How To Lose $610 Million In Basis

 

Let’s talk today about partnership taxation.

The driving concept is relatively straightforward: have tax step out of the way and let partners arrange their own deal.

Q. You are willing to forego future (potential) profits for a larger guaranteed paycheck today?

A. Fine.

Q. You do not want to be responsible for any partnership losses?

A. We can work with that.

The problem, of course, is that some people will always try to game the system, so Congress and the IRS have been busy for decades trying to close the most egregious loopholes. The passive activity rules, for example, represented Congress responding to the Thurston Howell III tax shelters.

The taxation of a vanilla partnership is usually straightforward. Introduce complexity – especially intentional complexity – and the taxation can challenge even the most trained professional.

Let’s look at a recent case, one involving German companies and a U.S. parent. Do not worry: we will not discuss international tax provisions.

Let’s call the first German company “Dorothy.”

Dorothy owned a (German) subsidiary called “Blanche.”

There was a U.S. company called “Sophia” that ultimately owned both Dorothy and Blanche. Sophia is relatively quiet in this story.

In March 2001 Dorothy issued Blanche a $610 million promissory note guaranteed by Sophia.

Blanche contributed the note to a spanking new partnership - let’s call it “Rose” - in exchange for a limited partnership interest.

There are a couple of Code sections at play.

Code § 722 - Basis of contributing partner’s interest

The basis of an interest in a partnership acquired by a contribution of property, including money, to the partnership shall be the amount of such money and the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

There is (usually) no gain or loss when a partner contributes property – including cash – to a partnership in exchange for an interest in the partnership. In fact, the only thing that (usually) happens is that the partner’s basis in the property (including cash) carries over to his/her basis in the partnership interest itself.

What about the partnership – does anything happen to the partnership?

26 U.S. Code § 723 - Basis of property contributed to partnership

The basis of property contributed to a partnership by a partner shall be the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.

The partnership (again – usually) just steps into the basis of the contributing partner.

But why Dorothy and all the weird maneuvering?

Remember that note which Dorothy issued to Blanche which was contributed to Rose? It will be paid off in 2009. With accumulated interest, the total would be over $1 billion.

Looks to me like we are moving money. And taxes, likely.

In April 2002, Blanche filed an entity classification election with the IRS to be disregarded as a entity separate from Dorothy.

The election was retroactive. Let’s check: retroactive to a few days BEFORE Dorothy issued the $610 promissory note to Blanche.

You may have heard of entity classification elections by another name: check-the-box. Much of this area has to do with the popularity of limited liability companies. Left alone and depending on ownership, an LLC might be taxable as a partnership, a corporation, a proprietorship, whatever. The IRS tried to bring order to this, hence the check-the-box rules. If the LLC wants to be taxed as a corporation, it makes an entity election. This is, in fact, a common technique for LLCs that intend to be taxed as S corporations, as it has to be (taxed as) a corporation before it can be taxed as an S corporation.

Blanche went the other way. Blanche decided it wanted to be disregarded from Dorothy, meaning that it would be regarded as a division, department or branch of Dorothy. The IRS would “disregard” Blanche as a separate entity.

But one has to be careful. One wants to review tax-significant transactions, especially when check-the-box is retroactive. There is a Thanos finger snap element here.

Let’s go back to the basis that is powering Code sections 722 and 723. More specifically, let’s look at the section for basis itself:

Sec. 1012 Basis of property - cost

(a) In general. The basis of property shall be the cost of such property, except as otherwise provided in this subchapter and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses).

Typical tax: the description of one word leads to another. Basis shall be the cost, padawan.

So, what is “cost”?

Black’s Law Dictionary (4th ed. 1957) tells us “that which is actually paid for goods.”

What did Dorothy start this story with?

A note to Blanche.

Can a note represent “cost”?

You betcha, if I owe it to someone who can and intends to collect from me. Think about the note on a car purchase, for example.

Dorothy “actually paid for goods” before the Thanos snap. Blanche was a separate company and could enforce collection.

What happened after the Thanos snap?

There is no Blanche, at least not as a separate company.

Dorothy in effect owed itself.

Here is the Court:

… CSC Germany paid no amount, in money or property, to create the Note. Nor did CSC Germany “engage to pay or give” anything to someone else in exchange for that third person’s help in making the Note. The Note’s adjusted basis in CSC Germany’s hands was therefore zero, as we have held in multiple similar cases.”

Dorothy cannot create “cost” by issuing a note to itself. To phrase it differently, I cannot make myself a millionaire by issuing a million-dollar promissory note to myself.

Without cost, Dorothy does not have “basis” in the note.

Which means that Blanche does not have “basis” in Rose, since Blanche’s basis is just a roll-forward of Dorothy’s basis.

So, what happens when Dorothy pays Rose $1 billion in 2009?

I expect:

              Proceeds                         $1 billion

              Basis                                  zero (-0-)

              Gain                                  $1 billion

Blanche thought it had a $610 million asset on its books.

It did.

Blanche thought it had basis of $610 million in that asset.

It did … until the finger snap.

Our case today was Continental Grand Limited Partnership v Commissioner, 166 T.C. No. 3 (March 2, 2026).