United States: Partners And Partnership Had No Basis In Contributed, Unsecured Notes, Tax Court Holds

In VisionMonitor Software LLC v. Commissioner, T.C. Memo 2014-182 (Sept. 3, 2014), the Tax Court held that both the partners and the partnership had zero tax basis in personal promissory notes contributed to the partnership because the notes were "only a contractual obligation" and not equal to a cash contribution.  

The partnership was formed in 2002 by two individuals and a corporation with the funds to keep the business afloat. When the partnership needed additional funding in 2007, the corporate partner wasn't willing to contribute additional cash unless the other partners "put some additional 'skin in the game,' " according to the court.  

The parties agreed to the partners' contributing promissory notes in 2007 and 2008. The partnership recorded the notes as assets on its books. The partners increased their outside basis by the face value (and deducted larger losses on their personal returns in 2007 and 2008). The notes, however, were poorly drafted and weren't properly notarized. They also didn't reflect the correct amounts payable.

The IRS audited one of the partner's and the partnership's returns for the 2007 and 2008 tax years, which were loss years for the partnership, and argued that both the partnership and partners had zero tax basis in the notes. VisionMonitor cited Gefen v. Commisioner, 87 T.C. 1471 (1986), which involved a partner who assumed personal liability for existing, third-party recourse debt of the partnership and agreed to make additional capital contributions if called upon by the partnership. The Tax Court distinguished Gefen because neither of the individual partners was guaranteeing any of the existing partnership debt. Also, there was no evidence that either partner would be obligated to contribute to the partnership to fund any existing debt.

Citing Gemini Twin Fund III v. Commissioner, T.C. Memo 1991-315, the court held that the partners had zero tax basis in the notes, and until payment is made, the notes are merely a "contribution obligation to their partnership." The Tax Court didn't rule on whether the notes would provide additional basis to the individual partners' outside basis under the "at risk" rules of Section 465 stating that the "relevant question isn't whether the notes were a debt owed by the partners to VisionMonitor, but whether the partners had basis in the notes."

The Tax Court also did not discuss the Section 704(b) capital account consequences of a partner's contribution of his/her own promissory note. Under Reg. Section 1.704-1(b)(2)(iv)(d)(2), if a partner contributes to its own promissory note to his/her partnership, the partner does not receive capital account credit at the time of contribution. Rather, the partner's capital account will be increased with respect to the note only when there is a taxable disposition of the note by the partnership or when the partner makes principal payments on such note.

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