The Tax Court has denied basis to individuals who contributed unfunded, unsecured notes to a partnership and claimed basis for the amounts on the notes. As a result, the partners’ bases in their partnership interests were too low for them to claim greater pass-through losses on their individual income tax returns.

The court relied on a long line of cases holding that a partner’s contribution of his or her own note is not the equivalent of cash and, without more, does not increase the partner’s basis in the partnership interest. Although the partners clearly lost on the basis issue, the court held that they were not liable for negligence penalties because they had appropriately relied on a competent professional for his advice that they were entitled to basis.

The court, discussing its jurisdiction, concluded that a partner’s basis in an item contributed to a partnership was a partnership matter that the court could address under TEFRA, whether or not the IRS adjusted it in its notice to the partnership. The court also had jurisdiction to determine the applicability of any penalty that relates to the adjustment of a partnership item.


Two individuals and an investment company started a partnership. For several years, the partnership lost money and ran through its capital. The investment company agreed to make additional contributions but only if the individual partners also made additional contributions. The partners lacked the liquidity to contribute cash.

After consulting with their longtime attorney and tax advisor, the partners decided to contribute promissory notes. The advisor concluded that the notes were enforceable, would be treated as assets by the partnership, and would create basis in the partnership. The partners also agreed to freeze their salaries, to provide personal credit to the partnership’s vendors, and to provide notes payable to improve the company’s financial position.

After the partners provided notes for $213,000, the investment company contributed $900,000 to the partnership. The notes were seven-year notes with six-percent interest and a balloon payment. The partners failed to make any interest payments.

Basis in partnership interest

The IRS argued that the partners’ basis in their own notes was zero, and the Tax Court agreed. The court distinguished Gefen (TC, 1986), which granted a partner basis where the partner assumed personal liability to the partner’s existing creditor for an amount owed by the partnership. That partner also agreed to contribute to the partnership an amount of the partnership’s outstanding debt, if the partnership called on her.

The court agreed that the notes may have been needed to persuade a third party (the investment company partner) to make additional contributions to the partnership. However, the individual partners did not guarantee any preexisting partnership debt to a third party, and did not directly assume any of the partnership’s outside liabilities. Furthermore, there was no evidence that either partner ever actually provided any personal credit to company vendors, despite their agreement to do so.


The IRS imposed a 20 percent accuracy-related penalty on the individual partners for negligence or intentional disregard of rules and regulations. The partners claimed that they relied on professional advice.

The Tax Court found that the partners satisfied the three-factor test for reliance on a professional, and that they did not owe any penalties:

  • They relied on a competent professional with sufficient expertise to justify reliance.
  • They provided all necessary information to the adviser, including the factual background for the notes and access to all company records regarding the notes.

They reasonably relied on the professional’s advice in good faith.

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