Zero, Zip, Zilch, Nada: No Basis In Partner Contributed Note

The Tax Court recently held that a partner had zero basis in a contributed promissory note following a retroactively filed entity classification election.

A partner who merely contributes a promissory note to a partnership in exchange for a partnership interest generally has zero basis in its partnership interest at the time of contribution. In Continental Grand Limited Partnership v. Commissioner, the Tax Court extended this principle to a complex fact pattern involving a retroactively filed entity classification election.

In Continental Grand, a German holding company (“Parent”) issued a $610 million promissory note to its wholly owned German subsidiary (“Subsidiary”), and Subsidiary immediately contributed the note to a newly formed U.S. partnership (“Partnership”). Both Parent and Subsidiary were classified as corporations for U.S. federal income tax purposes at the time of the issuance and the contribution. More than a year after assigning the note to Partnership, Subsidiary elected for U.S. federal income tax purposes to be disregarded as an entity separate from Parent. The parties stipulated that the election was retroactively effective to three days before Parent issued the note.

Confronted with the retroactive election, the Tax Court reordered the transaction as follows. On the election’s effective date, Subsidiary was deemed to have liquidated and distributed its assets and liabilities to Parent. As a result, Parent’s subsequent issuance of the note to Subsidiary was disregarded for U.S. federal tax purposes, and Parent was treated as contributing its own note to Partnership in exchange for an interest in Partnership.

Under prior Tax Court decisions, because a partner incurs no costs in issuing its own note, its basis in note is zero. Under the Internal Revenue Code, a partner’s basis in its partnership interest includes the adjusted basis of any property contributed. Correspondingly, a partnership’s basis in property equals the contributing partner’s basis in such property increased by any gain recognized upon the contribution.

Accordingly, the Tax Court held that (i) the note’s basis was zero when it was contributed to Partnership, (ii) Parent’s basis in its partnership interest received in exchange for the note was zero, and (iii) Partnership’s basis in the note immediately after the contribution was zero.

Notably, if the note parties had both been regarded entities at the time of the contribution, then the lender (Subsidiary) would have had basis in the note equal to the cash advanced, which the opinion assumed was $610 million. Thus, Subsidiary’s decision to retroactively elect disregarded entity status before the contribution of the note appears to be quite peculiar.

The case demonstrates a meaningful extension of the Tax Court’s zero basis precedents to a note first issued to an entity recognized for state law, but not U.S. tax, purposes, and then contributed to a partnership. It also highlights the importance of carefully considering the implications of entity classification elections when structuring transactions.