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.

 

Disregarded, Consolidated And Surly

 

I was reading a consolidated group tax case recently.

It made me think: it has been a moment since I have worked with a consolidated return. It did however remind me a of a favorite tax term.

I consider consolidated groups more the realm of Fortune 500 companies. The reason is that these companies have publicly-traded stock, and publicly-traded stock is a cousin (if not a sibling) to cash. If I am a Fortune 500 and want to buy your company, I am motivated to use my stock to pay for some/all of the purchase price. Why? Because I am not depleting my cash reserves. Since my stock is publicly-traded, however, you are likely to consider it as similar to cash, but being stock there may be tax strategies available to avoid the heavy hand of immediate taxation. It is about as close to a win:win as you can find in the Code.

Let’s take a brief look at this part of the Code.

What is a Consolidated Tax Return?

First of all, we are now talking about corporations. These corporations have sufficient common ownership (that is, are “affiliated”) to combine their separate tax returns into one (“consolidated”) tax return which will be treated as a single unit for tax purposes.

        Code § 1501 - Privilege to file consolidated returns

An affiliated group of corporations shall, subject to the provisions of this chapter, have the privilege of making a consolidated return with respect to the income tax imposed by chapter 1 for the taxable year in lieu of separate returns. The making of a consolidated return shall be upon the condition that all corporations which at any time during the taxable year have been members of the affiliated group consent to all the consolidated return regulations prescribed under section 1502 prior to the last day prescribed by law for the filing of such return. The making of a consolidated return shall be considered as such consent. In the case of a corporation which is a member of the affiliated group for a fractional part of the year, the consolidated return shall include the income of such corporation for such part of the year as it is a member of the affiliated group.

As shorthand, we will refer to the area of the tax Code that deals with consolidated returns as the “15XX Regulations.”

Who Can File a Consolidated Return?

The affiliated group will have at least two corporations connected through a common parent. The corporations (other than the parent) must be at least 80% owned by another corporation (it does not have to be the parent) in the group.

In general, S corporations and foreign corporations cannot be members of an affiliated group. 

BTW you can remain an affiliated group indefinitely and not elect to file a consolidated return.

Like Hotel California, however, once you elect it is not so easy to leave.

Why Would I File a Consolidated Return?

One key advantage is being able to offset the losses from one member of the group against the income of another member.

If one were to file separately, then the profitable member would have taxable income (and pay tax) while the loss member would have a net operating loss that carries over to some future profitable year. It is not the end of the world, but one would probably prefer to use those NOLs now.

How Do Affiliated Corporations Come into Existence?

The first way is organic: the parent creates a subsidiary. In a later year, perhaps the parent creates another subsidiary, or an existing subsidiary creates a new subsidiary.

A second way is to acquire other corporations via mergers and acquisitions.

As shorthand, we will refer to the area of the tax Code that deals with corporate formations, mergers, acquisitions and divisions as the “3XX Regulations.”

Are the Rules Complicated?

You bet.

The 15XX Regulations are some of the most difficult and byzantine rules you will ever work through.

And the 15XX Regulations - just to make it sporting - like to cross-reference the 3XX Regulations.

You will spend time flipping pages, at least until you memorize the citations.

Let’s Look at One Rule: The SRLY

This is pronounced “surly.”

The idea is that a corporation enters the consolidated group with net operating losses. One’s first thought is that the group can immediately use those losses to offset income from other members.

No, it can’t. Congress thought of this, which is how SRLY came into existence.

In general, the SRLY rules will limit the use of net operating losses to future income from the same corporation that brought the losses into the group.

There is a cousin to this rule in 3XX Regulations upon ownership changes, but it does not require an affiliated group. SRLY, on the other hand, is found in the 15XX Regulations and applies to consolidated groups.

Let’s Look at a Recent Case Involving a SRLY

As we have sometimes done before, we will change the names to make this more readable.

Scooby was created pursuant to a reorganization in 2012. Scooby was an S corporation, and it had a subsidiary called Shaggy, itself another S corporation. An S corporation generally cannot have a corporation as a shareholder, so Scooby elected to treat Shaggy as a Qualified Subchapter S Subsidiary (QSSS).

Shaggy in turn acquired a C corporation we will call Daphne. A C corporation (as contrasted to an S corporation) can have a corporation as a shareholder. Daphne was dragging net operating losses behind it.

Shaggy distributed Daphne to Scooby.

At this point we have an S corporation (Scooby) owning a C corporation (Daphne) and an S corporation subsidiary (Shaggy).

COMMENT: We are not there yet, but you see a key piece to a potential SRLY: a C corporation with NOL carryovers. To provoke SRLY, we next need a consolidated group.

In 2018 Scooby revoked its S election.

Scooby elected to treat Daphne as a disregarded entity. For federal tax purposes, Daphne liquidated into Scooby and ceased to exist as a separate entity.

Scooby then formed a consolidated group (which we will call Super Scooby).

Super Scooby was knocking it out of the park. It had group taxable income of $13 million for 2018, $46 million for 2020, and $89 million for 2021, even though Scooby/Daphne had zero (-0-) profit of its own. All the profit was coming from the subsidiaries.

Super Scooby – of course – wanted to use the corporation-previously-known-as-Daphne NOLs. The amount was significant - $108 million.

The IRS said No. Why? Because of SRLY, that’s why.

Off to Tax Court they went.

Super Scooby had a straightforward argument: there was no SRLY because Daphne was disregarded. What was Daphne’s was now Scooby’s, and there is no SRLY rule on the parent of an affiliated group.

True, but there is a “predecessor and successor” rule in the thicket of the 15XX Regulations.

The IRS saw Daphne as a predecessor. Super Scooby did not. Super Scooby argued that Scooby once owned Daphne as a separate corporation. After the S revocation, Daphne ceased to exist, and there remained only Scooby.  Super Scooby was then created upon election to file a consolidated return.

Why the pedantism?

Super Scooby wanted the “lonely parent” exception found in the 15XX Regulations.

COMMENT: I love this term. The idea is that the parent can always drag its NOLs behind it without SRLY restrictions. The idea makes sense if the parent remains the same. It makes less sense if the tax planners restructure the group to result in a new parent, or – as in this case – when a previously existing corporation goes “poof” into the parent.

Do you test the lonely parent before or after the poof?

Super Scooby argued that the test was after the poof.

The IRS of course argued that the test was before.

The Court approached the issue by looking at the predecessor-successor rules in the 3XX Regulations:

In general, a predecessor is any transferor in a Section 381 transaction.”

COMMENT: Section 381 addresses carryovers when corporations acquire corporations.

                

Scooby “acquired” Daphne when it revoked its S election and Daphne liquidated under Section 332. The liquidation triggered Section 381 for any Daphne carryovers, which in turn triggered the “transferor in a Section 381 transaction” requirement for a predecessor-successor.

Daphne was a predecessor.

On to the lonely parent:

Where a member of the group is the successor in a 381 transaction, any net operating loss of the predecessor corporation are considered to have occurred in a SRLY if the predecessor was not a member of the group for each day of such year. The lonely parent rule does not apply in these situations, and the loss carryovers are subject to the SRLY restrictions, despite the fact that the common parent may be the successor corporation in the 381 transaction.”

In recap, the Court reasoned that:

• Daphne was a predecessor.

• Daphne was never a member of the Super Scooby consolidated group.

• The lonely parent rule cannot be extended to predecessors not members of the (consolidated) group.

• Daphne’s SRLYs remained SRLYs.

Super Scooby struck out trying to claim Daphne’s NOLs.

Why was Super Scooby swinging so hard? There was consolidated taxable income of – what? - $13 million, $46 million, $89 million. There appeared plenty of income to go around.

But there wasn’t.

All the consolidated income came from the subsidiaries.

The Daphne SRLY looked only at the income that Daphne (now liquidated into Scooby) brought into the consolidated group.

Scooby/Daphne itself had zero (-0-) income.

Meaning the SRLY was also limited to zero (-0-).

NOTE: The solution to Super Scooby’s problem seems straightforward: why not check-the-box to disregard one (or more) subsidiaries as separate from Scooby? Scooby would then have income to absorb the Scooby/Daphne NOLs. Yes, we still have a SRLY, but we are putting (as much) income (as necessary) into Scooby/Daphne to release some/all of the NOL. Maybe we burn the NOL over several years rather than just one, but that is still a better result than the above.

Our case this time was HBM Holdings Co v Commissioner, 167 T.C. No. 6 (July 27, 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.