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Partner Must Have Basis to Deduct Loss

Published on: 09:23AM Sep 04, 2014

In an US Tax Court case that was released yesterday, partners were found not to have tax basis in promissory notes that they "contributed" to the partnership. Farmers will create partnerships to run their operation and since farm tax law allows farm businesses to usually generate a small profit or even a loss; partners must have "tax basis" in order to deduct these losses.

In the VisionMonitor case, two partners had started a company to perform services related to the energy business. The partnership burned up a lot of money in the first few years and they had a corporate partner with deep pockets that was only willing to contribute additional funds if the two partners would put "more skin in the game". They did this by contributing notes to the partnership. The partners elected to sign promissory notes for about $210,000 during 2007 and 2008. By signing these notes, the corporate partner contributed another $900,000 of cash which kept the company afloat and eventually the partnership became profitable and everyone was very happy. Except for the IRS.

They audited the return and determined that the partner's had no basis in the promissory notes that they contributed to the partnership. When a partner contributes cash, they get additional basis based upon the amount of cash they contributed. However, when they contribute property such as these notes, the basis in the partnership that they receive is equal to the basis in the property contributed. Since these notes had no basis, they get no additional basis in the partnership. This results in the loss they originally deducted being disallowed and then suspended.

All is not lost, however. The loss is carried forward and allowed to be offset income earned in later years.

The bottom line is if you show a loss from a partnership, make sure you have enough "basis" to deduct the loss.