                                                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

                                                                                                                                      263




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                                      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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                                      (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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                                      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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                                      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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                                      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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                                      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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                                         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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                           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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                      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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                                                                               f
                                                                                                                                           appendix.eps




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