someone in the business of managing venture

capital funds, who could locate attractive investment targets,

investigate those companies, negotiate investment terms,

help the companies to thrive, design exit strategies, liquidate

the holdings, and achieve an attractive return for them; and

the General Partner L.L.C. conducted that business.

The General Partner L.L.C.s’ relatively small activity of

investing had a nonbusiness character; but the General

Partner L.L.C.’s compensation for its work—i.e., the 20-per-

cent profits interest—dwarfed the General Partner L.L.C.’s

expected and actual return on its 1-percent investment. The

General Partner L.L.C.s were therefore in the trade or busi-

ness of managing venture capital funds by virtue of their

management activities.

C. The capital nature of income earned

The IRS contends that the nonbusiness character of the

General Partner L.L.C.’s activity is evident from the fact that

it received not ordinary income but capital gain—an inves-

tor’s return. However, while investment often produces cap-

ital gain income, capital gain income is not necessarily indic-

ative of investment activity rather than business activity.

See King v. Commissioner, 89 T.C. at 460 (‘‘we are faced with

the unusual situation of a taxpayer engaged in a trade or

business [trading commodity futures] which produces capital

gains and losses’’). It may be anomalous that, with the IRS’s

concurrence, a venture capitalist may treat its receipt of

‘‘carry’’ as a nontaxable event, see Rev. Proc. 93–27, sec. 4.01,

1993–2 C.B. 343, 344, and may then report its eventual

income as capital gain, see Rev. Proc. 2001–43, sec. 4.01,

2001–2 C.B. 191, 192; 23 but that treatment is not challenged

here. Accordingly, even though this profit interest is com-

pensation for personal services, it is deemed to remain pass-

through income with the same character in the hands of the

23 See Staff of Joint Comm. on Taxation, Present Law and Analysis Relating to Tax Treatment

of Partnership Carried Interests and Related Issues (Part I) 3 (J. Comm. Print 2007) (‘‘the car-

ried interest held by the fund manager is a profits interest in the investment fund partnership.

The Internal Revenue Service takes the position that the receipt of a partnership profits interest

for services generally is not a taxable event * * * [and that] income from a carried interest may

be reported as long-term capital gain’’). Although Congress has considered taxing carried inter-

est as ordinary income, see, e.g., American Jobs and Closing Tax Loopholes Act of 2010, H.R.

4213, 111th Cong. secs. 411–413 (2010) (engrossed House amendment, May 28, 2010), it has yet

to do so.

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(263) DAGRES v. COMMISSIONER 287

recipient (the General Partner L.L.C.) as in the hands of the

partnership (the Venture Fund L.P.)—i.e., primarily capital

gains from investment. See secs. 701 and 702; 26 C.F.R. secs.

1.701–1, 1.702–1, Income Tax Regs. We do not agree with the

IRS that the character of this income proves that the General

Partner L.L.C.s were investors and were not in a trade or

business.

The IRS relies upon Syer v. United States, 380 F.2d 1009

(4th Cir. 1967), and similar cases, which involved taxpayers

who claimed they incurred business bad debt losses in their

business of organizing and promoting corporations. The

Court of Appeals for the Fourth Circuit required the tax-

payer to prove not only that his business was to develop cor-

porations into going concerns for sale in the ordinary course

but also that his participation in those companies exceeded

that of an investor seeking profits from the operations of the

businesses. Id. at 1010. The Court of Appeals did not answer

the question whether the taxpayer was in the business of

promoting corporations, because it held that, whether he was

or not, the bad debt at issue was sustained by the taxpayer

in his capacity as an investor and not in connection with his

alleged business. Id.

The Court of Appeals observed that its outcome—limiting

the deduction to capital loss—was ‘‘not inequitable’’ because

‘‘[i]f the business had prospered and the taxpayer had sold

his stock for a profit, he would have reported his profit as a

capital gain. A loss should receive the same treatment.’’ Id.

at 1012. However, while Syer may well be correct that such

a disallowance is ‘‘not inequitable’’, since it would make the

income and the loss symmetrical, Syer does not hold that the

character of anticipated gain necessarily dictates the char-

acter of losses. The fact that the income and loss are not

symmetrical in this case is the result of the anomalous cap-

ital treatment, explained above, that is allowed to the

recipient of a carried interest. We cannot address this

anomaly by giving ordinary business bad debt losses an

otherwise unwarranted capital characterization.

This real issue in Syer—whether the taxpayer made a

given loan as promoter or as investor—is very pointed where,

as in Syer, the bad debt that the taxpayer would deduct

arises from a loan that he made to the very business that he

claims is not an investment but is only a promotion project.

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288 136 UNITED STATES TAX COURT REPORTS (263)

The salient question is whether that given corporation is not

only a promotion project but instead is also an investment;

and the loan, made to that very corporation, is itself some

evidence that the corporation is simply an investment. No

analogous circumstance exists in this case, where Mr.

Dagres’s loan was to Mr. Schrader and not to the General

Partner L.L.C.s or to the Venture Funds. That loan by Mr.

Dagres to Mr. Schrader is itself no evidence that the Venture

Fund L.P.s are simply investments of the General Partner

L.L.C.s. Thus Syer says little that is pertinent to this case.

Likewise, in another case the IRS cites—Deely v. Commis-

sioner, 73 T.C. 1081 (1980), modified T.C. Memo. 1981–229—

the taxpayer lent money not to a third party but to a cor-

poration that he claimed was a part of his business of pro-

moting corporations. In Deely we reached the question not

resolved by the Court of Appeals for the Fourth Circuit in

Syer, and we held that the taxpayer was not in the business

of promoting corporations. Among the principal reasons for

this holding was that the taxpayer’s alleged business pro-

motion activity was (unlike the facts here) not ‘‘conducted for

a fee or commission’’. Id. at 1093. We did indeed note, as the

IRS points out, that ‘‘he always reported the proceeds as long-

term capital gain or loss’’, id. at 1095; but in that case the

long-term capital nature of his reported gains was evidence

that, contrary to the taxpayer’s contentions, he was not

making rapid turnaround of his interests in the corporations

but was instead holding onto them as long-term investments.

Such evidence contradicts a claim that one is in the business

of dealing in corporations (rather than holding interests in

them for investment); it would not defeat a claim that one is

in the business of investing other persons’ money and taking

as compensation a share of their profits (chiefly capital

gains).

As we have pointed out, a General Partner L.L.C. was enti-

tled to a 1-percent investor’s return for its investment of 1

percent of the capital of the Venture Fund L.P. However, it

was for its management of the venture capital activity (not

for its investment) that the General Partner L.L.C. earned

the 20-percent carry. The investors considered the efforts of

the managers sufficiently valuable to compensate the Gen-

eral Partner L.L.C. with 20 percent of the profits from the

venture, above and beyond its 1-percent investment returns.

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(263) DAGRES v. COMMISSIONER 289

The General Partner L.L.C.’s function in employing capital—

99 percent of which belonged to other investors—was dif-

ferent in quantum and in kind from that of an investor; and

the skills that the General Partner L.L.C.s employed in

finding, vetting, funding, and helping to manage the target

companies produced the returns that the Venture Fund L.P.s

enjoyed and shared with the General Partner L.L.C.

Having concluded that the General Partner L.L.C.s’

management of the Venture Fund L.P.s was a trade or busi-

ness, we now turn to the question whether Mr. Dagres made

his loan to Mr. Schrader in connection with that trade or

business.

IV. Whether Mr. Dagres made his loan in connection with the

business of managing the Venture Fund L.P.s

Mr. Dagres was a Member Manager of the General Partner

L.L.C.s. The IRS does not dispute that it was as a result of

that Member Manager status that Mr. Dagres received his

share of the carried interests of those L.L.C.s, and does not

dispute that a Member Manager is deemed to carry on the

trade or business of his L.L.C. See Rev. Rul. 98–15, 1998–1

C.B. 718; cf. Hoffman v. Commissioner, 119 T.C. 140, 149

(2002) (‘‘A general partner may be deemed to be conducting

the trade or business activity of the partnership of which she

is a member.’’). We have held that the General Partner

L.L.C.s’ activity was not mere investment but was the trade

or business of managing venture capital funds. Consequently,

it follows that Mr. Dagres was in that trade or business.

However, as we have noted, Mr. Dagres was also an

investor (i.e., of his portion of 1 percent of the Venture Fund

L.P.’s capital), and if his loan to Mr. Schrader was proxi-

mately related to his investment interest, then the resulting

bad debt was not a business bad debt. Moreover, Mr. Dagres

was also a salaried employee of BMC and was therefore in the

trade or business of being an employee. If his loan to Mr.

Schrader was proximately related to his employment, rather

than to the venture capital business, then the deduction of

the resulting bad debt loss is severely limited. See supra part

II.A. We must therefore determine to which of these activi-

ties—his investment, his employment, or his venture capital

management—the loan was proximately related.

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290 136 UNITED STATES TAX COURT REPORTS (263)

In United States v. Generes, 405 U.S. at 103, the Supreme

Court indicated that when determining whether a bad debt

has a proximate relation to a taxpayer’s trade or business

and therefore qualifies as a business bad debt, the question

to ask is whether the ‘‘dominant motivation’’ for the loan was

business; a merely ‘‘significant motivation’’ is insufficient to

show a proximate relation. In Generes, the Supreme Court

held that the dominant motivation for the taxpayer’s lending

money to his company was not the business motive of pro-

tecting his modest salary; rather, in addition to protecting

his son-in-law’s livelihood, he was motivated to protect his

sizable investment in the company. Id. at 106. Accordingly,

non-business motives prompted the loan, and therefore the

loss was not a business bad debt.

In this case, however, Mr. Dagres’s compensation for his

work as a manager of the Venture Fund L.P.s—i.e., his share

of the 20-percent profits interest and the 2-percent manage-

ment fee—exceeded by twenty-fold his share of the return on

the 1-percent investment. Moreover, although his salary from

BMC (i.e., his share of the management fees) was significant

in absolute terms (nearly $11 million in five years, of which

he received almost $2.6 million in the year of the loan), his

carry was clearly dominant ($43 million of capital gains in

those same five years, of which $40 million was carry

received in the year of the loan). He lent $5 million to Mr.

Schrader to protect and enhance what he considered a valu-

able source of leads on promising companies in which, as

Member Manager of General Partner L.L.C.s, he could invest

the money of the Venture Fund L.P.s, help manage those

companies, and earn substantial income in the form of carry.

Mr. Dagres’s carry significantly exceeded both his salary and

his return on his own investment. We are satisfied that ven-

ture capital motives and not employment or investment

motives were the primary motivation for his loan. It is that

venture capital business motive that characterizes the subse-

quent bad debt loss.

It is true that Mr. Dagres’s Schedule C did not identify his

principal business or profession associated with the bad debt

loss as anything explicitly related to ‘‘venture capital’’, but

rather as ‘‘Loan and Business Promotions’’, along with a code

entered of 523900, meaning ‘‘Other financial investment

activities (including investment advice)’’. As we have pointed

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(263) DAGRES v. COMMISSIONER 291

out, however, the caselaw discusses business promotion as

meaning ‘‘promoting, organizing, financing, and/or dealing in

corporations * * * for a fee or commission or with the imme-

diate purpose of selling the corporations at a profit in the

ordinary course of that business’’, Deely v. Commissioner, 73

T.C. at 1093, and that business overlaps substantially with

the business of managing venture capital funds. Moreover,

the naming of his business on his return is hardly dispositive

of his actual trade or business. 24 Next to his signature on

page 2 of his return, he did identify his ‘‘occupation’’ as ‘‘VEN-

TURE CAPITALIST’’; and the IRS does not suggest any code

other than 523900 that would be appropriate for a business

of managing venture capital funds. Mr. Dagres’s reporting on

his return does not estop him from contending that he was

engaged in that business.

V. Accuracy-related penalty

Section 6662 imposes a 20-percent penalty on an ‘‘under-

payment’’ of tax that results either from negligence or dis-

regard of rules and regulations or from a ‘‘substantial under-

statement’’ of income tax. See sec. 6662(a) and (b)(1) and (2).

Stated simply, an ‘‘underpayment’’ of tax is the amount by

which the tax actually imposed by the Code exceeds the

amount of tax that the taxpayer reported. Sec. 6664(a).

The IRS imposed an accuracy-related penalty in the notice

of deficiency because it found an underpayment attributable

to both the bad debt loss and the $30,000 of interest income

that Mr. Dagres omitted from his return. Mr. Dagres

reported zero taxable income, because the bad debt loss he

claimed exceeded the amount of all the income he reported;

but when the IRS disallowed the loss and included the

income, it determined an underpayment that was attrib-

utable to a ‘‘substantial understatement’’.

However, we have held in Mr. Dagres’s favor as to the

business bad debt loss he claimed. Even though he concedes

24 We consider multiple factors in analyzing whether a taxpayer is engaged in a trade or busi-

ness and in identifying which trade or business he is in; and no specific factor is conclusive,

but all are to be weighed—even an inaccurate or inconsistent description on Schedule C. See

Scallen v. Commissioner, T.C. Memo. 2002–294, slip op. at 25–26; Ruppel v. Commissioner, T.C.

Memo. 1987–248 (‘‘Reporting an activity on Schedule C is indicative of a trade or business. How-

ever, petitioner’s failure to so report his income from lending activities on Schedule C is not

conclusive of the absence of a trade or business. This is particularly true when as here the re-

turn was prepared by a CPA.’’).

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292 136 UNITED STATES TAX COURT REPORTS (263)

that the $30,000 of interest income should be included in his

income, the bad debt loss still offsets all his income, and for

2003 he has no taxable income and, consequently, income tax

liability of zero—the same amount he reported on his return.

There is therefore no understatement of income tax for pur-

poses of section 6662(d), and no liability for the accuracy-

related penalty.

To reflect the foregoing,

An appropriate order and decision will be

entered.

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(263) DAGRES v. COMMISSIONER 293

f

appendix.eps

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