A couple of suggestions to try. Typically the "MachineToApplication" is the virtual directory not being set as an application and/or a web.config at a higher level is also getting picked up. Open up IIS on the server and create a seperate (new) application pool and call it BugNetPool. The .NET 1.1 and .NET 2.0 applications on the server need to run in seperate pools from each other (there can be mulitple virtual directory applications running in each pool, but all the apps for each pool must be for the same .NET version). Now, open the properties on the IIS virtual directory for the BugNet. On the Virtual Directory tab, under Application name, it should not be grayed out. If it is, click Create and give it a name, BugNet, and select the Application pool you just created, BugNetPool. Next verify that the 'ASP.NET/ASP.NET version' is set for 2.0 and click ok. Back in IIS, right-mouse on the BugNet virtual directory application and click Browse.
To verify visually that it's an application, I'm not sure of the icon names, but an appliation virtual directory will look like the icon for the application pools. A non-application virtual directory will have a folder with a globe.