A Common Fact Pattern

Partner One and Partner Two started LLC in 2002. LLC was treated as a partnership for tax purposes. They contributed a good deal of their savings and labor, but LLC lost money for the first several years of operation. Another partner, deep-pocketed Corporation, was willing to contribute almost one million dollars to keep LLC afloat, but it wanted Partners One and Two to put themselves at greater risk. This was a problem because neither Partner had the liquidity to contribute cash.

As a result, the Partners agreed to freeze their salaries. After speaking to their “longtime attorney” (who did some “cursory research” to as to the tax implications), the Partners also contributed their own promissory notes to LLC in 2007 and 2008. LLC recorded the notes on its books as additional capital and accrued interest on them–but neither Partner funded them during either year. LLC generated losses in both years.

The notes were unsecured, term-balloon notes that bore annual interest. Neither Partner assumed any LLC debt. Indeed, strapped for cash, neither Partner made interest payments, either.  Instead, LLC reported unpaid accrued interest on the unpaid notes.

This was enough for Corporation.  Satisfied that the Partners were “all in,” Corporation provided LLC with an additional $900,000 to sustain its operations and, in exchange, received $450,000 in equity and $450,000 in convertible debt.

Corporation’s money did its job, and LLC became profitable in 2012 and continued to grow in 2013.

Everyone loves an almost happy ending.  

Partners’ Outside Bases

The IRS audited Partner One’s and Partner Two’s personal income tax returns for 2007 and 2008, and issued notices of deficiency to each Partner, asserting that they failed to generate bases in their LLC interests when they contributed their personal promissory notes. The IRS said that LLC’s basis in each note was zero because the Partners’ bases in the notes were zero and, so, the Partners’ bases in their membership interests were zero. Because a partner’s distributive share of partnership loss is allowed as a deduction only to the extent of the partner’s adjusted basis for his or her partnership interest (so-called “outside basis”) at the end of the tax year in which the loss was incurred, the deductions claimed by each Partner for his share of LLC’s 2007 and 2008 losses were disallowed, resulting in an income tax deficiency. The disallowed deductions would then be carried forward by the Partners until they had sufficient outside basis to absorb the losses.

The Partners argued that the contribution of their promissory notes increased their bases in their LLC interests by amounts equal to the face value of the notes, which would allow the Partners to claim greater pass-through losses from the 2007 and 2008 tax years on their individual returns. The Partners claimed that the notes put them at substantial financial risk and that should have been enough to create outside basis.

Do Promissory Notes Generate Basis?

The Tax Court agreed with the IRS, stating that the contribution of a partner’s own note to his or her partnership is not the equivalent of a contribution of cash and, without more, it will not increase the partner’s basis in his or her partnership interest. It stated that the contribution of a note by itself does not increase a partner’s outside basis because the partner has a zero basis in the note. Similarly, a partner’s capital account is not increased with respect to a note issued by that partner until there is either a taxable disposition of the note by the partnership or the partner makes principal payments on the note.

The Court distinguished the Partners’ situation from one in which a partner directly assumes a partnership’s recourse indebtedness and becomes obligated to make additional capital contributions. While it was true that the contribution of the notes in the present case was necessary to persuade Corporation to provide more funding to cash-strapped LLC,  neither Partner was guaranteeing a preexisting LLC debt to a third party, nor did they directly assume any of LLC’s outside liabilities–these notes represented the Partners’ liability to LLC, not an assumption or guaranty by the Partners of LLC’s debt to a third party.  Moreover, there was also no evidence that the Partners were personally obliged under LLC’s operating agreement to contribute a fixed amount for a specific, preexisting partnership liability.
Thus, the Court concluded, the Partners had no adjusted basis in their notes and, until they were paid, the notes were only a contractual obligation to LLC. Thus, the Partners’ bases in their promissory notes during the 2007 and 2008  tax years were zero, LLC’s basis in the contributed notes was zero, the Partners’ bases in their LLC membership interests were zero, and the deductions claimed by them were properly disallowed.


 What is a partner to do when faced with the prospect of insufficient outside basis? Every situation is different, but there are a number of options to consider.

  • A cash contribution is obvious, as is a loan of cash to the partnership or the payment of a partnership debt, but as we saw above, these options may not be feasible. A contribution of other property (including a third party note) would do the trick, but only to the extent of the partner’s basis in the contributed property (not its fair market value).
  • If a partner owns another business entity, he or she may be able to cause that entity to make a loan to the partnership, thereby generating additional outside basis.
  • A partner may consider borrowing money from a third party and then contributing or lending it to the partnership, provided a willing lender can be found.
  • In addition, a partner’s personal guarantee or assumption of a partnership liability to a third party may generate outside basis, but the partner may not be in a position to effect these options.
  • The partner who purchases a partnership interest from another partner, even for an installment note, will receive a cost basis in such interest against which partnership losses may be deducted.
  • Finally, the acceleration of partnership income or the deferral of deductions or distributions may assist in giving the partner outside basis for purposes of absorbing losses.

In reviewing the available alternatives, it will behoove a partner that is facing the possible disallowance of loss deductions to consult with his or her tax adviser (unlike the Partners in the decision, above). In doing so, the partner must not forget the taxpayer’s mantra: before you pursue a course of action to achieve a particular tax goal, be certain that it makes sense from a business perspective.