The Tax Court has previously held that a partner who contributes his own note to a partnership in exchange for a partnership interest takes no basis in the interest and their capital account is not credited for the value of the contribution.
In the case discussed below, an entity that was disregarded for purposes of the income tax received a promissory note from its sole owner, which it then contributed to a newly formed partnership in exchange for an interest in that partnership.[i]
What followed was not intended by the parties.
The Loan
Parent-Corp was a holding company that wholly owned several subsidiary corporations that were engaged in an active business. Although Parent-Corp and each of its subsidiaries were organized outside the U.S., their ultimate parent (“US-Corp”) was organized in the U.S. One of Parent-Corp’s foreign subsidiaries was Sub-Corp.
In exchange for a cash loan, Parent-Corp issued to Sub-Corp a promissory note (the “Note”), guaranteed by US-Corp, with an issue price of approximately $610 million.
The Note specified that Parent-Corp would pay just over $1.1 billion to the holder when the Note matured in just over 8 years. That amount reflected the issue price and accrued but unpaid interest. The Note was a legal, valid, and binding obligation of Parent-Corp and was enforceable against Parent-Corp in accordance with its terms.
The parties stipulated that the fair market value of the Note when issued was approximately $610 million.[ii]
The Contribution
Partnership was organized as a limited partnership under State law a few days before Parent-Corp issued the Note to Sub-Corp. It owned certain equipment that it leased to US-Corp’s affiliated entities.[iii]
Immediately upon receiving the Note from Parent-Corp, Sub-Corp transferred it to Partnership in exchange for a limited partnership interest. For the next 8 years – i.e., over the term of the Note – the Partnership had three partners: Sub-Corp, Credit-Corp., and Member-Corp.[iv]
Check-the-Box
Just over a year after assigning the Note to Partnership, Sub-Corp elected to be disregarded as an entity separate from Parent-Corp for purposes of the U.S. income tax.[v]
Sub-Corp’s election was given retroactive effect to the date Partnership was organized;[vi] i.e., to a date before Sub-Corp contributed the Note to Partnership in exchange for a limited partnership interest.
The Transaction
Nearly eight years after the formation of Partnership, Parent-Corp, Partnership, and Sub-Corp entered into an addendum to the Note, pursuant to which Parent-Corp agreed to prepay its principal and interest obligations under the Note by transferring approximately $1.07 billion to Partnership.
Parent-Corp transferred the funds to Partnership the same day.
Also on that day, Partnership distributed approximately $1.08 billion in funds to Sub-Corp in liquidation of its limited partnership interest in Partnership.
The Audit
The IRS examined Partnership’s federal tax return[vii] on which Parent-Corp’s prepayment of the Note and Partnership’s liquidation of Sub-Corp’s limited partnership interest were reported.
Following the audit, the IRS issued a Notice of Final Partnership Administrative Adjustment.
In its Explanation of Adjustments, the IRS asserted that: (i) Parent-Corp should have been treated as having zero basis in the Note; (ii) Parent-Corp should have been treated as having zero basis in its limited partnership interest in Partnership as of the date of the contribution; and (iii) Partnership should have been treated as having zero basis in the Note as of the date of the contribution.4
Although not spelled out in the Tax Court’s opinion, the tax treatment of the Note would have affected, among other things, the calculation of Parent-Corp’s basis in its partnership interest and the gain realized by Parent-Corp on the liquidation of its interest in Partnership; specifically, where money is distributed by a partnership to a partner, no gain is recognized by the partner except to the extent that the amount of money distributed exceeds the adjusted basis of the partner’s interest in the partnership immediately before the distribution. This rule applies to both to current distributions and to distributions in liquidation of a partner’s entire interest in a partnership.[viii]
Tax Court
Member-Corp (as the tax matters partner) timely petitioned the Tax Court for review. Member-Corp asked the Court to look behind Sub-Corp’s substantial basis in the promissory note at the time of its contribution.
In a motion for partial summary judgment, the IRS asked the Court to treat the Note as though it had been contributed from Parent-Corp directly to Partnership.
Relatedly, the IRS moved for partial summary judgement on three issues: (1) Parent-Corp’s adjusted basis in the Note when the Note was contributed to Partnership; (2) Parent-Corp’s basis in the partnership interest immediately after the contribution; and (3) Partnership’s basis in the Note immediately after its contribution.
It was the IRS’s position that that Parent-Corp’s contribution of the Note to Partnership was not a “contribution of property”; alternatively, the IRS contended that Parent-Corp had no basis in the Note at the time of the contribution.
By contrast, Member-Corp argued that the Note was “property” within the meaning of the Code rules governing the determination of a partner’s basis in a partnership interest.
Some Basics
Before addressing the basis consequences of the transactions among Parent-Corp, Sub-Corp, and Partnership, the Court first considered the effect of Sub-Corp’s election to be disregarded as an entity separate from Parent-Corp.
Entity Classification
The Court began by stating that the tax treatment of a business entity depends, in no small part, on the type of entity it is. Entities that are not classified as corporations per se[ix] can elect their tax treatment.[x] A foreign entity with a single owner may elect to be treated as an association (i.e., a corporation) for U.S. tax purposes or to be disregarded as an entity separate from its owner.[xi]
Next, the Court explained that when a single owner entity previously classified as an association elects to be disregarded, the following is deemed to occur: “The [corporation] distributes all of its assets and liabilities to its single owner in liquidation of the [corporation].”[xii] Thereafter, “its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.”[xiii]
As of the date of its organization, Sub-Corp[xiv] was initially classified as an association under the check-the-box regulations. Later, when Sub-Corp elected to be disregarded for purposes of the U.S. income tax effective retroactively as of the date of Partnership’s organization, Sub-Corp was deemed to have liquidated and distributed its assets and its liabilities as of such date to its sole shareholder, Parent-Corp.[xv] After that date, for U.S. federal income tax purposes, Sub-Corp had no assets of its own; indeed, it had ceased to exist as of such date for such purposes.
Importantly, the deemed distribution of Sub-Corp’s assets included all of Sub-Corp’s cash; meaning, any cash that Sub-Corp subsequently loaned to Parent-Corp belonged to Parent-Corp – not to Sub-Corp – for federal tax purposes. Moreover, from the date of the deemed distribution onward, Sub-Corp’s activities were treated as activities of a branch or division of Parent-Corp.[xvi]
Disregarded and Deemed Transfers
As a result, the Court concluded, the issuance of the Note by Parent-Corp to Sub-Corp had to be disregarded for federal tax purposes – Parent-Corp could not make a loan to itself.
Similarly, because Sub-Corp was no longer regarded as an entity separate from Parent-Corp (its owner), the assignment of the Note to Partnership was treated as if it were undertaken by a branch or division of Parent-Corp. Thus, from a federal tax perspective, Parent-Corp, not Sub-Corp, was viewed as having contributed its own note to Partnership in exchange for a limited partnership interest.[xvii]
Basis Basics[xviii]
Having determined how the relevant transactions involving the transfer of the Note among Member-Corp, Sub-Corp, and Partnership were to be viewed for tax purposes, the Court turned to the basis consequences of Parent-Corp’s contribution of the Note to Partnership.
The Code provides that a partner’s initial basis in a partnership interest that the partner acquired from the issuing partnership in exchange for a contribution of property, including money, is generally equal to the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution.[xix]
The partner’s adjusted basis for his interest in the partnership is determined by starting with the initial basis, and then increasing or decreasing such basis by the amount of certain items including, for example, the partner’s distributive share of partnership income and loss, and the distributions made to the partner.[xx]
The Court’s Analysis
The Court began its analysis by assuming that Parent-Corp’s deemed contribution of the Note to Partnership was a “contribution of property” for purposes of the partnership basis rules described above.[xxi]
Under that assumption, the basis of Parent-Corp’s limited partnership interest in Partnership was equal to the adjusted basis of the Note (issued by Parent-Corp) in the hands of Parent-Corp at the time of the contribution.[xxii]
What, then, was Parent-Corp’s adjusted basis for the Note?
According to the Court, under the Code’s generally applicable basis rules, the adjusted basis of property is the property’s cost basis (the amount paid for it),[xxiii] adjusted for certain items enumerated by the Code (for example, items chargeable to capital account).[xxiv]
The Court stated that, under these rules, the Note in the hands of its maker (Parent-Corp) had no cost. That is, Parent-Corp, as the borrower, paid no amount, in money or property, to create the Note; rather, the Note represented a liability owed by Parent-Corp, not an asset. Thus, the Court concluded, the Note’s adjusted basis in the hands of Parent-Corp was zero.
The Court then addressed Member-Corp’s arguments in support of its claim that the adjusted basis of the Note in Parent-Corp’s hands was equal to its fair market value of $610 million at the time of Parent-Corp’s deemed contribution of the Note to Partnership, and that “the common and ordinary meaning of ‘cost’ includes amounts engaged to be paid.”
“This argument,” the Court responded, “misses the mark.” When the Code refers to “cost basis,” the Court explained, it is instructing the taxpayer “to consider the cost paid by a taxpayer to acquire property.” This may include an amount borrowed by the taxpayer that was then used to purchase property; the taxpayer is entitled to include the amount of the loan in computing his basis in the purchased property because of the taxpayer’s obligation to repay such amount the loan.
Likewise, a purchaser’s cost basis includes both promissory notes issued by the purchaser to the seller and any liabilities of the seller assumed by the purchaser as consideration for the sale; in both cases, the taxpayer is obligated to satisfy their liability to the seller or the seller’s liability to another person.
In this case, however, the Code provides that a partner’s initial basis for a partnership interest acquired in exchange for a contribution of property to the partnership is equal to the contributing partner’s adjusted basis for the property contributed; meaning that Parent-Corp’s basis in the Note was relevant, not the “cost” of Parent-Corp’s partnership interest.
Parent-Corp’s obligation to satisfy the Note, the Court stated, was not a “cost” of the Note. Parent-Corp did not acquire the Note by incurring its obligation – the Note merely evidenced the obligation. Consequently, Parent-Corp’s obligation to make payments under the Note was not part of the cost of making the Note nor was it included in computing the adjusted basis of the Note.
This was consistent with what the Court described as “the established rule” that “the contribution of a partner’s own note to his partnership isn’t the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest.”
Next, the Court considered two decisions[xxv] that arose in the context of capital contributions to corporations that involved the application of a Code provision[xxvi] different from the ones before the Court. Member-Corp pointed to these decisions as indicators that Parent-Corp should have received some basis in its partnership interest.
According to the Court, neither decision was applicable to the issues raised by the IRS in the case of Parent-Corp. Both decisions involved a situation in which a taxpayer had “transferred” liabilities to a corporation that exceeded the adjusted basis of assets that the taxpayer had contributed to the corporation in exchange for stock of the corporation.[xxvii] In each case, the taxpayer sought to avoid recognizing gain[xxviii] of an amount equal to the excess of such liabilities over such adjusted basis, by promising to pay an amount to the corporation equal to the “excess contributed liabilities.”[xxix]
By contrast, there was no attempt in the present case at avoiding gain by offsetting excess liabilities. Partnership did not assume any of Parent-Corp’s liabilities as part of the contribution, and Parent-Corp did not recognize gain as a result of the contribution. In addition, Parent-Corp made its contribution to a partnership, not to a corporation.
The first of the two cases stated that the note in question had a zero basis in the contributing taxpayer’s hands,[xxx] but then concluded that the note had a basis in the transferee corporation’s hands equal to its face value.[xxxi] The second case held that the note had a face value basis to the transferor-shareholder. It also stated that its decision did not apply to pass-through entities.
With that, the Court concluded that Parent-Corp’s adjusted basis in the Note at the time of contribution was zero and, therefore, Parent-Corp took a zero basis in its limited partnership interest in Partnership as well.
The Code provides that the basis of property contributed to a partnership by a partner is generally equal to the adjusted basis of such property to the contributing partner at the time of the contribution.[xxxii]
As discussed above, the adjusted basis of the Note to Parent-Corp at the time of its contribution to Partnership was zero. Thus, the basis of the Note in the hands of Partnership was zero.
Therefore, the Court granted the IRS’s motion for partial summary judgment.
Observations
If Sub-Corp (a German GmbH and eligible foreign entity) had not elected to change its classification for U.S. tax purposes, it would have continued its default treatment as a corporation for such purposes.
In that case, Sub-Corp’s contribution of the Note (issued by Parent-Corp) to Partnership would have been treated as a contribution of property (the note of a person other than the contributor). Thus, Sub-Corp’s basis for the limited partnership interest issued by Partnership in exchange for the Note[xxxiii] would have been the same as Sub-Corp’s basis in the Note at the time of contribution.[xxxiv] Similarly, Partnership would have held the Note with the same basis.
The income tax results arising from Partnership’s subsequent liquidating distribution of Sub-Corp’s limited partnership interest in exchange for money would have been determined by reference to this basis.
Of course, Sub-Corp elected to be disregarded as an entity separate from Parent-Corp, which required the Court to treat Parent-Corp as though it had contributed the Note directly to Partnership in exchange for the limited partnership interest. The consequences of that treatment for the basis of Parent-Corp’s interest in Partnership, and the basis of the Note in the hands of Partnership, were straightforward. Parent-Corp took a zero basis in its partnership interest, and Partnership took a zero basis in the Note.[xxxv]
As the Court pointed out, Sub-Corp’s election came more than one year after the formation of, and the contribution of the Note to, Partnership. Sub-Corp presumably made its choice because being disregarded for U.S. income tax purposes was its preferred classification. In fact, it appears that Sub-Corp must have requested permission from the IRS to make a late election with retroactive effect to a time before the Note was even issued.
Obviously, this left the Parent-Corp “family” in a disadvantageous position tax-wise, from which it tried to extricate itself by asserting the basis-generating arguments described above.
However, the Court rightly reminded Member-Corp (the tax matters partner) that while a taxpayer is free to organize its affairs as it chooses, once it has done so the taxpayer must accept the tax consequences of its choice, whether these were foreseeable or not, and may not enjoy the benefit of some other route the taxpayer might have chosen to follow but did not.
It is imperative that advisers understand this last point and appreciate the difference between “correcting” earlier missteps with “creative” drafting or revisionist interpretation of facts, on the one hand, and acting within the processes for relief established under the law,[xxxvi] on the other.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] Continental Grand Limited Partnership v. Comm’r U.S. Tax Court (Filed March 2, 2026)
[ii] The interest must have reflected an arm’s length rate and US-Corp must have had sufficient assets to make its guarantee meaningful.
[iii] Although not discussed in the Tax Court’s opinion, a foreign corporation is considered as being engaged in a trade or business within the U.S. if the partnership of which such corporation is a member is so engaged. IRC Sec. 875.
If a foreign corporation owns, directly or indirectly, an interest in a partnership which is engaged in any trade or business within the U.S., gain or loss on the sale or exchange of all (or any portion of) such interest may be treated as effectively connected with the conduct of such trade or business. IRC Sec. 864(c)(8).
[iv] Member-Corp was designated as Partnership’s tax matters partner.
While Sub-Corp contributed the Parent-Corp Note in exchange for its interest in Partnership, it is unclear what the other two members contributed.
[v] Because a GmbH (a foreign eligible entity) provides limited liability protection for all its owners, the IRS treats it as a corporation for U.S. income tax purposes. Reg. Sec. 301-7701-3(b)(2)(i)(B). However, a GmbH may elect to change its tax classification The election is made by filing IRS Form 8832, Entity Classification Election. Reg. Sec. 301.7701-3(c).
It is not clear why Sub-Corp elected to change its classification for tax purposes. For some reason, it must have determined that the change in tax status would be beneficial.
[vi] The effective date specified on Form 8832 cannot be more than 75 days prior to the date on which the election is filed. Reg. Sec. 301.7701-3(c)(1)(iii). Sub Corp must have requested relief from the IRS to make a late election. See Reg. Sec. 301.9100-1; Reg. Sec. 301.9100-3; Rev. Proc. 2002-59.
[vii] Form 1065, U.S. Return of Partnership Income.
[viii] IRC Sec. 731(a). Any such gain is considered as gain from the sale or exchange of the partnership interest of the distributee partner, which is considered as gain from the sale or exchange of a capital asset, except as otherwise provided in IRC Sec. 751 (relating to unrealized receivables and inventory items). IRC Sec. 741.
[ix] Under Reg. Sec. 301.7701-2(b).
[x] Reg. Sec. 301.7701-3(a).
[xi] As stated earlier, an election can be made retroactively; i.e., up to 75 days prior to the date on which the election is filed. In this case, the parties stipulated that Sub-Corp’s election was effective retroactively outside the 75-day period. Although the record was silent on this point, in view of the parties’ stipulation as to the effective date of the election, the Court assumed that the IRS exercised its discretion to grant such an extension. Reg. Sec. 301.9100-1, -2, and -3 provide standards the IRS uses to determine whether to extend the time to make regulatory elections like the one at issue.
[xii] Reg. Sec. 301.7701-3(g)(1)(iii).
[xiii] Reg. Sec. 301.7701-2(a). However, the Court continued, there are instances – none of which were applicable in the present case – in which an otherwise disregarded entity is not “invisible” for federal tax purposes but is, instead, treated as an entity separate from its owner.
[xiv] A German GmbH; a foreign eligible entity within the meaning of Reg. Sec. 301.7701-3(b)(2).
[xv] Reg. Sec. 301.7701-3(g)(1)(iii).
[xvi] Reg. Sec. 301.7701-2(a).
[xvii] At this point in its discussion, the Court paused to explain that its tax treatment of the loan did not “destroy state-created property rights.” Whether Parent-Corp became indebted to Sub-Corp, the Court stated, and whether Sub-Corp transferred a promissory note to Partnership, were questions of state property law, not federal tax law. While state law creates legal interests and rights, the federal tax law determines how those interests or rights, so created, are to be taxed.
Where a single-member LLC’s corporate form is disregarded for federal tax purposes, it is only the form that is disregarded and only for such purposes. In other words, the legal entity that was organized under state law persists, but the tax consequences of its transactions change.
Similarly, even when transactions between a disregarded entity and its parent entity are disregarded for federal tax purposes, their existence or character for purposes of state property law is not altered.
[xviii] I realize this is up (or down?) there with corny dad jokes.
[xix] IRC Sec. 722.
[xx] IRC Sec. 705(a).
[xxi] Thereby bypassing the IRS’s first argument, stated earlier, that the Note was not property for these purposes.
However, query whether such treatment required that Parent-Corp’s capital account ne credited with the fair market value of the Note, which the parties agreed
[xxii] IRC Sec. 722.
[xxiii] Under IRC Sec. 1012; Reg. Sec. 1.1012-1(a).
[xxiv] IRC Sec. 1011, Sec. 1016.
[xxv] Lessinger v. Comm’r, 872 F.2d 519 (2d Cir. 1989), and Peracchi v. Comm’r, 143 F.3d 487 (9th Cir. 1998), rev’g T.C. Memo. 1996-191.
[xxvi] IRC Sec, 351.
[xxvii] IRC Sec. 357(c), which applies to exchanges described in IRC Sec. 351, and to exchanges described in IRC Sec. 368(a)(1)(D) and Sec. 355.
[xxviii] Under IRC Sec. 357(c).
[xxix] The hope being that the dollar amount of this obligation would provide additional basis to offset the excess liabilities.
[xxx] The Second Circuit expressed doubt that the transferor taxpayer had basis in his promise to pay the corporation. Lessinger v. Commissioner, 872 F.2d at 525. “The taxpayer could, of course, have no ‘basis’ in his own promise to pay the corporation $255,000, because that item is a liability for him.”
[xxxi] Scratching your head?
[xxxii] IRC Sec. 723.
[xxxiii] IRC Sec. 721.
[xxxiv] On the present facts, generally the issue price, assuming interest at the AFR.
[xxxv] The Court conceded it was possible that additional contributions to Partnership by Parent-Corp, or other transactions with basis consequences in the years following Parent-Corp’s contribution to Partnership, could have increased Parent-Corp’s basis in its partnership interest before its liquidation.
[xxxvi] For example, the recission doctrine or requesting permission from the IRS to make or undo an election.