Partnership Basis in Contributed Promissory Notes and Guarantees: Tax Tips

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Partners of a partnership sometimes contribute promissory notes to the partnership.  As an example, a partner drafts a note payable to the partnership promising to pay the partnership a sum of money.  The question then becomes whether the partner has an increase in partner basis for this.  The other question is what is the partnership’s basis in the promissory note.

Another related scenario is where a partner guarantees a partnership debt owed to a third party.  The question is whether this guarantee increases the basis of the partner in the partnership.

Partnerships don’t pay income tax, but they do file  information returns, and partners are supposed to use the numbers from those returns on their own individual returns. See IRC secs. 701, 6031, 6222(a).  Partnership basis is important because it determines whether a distribution such as cash is taxed or not.  It also determines the amount of taxable gain or loss upon sale. An increase in a partner’s basis is desirable.  We provide legal and tax services to partnerships, including partnership tax return preparation and Form 1065 reporting.

The value of what a partner contributes to his partnership can be tricky when he contributes something other than cash–like promissory notes or guarantees. A partnership’s basis in property contributed by a partner is the adjusted basis of that property in the hands of the contributing partner at the time of the contribution. IRC sec. 723.

The Tax Court has held that the contribution of a partner’s own note to his partnership isn’t the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest. See Dakotah Hills Offices Ltd. P’ship v. Commissioner, T.C. Memo. 1998-134, 75 T.C.M. (CCH) 2122.

As such, the partner’s basis does not increase and the partnership’s basis in the notes is zero.

When a Guarantee Can Affect Partnership Basis

A guarantee of partnership debt can affect a partner’s outside basis, but signing a guarantee does not automatically create basis. The analysis depends on the partner’s share of liabilities under §752 and the applicable regulations.

For recourse liabilities, examine who bears economic risk of loss, including recognized payment obligations, reimbursement rights, indemnities, enforceability, and applicable anti-abuse and bottom-dollar guarantee rules. See Treasury Regulation §1.752-2. Nonrecourse liabilities follow different allocation rules.

In Gefen v. Commissioner, 87 T.C. 1471 (1986), the court upheld a basis increase on the facts of a limited guarantee. That decision does not establish that every guarantee increases basis under current rules.

• Review the actual liability and guarantee documents before calculating basis.
• Identify obligations to pay and any right to reimbursement or indemnification.
• Distinguish outside basis from the amount at risk under §465.
• Consider the economic exposure as well as any potential tax consequence; a guarantee can create a real obligation to pay.

See outside basis versus the K-1 capital account for the broader reconciliation. Before leaving the business, review how liability relief affects a partner’s exit and whether an abandonment loss is ordinary or capital.

See also our page on the sale of a partnership and also tax compliance/preparation.

Philip Falco, Attorney, CPA tracks inside and outside partnership basis, prepares 1065 Tax Returns and K1’s (303) 626-7000 phil@coloradolegal.com