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).

Use Of Wrong Form Costs A Tax Refund

Let’s talk about the following Regulation:

26 CFR § 301.6402-2

Claims for credit or refund

(b) Grounds set forth in claim.

(1) No refund or credit will be allowed after the expiration of the statutory period of limitation applicable to the filing of a claim therefor except upon one or more of the grounds set forth in a claim filed before the expiration of such period. The claim must set forth in detail each ground upon which a credit or refund is claimed and facts sufficient to apprise the Commissioner of the exact basis thereof. The statement of the grounds and facts must be verified by a written declaration that it is made under the penalties of perjury. A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

That last sentence is critical and – potentially – punishing.

I suspect the most common “claim for refund” is an amended return. There are other ways to claim, however, depending on the tax at issue. For example, businesses requested refunds of federal payroll taxes under the employee retention credit (“ERC”) program by filing Form 941-X. You or I would (more likely) file our claim for refund on Form 1040-X. 

File a 1040-X and the tax “variance doctrine” comes into play. This means that the filing must substantially inform the IRS of the grounds and reasons that one is requesting a refund. Both parties have responsibilities in tax administration. A taxpayer must adequately apprise so the IRS can consider the request without further investigation or the time and expense of litigation.

Here is a Court on this point in Charter Co v United States:

The law requires a taxpayer “to do more than give the government a good lead based on the government’s ability to infer interconnectedness.”

Another way to say this is that the IRS is not required to go all Sherlock Holmes to figure out what you are talking about. 

Let’s look at the Shleifer case.

Scott Shleifer was a partner in an investment firm. He travelled domestically and abroad to investigate new and existing investment opportunities. Scott was not a fan of commercial airfare, so he used his personal plane. He waived off reimbursement from the partnership for his air travel.

COMMENT: Scott is different from you or me.

The Shleifers filed their 2014 joint individual tax return. Whereas it is not stated in the case, we can assume that their 2014 return was extended to October 15, 2015.

In October 2018 they filed an amended return requesting a refund of almost $1.9 million.

COMMENT: And there you have your claim. In addition, notice that the two Octobers were three years apart. Remember that the statute of limitations for amending a return is three years. Coincidence? No, no coincidence.

What drove the amended return was depreciation on the plane. The accountant put the depreciation on Schedule C. It was – in fact – the only number on the Schedule C.

In July 2020 the IRS selected the amended return for audit.

COMMENT: A refund of almost $1.9 million will do that.

The Shleifer’s accountant represented them throughout the audit.

In March 2022 the IRS denied the refund.

Why?

Look at the Schedule C header above. It refers to a profit or loss “from business.” Scott was not “in business” with his plane. It instead was his personal plane. He did not sell tickets for flights on his plane. He did not rent or lease the plane for other pilots to use. It was a personal asset, a toy if you will, and perhaps comparable to a very high-end car. Granted, he sometimes used the plane for business purposes, but it did not cease being his toy. What it wasn’t was a business.

The accountant put the depreciation on the wrong form.

As a partner, Scott would have received a Schedule K-1 from the investment partnership. The business income thereon would have been reported on his Schedule E. While the letters C and E are close together in the alphabet, these forms represent different things. For example:

·       There must be a trade or business to file a Schedule C. Lack of said trade or business is a common denominator in the “hobby loss” cases that populate tax literature.

·       A partnership must be in a trade or business to file Schedule E. A partner himself/herself does not need to be active or participating. The testing of trade or business is done at the partnership - not the partner - level.

·       A partner can and might incur expenses on behalf of a partnership. White there are requirements (it’s tax: there are always requirements), a partner might be able to show those expenses along with the Schedule K-1 numbers on his/her Schedule E. This does have the elegance of keeping the partnership numbers close together on the same form.   

After the audit went south, the accountant explained to the IRS examiner that he was now preparing, and Scott was now reporting the airplane expenses as unreimbursed partner expenses. He further commented that the arithmetic was the same whether the airplane expenses were reported on Schedule C or on Schedule E. The examiner seemed to agree, as he noted in his report that the depreciation might have been valid for 2014 if only the accountant had put the number on the correct form.

You know the matter went to litigation.

The Shleifers had several arguments, including the conversation the accountant had with the examiner (doesn’t that count for something?); that they met the substantive requirements for a depreciation deduction; and that the IRS was well aware that their claim for refund was due to depreciation on a plane.

The Court nonetheless decided in favor of the IRS.

Why?

Go back to the last sentence of Reg 301.6402-2(b)(1):

A claim which does not comply with this paragraph will not be considered for any purpose as a claim for refund or credit.

The Shleifers did not file a valid refund claim that the Court could review.

Here is the Court:

Although the mistake was costly and the result is harsh …”

Yes, it was.

What do I think?

You see here the ongoing tension between complying with the technical requirements of the Code and substantially complying with its spirit and intent.

I find it hard to believe that the IRS – at some point – did not realize that the depreciation deduction related to a business in which Scott was a partner. However, did the IRS have the authority to “move” the depreciation from one form to another? Then again, they did not have to. The accountant was right: the arithmetic worked out the same. All the IRS had to do was close the file and … move on.

But the IRS also had a point. The audit of Schedule C is different from that of Schedule E. For example, we mentioned earlier that there are requirements for claiming partnership expenses paid directly by a partner. Had the examiner known this, he likely would have wanted partnership documents, such as any reimbursement policy for these expenses. Granted, the examiner may have realized this as the audit went along, but the IRS did not know this when it selected the return for audit. I personally suspect the IRS would not have audited the return had the depreciation been reported correctly as a partner expense. 

And there you have the reason for the variance doctrine: the IRS has the right to rely on taxpayer representations in performing its tax administration. The IRS would have relied on these representations when it issued a $1.9 million refund – or selected the return for audit.

What a taxpayer cannot do is play bait and switch.

Our case this time was Shleifer v United States, U.S. District Court, So District Fla, Case #24-CV-80713-Rosenberg.

Government Forces Sale to Cover Partner’s Tax Debt

 I was reading a case recently that bothered me. It involves something that – fortunately – I rarely see in practice.

Here is the Code section:

§ 7403 - Action to enforce lien or to subject property to payment of tax

(a) Filing. In any case where there has been a refusal or neglect to pay any tax, or to discharge any liability in respect thereof, whether or not levy has been made, the Attorney General or his delegate, at the request of the Secretary, may direct a civil action to be filed in a district court of the United States to enforce the lien of the United States under this title with respect to such tax or liability or to subject any property, of whatever nature, of the delinquent, or in which he has any right, title, or interest, to the payment of such tax or liability. For purposes of the preceding sentence, any acceleration of payment under section 6166(g) shall be treated as a neglect to pay tax.

(b) Parties. All persons having liens upon or claiming any interest in the property involved in such action shall be made parties thereto.

(c) Adjudication and decree. The court shall, after the parties have been duly notified of the action, proceed to adjudicate all matters involved therein and finally determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property, by the proper officer of the court, and a distribution of the proceeds of such sale according to the findings of the court in respect to the interests of the parties and of the United States. If the property is sold to satisfy a first lien held by the United States, the United States may bid at the sale such sum, not exceeding the amount of such lien with expenses of sale, as the Secretary directs.

(d) Receivership. In any such proceeding, at the instance of the United States, the court may appoint a receiver to enforce the lien, or, upon certification by the Secretary during the pendency of such proceedings that it is in the public interest, may appoint a receiver with all the powers of a receiver in equity.

And here is where you leave your tax CPA and hire a tax attorney.

Section 7403 permits a court to authorize the sale of property when a delinquent person owns property with a nondelinquent person. The IRS cannot do this on its own power, however; it must first go to district court and obtain approval.

To be fair, one is deep into the IRS Collection machinery before Section 7403 is even an issue. I would be screaming at you – and likely fired you as a client – long before we got here, unless bad fortune was involved. If there was bad fortune, we likely would be submitting an offer in compromise.

The heavyweight case in this area is United States v Rodgers. Rodgers was a Texas gambler who died, leaving a $900,000 tax debt. He (well, now his estate) and his wife owned their home. Under Texas law the surviving spouse had a lifetime right to live in the home. The government of course wanted its money.

The case went all the way to the Supreme Court, which identified four issues before the government could force any sale to collect taxes.

 (1) Statutory authority

Does the taxpayer have any “right, title or interest” to the property in question?

 

In Rodgers, yes. The deceased had the same rights to the entire home as did the widow.

 

The type of ownership can have a drastic effect on the government’s ability to reach the asset. A tenancy by the entirety, for example, might result in a different answer from a tenancy in common (which we will see below). 

            (2) Constitutional authority

This goes back to eminent domain. The government is not an ordinary creditor in this situation; rather it is exercising the prerogatives of a sovereign. Think of the government as a super creditor.

            (3) Practical undercompensation

Think actuarial calculations. For example, one could think that a 50/50 split of marital assets is fair. However, the value of a life estate to a surviving spouse aged fifty can be up to 95% of the home’s sales price. The spread between 95% and 50% is referred to as “practical undercompensation.”

            (4) Four-factor balancing test

             (a)  Will a non-sale prejudice the government?

   (b) Does the spouse have a legally recognized expectation of the house not being sold?

   (c)  Will the spouse suffer prejudice from practical undercompensation and dislocation costs?

   (d)  What are the relative characters and values of the two ownership interests?

Subsequent application of Rodgers focuses on these four factors.

Let’s move on to Driscoll.

Thomas Driscoll was a dentist. He owned a dental practice with Dr Vockroth. Together they also owned the building in which the dental practice was located.

Common enough.

Dr Driscoll became substantially delinquent with his tax obligations.

In April 2023, the government filed a motion for forced sale of both the practice and the building.

Meanwhile. Dr V had no tax issues. He may have made the mistake of partnering with someone who did, but that was the extent of his culpability.

The government – to its credit – allowed additional time to sell both assets.

But there were issues: trying to sell a dental practice in a small town and a building housing said practice in said small town. Let’s just say there was limited interest in buying either.

The government now wanted a forced sale.

Let’s go through the Rodgers four factors:

One

The Court decided Dr V could not show that the government would not be prejudiced by going after 50% rather than 100% of the practice and building.

Yes, the double negative is a bit difficult to follow.

This was a practice in a small town. It was going to be tough enough to sell without trying to sell half rather than the whole.

         The court decided that factor one weighed in favor of a sale.

         Two

Was Dr V as a tenant in common subject to a forced sale?

Here is the Court discussing the real estate:

This conclusion is also supported by the fact that, unlike tenants by the entirety or joint tenants, tenants in common enjoy no protections from forced sales or partition actions.”

Tough to be a tenant in common in New Jersey.

The court decided factor two weighed in favor of a sale.

Three

 Was there prejudice to Dr V in terms of personal dislocation of costs and undercompensation of interest?

Here is the Court:

 Dr Vockroth asserts that he will be ‘forced to lay off all of [his] employees,’ and that he will ‘no longer be able to see [his]  patients.'”

OK, Dr V may be laying it on thick, but that does not mean there is no truth here. Relocating a practice costs money. There are – for example - additional electrical and plumbing needs before a building can house a dental practice. Patients may not follow. Employees may not follow. The court is playing cavalierly with other people’s lives.

Here is the court in its best Frasier Crane voice:

 Furthermore, even if Dr Vockroth is negatively affected by the LLC in some way, this is not an undue prejudice of a magnitude to prevent a forced sale. It is axiomatic that LLCs and partnerships change, fail, dissolve and are bought and sold with regularity. Partners die or sell their shares The reality is simply part of being in business, and Dr. Vockroth is not exempt from this fact, especially when he fails to offer any reliable evidence to support his contentions.”

What is Dr V to do: poll his patients and employees to see whether they would follow? Oh, that will go swimmingly.

BTW the sale of a dental practice will certainly include a noncompete, meaning that Dr V could not open a dental practice within so many miles of the existing practice. Well, he could, but he would be sued.

One would think a judge would know that.

Four

  The relative character and value of the property owned by the two owners.

There was not much play here as both doctors owned 50%.

The court decided that the government could foreclose on both the practice and the real estate.

Technically right, but lousy law. Consider this menacement from Rodgers:

We do emphasize, however, that the limited discretion accorded by § 7403 should be exercised rigorously and sparingly, keeping in mind the Government's paramount interest in prompt and certain collection of delinquent taxes.

Section 7403 is not taxpayer friendly.

Our case this time was United States v Driscoll, 2025 BL 2655, D.N.J. No. 3:18-cv-11762, 1/6/25.

Taxing A 5-Hour Energy Drink

 

I am skimming a decision from the Appeals Court for the District of Columbia. I am surprised that it is only 15 pages long, as it involves a gnarly intersection of partnership tax and the taxation of nonresident aliens.

Let’s talk about it.

In general, partnerships are not treated as a taxable entity. A partnership is a reporting entity; it reports income and expenses and then allocates the same to its partners for reporting on their tax returns. Mind you, this can get mind-numbing, as a partner in a partnership can itself be another partnership. Keep this going a few iterations and being a tax professional begins to lose its charm.

A partner will - again, in general - report the income as if the partner received the income directly rather than through the partnership. If it was ordinary income or capital gain to the partnership, it will likewise be ordinary income or capital gain to the partner.

Let’s introduce a nonresident alien partner.

We have another tranche of tax law to wade through.

A nonresident alien is fancy talk for someone who does not live in the United States. That person could still have U.S. income and U.S. tax, though.

How?

Well, through a partnership, for example.

Say the partnership operates exclusively in the United States. A nonresident alien generally pays tax on income received from sources within the United States. Let’s look at one type of income: business income. We will get to nonbusiness income in a moment.

The tax Code wants to know if that business income is “effectively connected” with a U.S. trade or business.

The business income in our example is effectively connected, as the partnership operates exclusively in the United States. One cannot be any more connected than that.

The partnership will issue Schedules K-1 to its partners, including its nonresident alien partner who will file a U.S. nonresident tax return (Form 1040-NR).

Question: Will any nonbusiness income on the K-1 be reportable on the nonresident?

The tax Code separates business and nonbusiness income because they might be taxed differently for nonresidents. Nonbusiness income can go from having 30% withholding at the source (think dividends) to not being taxed at all (think most types of interest income).

What if the Schedule K-1 reports capital gains?

I normally think of capital gains as nonbusiness income.

But they do not have to be.

There is a test:

If the income is derived from assets used or held for use in the conduct of an effectively connected business – and business activities were a material factor in generating the income  – then the income will taxable to a nonresident alien.

Think capital gain from the sale of farm assets. Held for use in farming? Check. Material factor in generating farm income? Check. This capital gain will be taxable to a nonresident.

Forget the K-1. Say that the nonresident alien sold his/her partnership interest altogether.

On first impression, I am not seeing capital gain from the sale of the partnership interest (rather than assets inside the partnership) as meeting the “held for use/material factor” test.

Problem: partnership taxation has something called the “hot asset” rule. The purpose is to disallow capital gains treatment to the extent any gain is attributable to certain no-no assets – that is, the “hot assets.”

An example of a hot asset is inventory.

The Code does not want the partnership to load up on inventory with substantial markup and then have a partner sell his/her partnership interest rather than wait for the partnership to sell the inventory. This would be a flip between ordinary and capital gain income, and the IRS is having none of it.

Question: have you ever had a 5-hour Energy drink?

That is the company we are talking about today.

Indu Rawat was a 29.2% partner in a Michigan partnership which sells 5-hour Energy. She sold her stake in 2008 for $438 million.

I can only wish.

At the time of sale, the company had inventory with a cost of $6.4 million and a sales price of $22.4 million. Her slice of the profit pending in that inventory was $6.5 million.

A hot asset.

The IRS wanted tax on the $6.5 million.

Mind you, Indu Rawat did not sell inventory. She sold a partnership interest in a business that owned inventory. That would be enough to catch you or me, but could the hot asset rule catch a nonresident alien?

The Tax Court agreed with the IRS that the hot asset gain was taxable to her.

That decision was appealed.

The Appeals Court reversed the Tax Court.

The Appeals Court noted that there had to be a taxable gain before the hot asset rule could kick in. The rule recharacterizes – but does not create – capital gain.

This capital gain does not appear to meet the “held for use/material factor test” we talked about above. You can recharacterize all you want, but when you start at zero, the amount recharacterized cannot be more than zero.

Indu Rawat won on Appeal.

By the way, tax law in this area has changed since Rawat’s sale. New law would tax Rawat on her share of effectively connected gain as if the partnership had sold all its assets at fair market value. Congress made a statement, and that statement was “no more.”

Our case this time was  Indu Rawat v Commissioner, No 23-1142 (D.C. Cir. July 23, 2024).