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 million 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 (recognized 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).

A Like-Kind Exchange To Avoid Tax

 

Let’s talk about like-kind exchanges.

A key point is - if done correctly - it is a means to exchange real estate without immediate tax consequence.

There was a time when one could exchange either personal property or real property and still qualify under the tax-deferral umbrella of a like-kind exchange. Congress removed the personal property option several years ago, so like-kinds today refer only to real estate.

The Code section for like-kinds is 1031, but today let’s focus on Section 1031(f):

(f) Special rules for exchanges between related persons

(1) In general If—

(A) a taxpayer exchanges property with a related person,

(B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and

(C) before the date 2 years after the date of the last transfer which was part of such exchange—

(i)  the related person disposes of such property, or

(ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer,

there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.

(2) Certain dispositions not taken into accountFor purposes of paragraph (1)(C), there shall not be taken into account any disposition—

(A) after the earlier of the death of the taxpayer or the death of the related person,

(B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or

(C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.

(3) Related person

For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).

(4) Treatment of certain transactions

This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.

This verbiage came into the tax Code in 1989.

What is the issue here?

Let’s use an easy example:

CTG owns a hotel building worth $1 million. Its adjusted basis is $175,00.

CTG II owns a warehouse worth $1 million and an adjusted basis of $940,000.

If CTG sells its building, the gain is $825,000 ($1 million minus 175,000).

If CTG II sells its building, the gain is $60,000 ($1 million minus 940,000).

Say that someone wants to buy CTG’s hotel. Can we beat down that $825,000 gain?

What if we have CTG and CTG II swap buildings? CTG Jr would then own the hotel but keep its $940,000 adjusted basis. CTG II would then sell the hotel at a gain of $60,000.

Yeah, no. Congress already thought of that.

You better wait at least two years before the (second) sale, otherwise you have smashed right into Section 1031(f)(1)(C). The Code then says that- unless you can sweet talk the IRS - there was never a like-kind exchange. You instead have taxable income. Thanks for playing.

Let’s look at the Teruya Brothers case.

This case requires us to determine whether two like-kind exchanges involving related parties qualify for nonrecognition treatment under 26 U.S.C. § 1031.

This appeal concerns the tax treatment of real estate transactions involving two of Teruya's properties, the Ocean Vista condominium complex (“Ocean Vista”), and the Royal Towers Apartment building (“Royal Towers”).

We will look at the Ocean Vista (OV) transaction only.

Someone wanted to buy OV.

Teruya was initially not interested. It relented – IF it could structure the deal as a Section 1031 like-kind exchange.

So far this is relatively commonplace.

Teruya wanted to buy property from Times Super Market (Times) as the replacement.

Issue: Teruya owned 62.5% of Times.

The gain (which Teruya was trying to defer) was in excess of $1.3 million.

Teruya exchanged and filed its tax return accordingly.

The IRS balked.

The IRS argued that Teruya went foul of Section 1031(f)’s “established to the satisfaction” and “structured to avoid” prohibitions.

Teruya argued that the IRS was making no sense: Times reported the gain on its tax return. It had no deferred gain from the like-kind exchange. Who would structure a transaction to avoid tax when one of the parties reported gain?

On first impression, the argument makes sense.

The Court noted that Times had a net operating loss that wiped out the gain from the sale. There was no tax.

Teruya had a problem. It sold the property within two years, meaning that the IRS had a chance to challenge. The IRS challenged, both under Section 1031(f)(2)(C) and (f)(4).

Here is the Court:

We conclude that these transactions were structured to avoid the purposes of Section 1031(f).

Teruya lost.

Teruya went into this transaction in 1995, when Section 1031(f) was relatively new. There would not have been much case law on working and planning with this Code section.

Teruya provided practitioners some of that case law. 

We now know that an advisor must expand his/her perspective beyond just the Section 1031 exchange and consider other tax attributes sitting on the tax returns of the related parties.

And sales within two years are courting death.

Dodge that and Section 1031(f)(4) might still nab you.

Our case this time was Teruya Brothers, LTD v Commissioner, 124 TC No. 4.