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.

 

Does An Offer In Compromise Survive A Taxpayer’s Death?

Today we will discuss offers in compromise:

§ 301.7122-1 Compromises.

(e) Acceptance of an offer to compromise a tax liability.

(1) An offer to compromise has not been accepted until the IRS issues a written notification of acceptance to the taxpayer or the taxpayer's representative.

Let’s talk about Jacqueline Farwell.

She had gotten herself into a tax mess for years 2008 through 2011, 2013 and 2015. The IRS had recorded a lien for almost $120 grand.

 She was deep into medical care and quickly burning thorough cash. She requested a CDP hearing and proposed an offer in compromise for $100.

COMMENT: We are so accustomed to the pennies-on-the dollar nonsense on radio and late-night television that we forget that real offers exist. Take an elderly person with diminishing assets, severe expenses, minimal or no likelihood to earn again and the IRS might accept $100. What the IRS won’t accept is a 40-something skipjack with plenty of earning power but an impaired sense of personal responsibility.

In February 2020 the IRS examiner requested updated financial information.

Farwell died in March 2020.

Nobody said anything.

In April 2020 the examiner told Farwell’s attorney that she advised accepting the offer.

Nobody said anything.

In September 2020 the IRS sent a letter that it had accepted the offer.

Nobody said anything.

Mind you, the IRS did not realize that Farwell was dead.

COMMENT: There may be reasons why the estate stalled - perhaps disagreement among the heirs, a delay in hiring lawyers, deciding who would have tax power of attorney. Still, it is … odd. I can see the IRS feeling manipulated.

In November 2020 the IRS realized her death and pulled the offer.

The estate asked Appeals to reinstate the offer. The IRS refused, arguing that mutual mistakes – not telling the IRS, for example - were made.

Off to Tax Court they went.

Our question is: does an offer in compromise survive the death of the taxpayer who requested it?

The estate argued that Regulations prevented the IRS from reopening the matter unless there was false information, concealment, or mutual mistake. The estate had that September letter and had no intention of giving it back.

COMMENT: Partially true. The IRS was prevented from reopening in the event there had been offer and acceptance.

The Code is not clear what happens when the taxpayer dies before acceptance. The Internal Revenue Manual however is.

5.8.7.5 (04-24-2025)

Termination of Consideration

1.      Consideration of an offer must be terminated upon the death of a single proponent. See IRM 5.8.10.4, Deceased Taxpayers and Estates. The date of termination is the taxpayer's date of death and the date used for the TC 482. If the taxpayer’s date of death is prior to the offer submission, refer to IRM 5.8.10.4.1, Death of a Taxpayer. Offers that are terminated do not receive appeal rights. See IRM 5.8.10.4.1, Death of a Taxpayer, for instructions on actions to take when advised that one party to a joint offer has died.

The estate was not impressed. The Internal Revenue Manual does not have the force of law, it hissed.

True, noted the Court, but it was in line with the statute and Regulations.

But we have a letter from the IRS accepting the compromise, the attorney whinged.

The letter was sent in error - one the estate contributed to - and the IRS was not bound by the error.

The attorney returned to the mutual mistake exception, arguing that mutual mistake was impossible as one of the parties was deceased.

The IRS repeated: look at Section 7122. An offer has to be accepted. Any extant powers expired when Farwell died, and there was a period after the death before an attorney was hired and a new power filed. A dead person cannot accept.

The IRS knew about Farwell’s terminal illness. You are accomplice to this, the attorney shrilled.

Methinks the attorney was losing it.

The IRS pointed out the obvious: have the estate submit its own offer in compromise. Farwell’s individual offer would wrap up, and the two sides could move to the estate’s offer. There is a whiff of common sense here ….

NO!! bayed the attorney.

Why? I presume that assets remained in the estate. Enough assets that the estate did not want to part with them.

Let’s return to Section 7122 at the top of this blog.

Requirement one: was there a written notice?

Maybe, possibly, perhaps that September letter, although one would be hard-pressed to argue that it had been sent to taxpayer’s representative.

Requirement two: was there acceptance of said notice?

No. Farwell had passed away. The estate had not yet named a new power. There was no one who could represent the estate at that instance.

The IRS won.

Our case this time was Estate of Jacqueline R. Farwell, U.S. Tax Court, No. 11555-22L, T.C. Memo 2026-95.

Identity Theft and A Tax Deficiency

 

To me it reads like a nightmare.

Brendan Bettis wanted to file his 2022 tax return. He had worked in 2021 for several employers, including Federal Express, DoorDash and Instacart. In April 2023 he saw a social media post recommending a tax preparer. Bettis called the phone number.

He spoke with someone. She instructed him to provide further information, including his W-2s, Forms 1099, social security number and bank account information through an online portal.

He - of course - heard nothing back for months.

COMMENT: I may be betraying my age, but hiring a professional sight unseen and through a website is unacceptable. Sending confidential information is less so. Even working among CPAs, I have known practitioners which I would not personally use and which I could not refer. To be fair, though, I suspect this one was a professional as much as I am a deep-sea diver.

In April 2023 she filed a 2022 Form 1040 reflecting Bettis’ name and social security number.

He did not know about it, much less authorize it. The return was signed by a Ms. Victoria Jackson of Cypress, Texas. Bettis never met her in person.

The return did show the W-2s, but then it became a work of fiction. It showed Bettis’ occupation as “landscaping,” as well as household wages of $21,108. The return also claimed a fuel tax credit of $23,790 for the off-highway use of 130,000 gallons of gasoline. I presume that is how and why “landscaping” entered the story.

At 130,000 gallons Bettis might as well have been installing a pipeline.

I suppose he was getting a surprise tax refund.

Nope.

Ms. Jackson, or someone in her employ, wanted to receive a “refund product.” This means that Jackson and/or her firm would receive some/all of the refund. The refund was to be sent to a bank Bettis did not know.

The IRS processed the return in June 2023.

It made three adjustments:

• The IRS applied $5,561 of the refund to offset Bettis’ 2015 tax liability.
• It next used $1,077 to offset his remaining 2018 tax liability.
• It then used the remainder of the refund to satisfy Bettis’ past-due child support.

Ms. Jackson – or someone in her employ – was furious. She/they demanded that Bettis pay his tax preparation fee.

Righhttt.

Eventually the IRS figured it out. In May 2025 the IRS sent Bettis a Notice of Deficiency for $24,780.

Which is how we got into Tax Court.

The IRS and Bettis agreed that the correct tax was $1,263. The court case was about the difference - $23,517.

And the key was the tax definition of the word “deficiency.”

26 U.S. Code § 6211 - Definition of a deficiency

(a) In general For purposes of this title in the case of income, estate, and gift taxes imposed by subtitles A and B and excise taxes imposed by chapters 41, 42, 43, and 44 the term “deficiency” means the amount by which the tax imposed by subtitle A or B, or chapter 41, 42, 43, or 44 exceeds the excess of—

(1) the sum of

(A) the amount shown as the tax by the taxpayer upon his return, if a return was made by the taxpayer and an amount was shown as the tax by the taxpayer thereon, plus

(B) the amounts previously assessed (or collected without assessment) as a deficiency, over—

(2) the amount of rebates, as defined in subsection (b)(2), made. 

(b) Rules for application of subsection (a) For purposes of this section—

(1) The tax imposed by subtitle A and the tax shown on the return shall both be determined without regard to payments on account of estimated tax, without regard to the credit under section 31, without regard to the credit under section 33, and without regard to any credits resulting from the collection of amounts assessed under section 6851 or 6852 (relating to termination assessments).

(2) The term “rebate” means so much of an abatement, credit, refund, or other repayment, as was made on the ground that the tax imposed by subtitle A or B or chapter 41, 42, 43, or 44 was less than the excess of the amount specified in subsection (a)(1) over the rebates previously made.  

The IRS came in hot. The fuel tax credit was the “rebate” referred to in Section 6211(b)(2). A rebate increases a deficiency (via the arithmetic of 6211(a)(2). Give me my money, said the IRS.

The Tax Court was not persuaded.

The Court reasoned that – before a 6211(b)(2) argument could be made – a Section 6211(a)(1)(A) argument must be made: the amount shown as tax by the taxpayer on his return.

Issue: Bettis was scammed. He never filed an authorized return. No real tax return was filed meaning no real tax was shown by the taxpayer on his return.

The IRS could not get past Section 6211(a)(1)(A) to get to the Section 6211(b)(2) it wanted.

The Court explained its reasoning:

• A fraudster obtains confidential information and files a false return seeking a refund to the fraudster’s bank account.
• The taxpayer has no idea. In fact, taxpayer does not even have to file a return.
• The IRS issues the refund.
• The IRS catches its mistake. It wants its money back from the defrauded taxpayer.

Nope. Can’t. What we have just described does not rise to the level of a “deficiency” that the IRS can pursue against the taxpayer.

The Court decided that the correct deficiency was $1,263, to which both sides had previously agreed.

Our case this time was Bettis v Commissioner, US Tax Court, Docket No. 6560-25S, dtd 9.25.26

Partnership Audits And BBA Graffiti

 

I am reading two amicus briefs filed with the Tax Court concerning a partnership audit.

I see that the IRS wants approximately $84 million in tax and $17 million in penalties.

Let’s talk about partnership audits this time. The issue here is caused by the IRS audit process itself.

Before 1982 the IRS would audit partnerships and – if there were adjustments – would also have to audit the partners separately. While not an issue with small partnerships, it was a significant issue with larger partnerships. Take a partnership with headquarters in Atlanta, for example. The partnership audit team might come from Georgia, but the partner audits might require IRS personnel from other states.  

Enter new rules with the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982. The partnership would designate a representative to deal with the IRS. There was one audit to bind the partnership and partners, a single judicial review of that audit and a unified limitations period for all. Just the presence of the partnership representative (tax matters partner or “TMP”) was enormous, as this required only one audit team. The IRS did not need to chase the partners for approval. The day to day was also streamlined, as the IRS did not need to notify any non-TMPs of ongoing audit activities.

But while the partnership was binding the partners, the IRS still had to coordinate the amended partner returns. As partnerships (and now LLCs) became larger and more popular, this became an increasingly formidable task.

Knowing this, what would you change to make partnership audits easier?

I would have the partnership itself pay any additional tax resulting from the audit. The partners could settle up as they wish, but the IRS would have moved on.

For the most part, that is the new system - the Bipartisan Budget Act (BBA) centralized audit regime - effective after December 31, 2017.

There are limited exceptions to the BBA regime. For example, a partnership can opt-out of BBA if it has less than 100 partners and every partner is an individual, the estate of an individual, a C or an S corporation. This seems a large exception, but is not. For example, a trust - even a grantor trust - will disallow an opt-out. A disregarded entity (almost every Schedule C is a disregarded entity these days) will also disallow an opt-out.

Fail to opt-out and you are working under BBA rules.

COMMENT: Even if you are in BBA, you can still elect to have the partners rather than the partnership pay tax on any adjustments. This is called a “push-out” election. Mind you, you are still in BBA, but you are electing to use an escape hatch.

BTW the above means that we have two audit regimes (BBA and non-BBA) functioning simultaneously out there. A partnership tax practitioner has to know and be able to work with both.

We will discuss BBA audits only from this point on.

There is an issue with the partnership paying tax on any audit adjustments.

Here is an example:

• You incorrectly reported a $2,000 asset as being placed in service by 12/31/XX.
• This resulted in an incorrect depreciation deduction of $500.
• Self-employment income was understated by $500.
• Qualified Business Income was understated by $500.
• QBI unadjusted asset basis after acquisition was overstated by $2,000.
• You inadvertently understated ending recourse liabilities by $400.

In the old days, the accounting would be straightforward. Say you had two 50:50 partners. The accountant would go back to the original tax returns, substitute the amended numbers for the original numbers and recalculate the tax. The accountant would do this for each partner, and the effect of the audit was the sum of the two changes in final tax.

Intuitive.

However, BBA does not have a tax return like the above. BBA works off the partnership return, which is an information return and does not separately calculate taxable income or arrive at a final tax.

Let’s look at our simple example. What is the change in BBA income from the above?

• $500
• $500 + $2,000
• $500 + $2,000 + $400
• $500 + $2,000 + $400 + ($500 times 20%)
• Something else?

You see the problem: the audit adjustments are divorced from a tax return. You can talk your self into knots over what to include and what to exclude.

So, the BBA created the concept of an Imputed Underpayment (IU). Think of it as a subtotal to which we will apply a tax rate.

Start by separating the adjustments into customary tax pools; income, gain, deduction, loss, and credit.

BBA adds one more pool: non-income items. This pool is the genesis of our problems.

Next separate your adjustments between positive (increase taxable income) and negative adjustments.

Positive adjustments are always included. Negative adjustments are allowed when both the positive and negative adjustments would be reported on the same line of a Schedule K-1. The effect, of course, is to leave many a negative adjustment on the table.

Let’s next look at Reg 301.6225-1(d)(2)(iii):

Got it: gobbledygook.

The hook here is that the customary tax pools (income, gain, deduction, loss, credit) can have both positive and negative sides.

The new BBA pool however – the non-income item – is always positive. The IRS arrives at this conclusion by looking at (d)(2)(ii) above. Since it does not subtract from income, the non-income item is not a negative adjustment. Since it is not negative, (d)(iii) means it must be positive.

Once we are done with positive and negatives, we crunch everything together to arrive at a sum called the Imputed Underpayment (“IU”).

We multiply the IU by the maximum tax rate to arrive at tax due from the BBA audit.

You can see the possible danger from non-income items. Land in this pool – voluntarily or involuntarily – and you can be in trouble. Items in the pool might be indirectly used in calculating tax (say QBI UBIA, for example), but not be directly involved in any tax calculation. You are still paying BBA tax on the pool, however.

Seems to me that someone who could put you in this pool potentially has the power to bankrupt you.

With the above as background, let’s briefly look at the Site Solar Fedok Fund III LLC case.

Site Solar is an Oklahoma partnership that owns, operates, and leases mobile solar generators. It reported a loss of approximately $68 million on its 2018 tax return. It also claimed energy credits on the solar equipment.

The IRS audited the 2018 tax return. It determined that approximately $80 million in depreciable assets were not actually placed in service by December 31, 2018. The IRS reduced depreciation by approximately $63 million. Since assets were not placed in service, the IRS also reduced the solar energy credit by approximately $24 million.

Stopping there and being very liberal with the numbers, we might say that a tentative IU is $104 million ($80 million plus $24 million).

The IRS calculated the IU to be $227 million.

Which translated into tax of approximately $84 million and penalties of $17 million.

How did we get from $104 million to $227 million?

Beats me.

Granted, there are rules to avoid double-counting, more specifically the “subsume rule” of Reg 301.6225-1(b)(4):

COMMENT: The subsume rule is far from perfect. Say for example that the IRS reclassifies an ordinary loss to a capital loss. The ordinary loss is a positive adjustment. The capital loss is a negative adjustment. They will not offset, as they appear on different lines of Schedule K-1. The partnership can wind up with tax due when its taxable income did not change a jot.

Treasury has explicitly stated that an IU is not intended to be the amount of tax that the partners would have owed. It instead is an entity-level calculation, disregarding whether any adjustments would have resulted in an actual tax liability to an actual partner.

Huh?

Maybe we need to regard that last point a bit more, folks. This otherwise is just scribbling numbers on a wall – BBA graffiti if you will.

I understand how this ended up in Court.

The taxpayer had no choice.

Our case this time was Site Solar Fedok Fund III, LLC v Commissioner, U.S. Tax Court Docket 19733-23.