Sweat Equity Tries To Deduct Losses

 It was the last two sentences that caught my attention:

P was a sweat equity partner.

The idea is simple: the income-only (IO) partner participates only if there is a profit. If there are losses, then the losses pass over the IO and are allocated to the other partner(s).

So, an IO partner would generally only report partnership income.

We continue: the IO also participates in cash distributions.

This might be simple. Let’s say the IO is allocated $100 in profits and receives a $75 distribution. The IO has reported (and paid tax) on $100 and received $75 cash. The IO is still positive (by $25) taxwise. The tax concept here is called “basis,” and it is critical in partnership taxation.

Basis is the amount of money a partner has invested in the partnership. Basis goes up and down with normal partnership activity.

         Increase basis

·      Contribute money into a partnership

·      Report partner share of partnership income

·      Increase partner share of partnership debt

Decrease basis

·      Receive distributions from partnership

·      Report partner share of partnership loss

·      Decrease partner share of partnership debt

Basis is fundamental: a partner can report losses only to the extent of basis (mind you, there are special rules and subrules here, but let’s keep this conversational). Once basis gets to zero, the partner stops deducting losses. The term here is “suspended,” and the losses wait until basis is restored. The losses can wait until the following tax year or they can wait forever - it depends on what happens with the partnership.

This is not a problem with the usual sweat equity, as the IO would not receive losses.

Mind you, distributions can create a problem - for example, distributions in excess of basis will create income. If you think about it, this makes sense. If you are an IO, receive zero allocation of income and a $100 distribution, that $100 is income - it is an increase in your wealth, you have no obligation to repay it, and it arrives with all the usual tax qualifiers.

Let’s further expand: you are sweat equity but can be allocated losses.

Basis now becomes an issue, as losses can only be deducted to the extent of basis. You can create basis by having allocable income and leaving it in the partnership. You will not have basis by contributing capital, however, because that is what “sweat equity” means.

Great. You can create basis by reporting (and paying tax) on partnership income, but you must leave (all or some) of the income in the partnership.

Probably not what you were thinking when you got involved.

Is there another way?

Yep.

Notice that your share of partnership debt can increase or decrease your basis.

We have to somehow allocate some of that debt to you.

Once again, this is not customary. Sweat equity partners are not normally allocated partnership debt.

Let’s look at someone who tried.

His name was Andrew West.

He owned three single member LLCs that he reported as sole proprietorships on his personal tax return. He also had a business relationship with a businessman (Oscar Quintanilla) spanning cattle, oil and gas, and real estate development activities. West served a president and CEO for several Quintanilla entities, and he was entitled to a 6% “operating bonus.”

I see potential sweat equity.

In 2014 West and Quintanilla formed a joint venture to manage commodity trading accounts.

Well, we do need losses somewhere to continue this discussion, and commodity trading will do it.

The two draw up a Commodity Trading Allocation Agreement (think of it as a partnership agreement), a secured Promissory Note (up to $5 million), and an Asset Security Agreement for all of West’s assets.

No surprise: Quintanilla contributed 100% of the capital. Both profit and losses, however, were allocated 50:50 between Quintanilla and West.

Losses will be a problem for West.

They however thought of this: any losses allocated to West will be deemed borrowed from Quintanilla via that (up to $5 million) promissory note.

Ah, clever.

The trading partnership lost over $11 million over two tax years.

Half of that loss went to West.

Who got booted out in 2016.

COMMENT: Let’s be fair, if you cost me over $11 million over two years, we probably are - at a minimum - exchanging words.

Enter the IRS into West’s 2015 and 2016 tax returns.

There were several issues in this case: the IRS used bank deposit analysis to reconstruct income, it reviewed documentation for (disallowed) business expenses, and so on. The only area we will discuss today are the partnership losses.

West wanted $6.8 million in losses.

The IRS allowed zero.

The parties stipulate that Mr. West and Mr. Quintanilla formed a partnership for Federal income tax purposes, pursuant to section 761(a), in taxable year 2014 when they signed the CTA, the CTA Note, and the CTA Security Agreement creating a new joint venture. Neither party disputes that gains and losses from the trading accounts would be partnership gains and losses; neither disputes that the termination of the partnership in February 2016 would have been a proper occasion for Mr. West’s recognition of such losses; and neither disputes that Mr. West received no distribution of any kind from the partnership upon its termination. However, as Mr. West seems to acknowledge, he can claim losses from the partnership only to the extent of his tax “basis” in the partnership; but it was Mr. Quintanilla who contributed all of the securities, and Mr. West was to contribute his effort; so Mr. West made no monetary contribution to the partnership that would have granted him any basis at its formation.”

West argued he had basis via the Promissory Note. He was personally liable for millions of dollars.

He had a point.

The IRS argued otherwise.

Here is byzantine: a partner cannot create basis by contributing his own promissory note to a partnership.

EXAMPLE: You and I form a partnership. You put in $25 grand. I put in a personal $25 grand promissory note. You have immediate basis of $25 grand. I have … nothing. Can I eventually match your $25 grand? Sure, as I put money in pursuant to the note. Contributing my own promise to pay accomplishes nothing taxwise until I actually pay.

Wait, wait you say. West was borrowing under the Promissory Note, which was a third-party note. How did we get from a third-party to a personal promissory note?

Because the note was between West and Quintanilla - not between West and the partnership.

Still, wouldn’t West have basis if Quintanilla loaned money to the partnership (via the note) on West’s behalf?

Yes, if Quintanilla had loaned money to the partnership (via the note) on West’s behalf.

OK, let’s try this another way. Could West have created basis by contributing his promissory note to Quintanilla to the partnership?

Nope. Quintanilla could have created basis (as he was collecting on the note), but West could not (as he was paying on the note). You cannot create basis by contributing your liability.

COMMENT: Contributing a note may have worked if this were an incorporation (which is a different area), but we are discussing partnership – not corporate – tax law.

The Tax Court decided that West had zero basis in the partnership and could not deduct the losses.

This beggars the question: will West ever be able to deduct the losses?

I doubt it.

The losses are suspended until West establishes basis. West will likely never establish basis, and therefore the losses will never release. They will mummify and be eventually lost to time.

And West’s story reminds me of my usual advice with sweat-equity arrangements: don’t get fancy. This thing is basically a bonus by another name. Have the sweat equity pay tax if there is income to share. Leave the losses with the wallet. An IO is an excellent incentive partnership tool, but any tool has its limitations. Do not overreach.

Our case this time was West v Commissioner, T.C. Memo 2026-105.