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 where 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.
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.
However, a guarantee of a partnership debt to a third party does increase a partner’s basis.
For example, in Gefen v. Commissioner, 87 T.C. 1471 (1986) a partner executed a limited guaranty as a condition of her acquisition of an interest in a limited partnership. Under its terms, she assumed personal liability to the partnership’s existing creditor for her pro rata share of the partnership’s recourse indebtedness to that creditor. She also agreed that the partnership could call on her to contribute to the partnership an amount equal to the partnership’s outstanding debt. The Tax Court upheld the partner’s increase in basis for her limited guarantee.
This can be a tricky area. However, here are tax tips:
- Consider guaranteeing a preexisting third party debt rather than contributing a promissory note to the partnership.
- Document that the partner is providing personal credit to partnership vendors.
- The partner should be obliged to make additional contributions under the guarantee.
- The guarantee must create a liability to a third party, not the partnership.
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
