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.

 

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.

Deducting Business Interest From Personal Credit Cards

The case caught my eye because it involves a very common fact pattern:

A small business owner obtains credit cards in his/her personal name and uses it/them for business purchases and activities.

Question: Can the business deduct the interest on the credit cards?

I doubt that there is a tax practitioner out there that hasn’t deducted this, but a recent case points out minimum requirements in case the IRS challenges the deduction.

Let’s look at C.A. Simmons, TC Memo 2026-34.

I admit that I was expecting some technical dive into the interest deduction, but this case is not that. It is a reminder that one has to get to first base before being able to reach home plate. Strike out and the rest is meaningless.

Cathryn Simmons and her sister owned a specialty store (called Stuff) in Kansas City, Missouri. They had sold handmade and small-batch goods since 1996. As is too common, Stuff struggled to obtain credit in its own name, so the sisters used personal credit cards and loans to finance the business. They used QuickBooks for their accounting, and they did try to segregate the credit cards between those used for business and those used personally.  

COMMENT: I suspect most clients I have advised can remember my standard sermon:

·      Establish a separate business account. Business deposits and expenses go through the business account. Personal expenses do not. I understand that the bank is going to charge for a business account, and it might be cheaper to lean into a personal account. Do not do that. You already incurred that expense when you started the business.

·      I understand that you might not be able to get a credit card in the business name and may have to use a personal card. Use one card for business and the rest for personal. Do not intermingle the two.

·      If you are using a personal card, I might have the business recognize it as a loan from you. We will formalize it with a note, mention an interest rate and make some reference to repayment. Do not be surprised if the interest rate on the note is the same as the credit card.

·      Keep records of all business deposits and expenses. At a minimum, buy an expanding file and file the paperwork by month. When we finish the tax return for the year, combine the return and its paperwork into a file or folder for the year, and hold onto it.

Back to Stuff.

The IRS looked at the 2017 business return and 2017 and 2019 personal returns. They expanded the business audit to include cost of goods sold, advertising, vehicle expenses, travel, meals and entertainment, charitable and promotion, and interest. We will discuss only the interest deduction today.

Stuff field a partnership return, and each sister’s share of the 2017 business profit was less than $3 grand.

There was a little chop with the interest deduction because it included both interest on the credit cards and interest on the personal loans. I point it out because the Court says the following about the personal loans:

As an initial matter, … fails to establish that the purported interest amounts Stuff paid to her and her sister arose from Stuff’s own indebtedness. The record contains promissory notes … but no ‘loan papers’ establishing Stuff’s indebtedness to the sisters.”

… we cannot conclude from these payments and the sisters’ testimony that Stuff had an actual legal obligation to pay interest to them.”

I get it but … harsh. I suppose Stuff was not following the terms of the promissory notes. We would - of course - redraft the terms of the notes. This is low hanging fruit.

What about the credit cards?

Ms. Simmons likewise fails to demonstrate that Stuff was entitled to deduct the credit card interest and finance charges recorded on its QuickBooks account. The evidence shows that Ms. Simmons obtained and used credit cards in her own name to finance Stuff’s business expenses given its inability to obtain credit on its own. Ms. Simmons fails to show that any credit card interest and finance charges constituted Stuff’s own indebtedness rather than her personal indebtedness, and thus no deduction is appropriate.”

Stop. I am having a problem here, as I am quite aware of Reg 1.163-8T.

Seems to me that if (1) I trace a business expense from the credit card statement to (2) the QuickBooks, I have at least a good chance of meeting the requirement that “debt is allocated by tracing the disbursements of the debt proceeds to specific expenditures.”

Back to the Court:

Assuming arguendo that credit cards opened by Ms. Simmons constituted an indebtedness of Stuff, the records before us would not substantiate the amounts claimed. Although the sisters testified that they used the six designated credit cards exclusively for Stuff’s expenses, they failed to establish the amounts and business purposes of the underlying expenditures that resulted in the interest and finance charges at issue.”

They failed to establish the amounts and business purposes …?

I believe two things happened here:

(1)  Stuff could not document a lot of expenses. On quick review, I see the IRS disallowing almost $13 grand of vehicle expenses, $22 grand of charitable and promotion expenses, and so on.

(2)  If those expenses ran through the credit cards, then I understand an allocable portion of the interest being disallowed.

However, the Court just nixed the interest deduction altogether.

Seems to me that some of the credit card interest – that allocable to deductions allowed – should be deductible. I presume the accounting was not clean enough to do a side calculation. The IRS will rarely play forensic, and the Tax Court certainly will not.

The Court did reemphasize that it wanted to see linkage between the business activity and the credit cards, but that has been the rule since I have been practicing. There is nothing new here. Somebody just forgot to get on first base.