Note contributed to partnership has zero basis

The Tax Court held that the owner of a disregarded entity had no basis in a promissory note that the disregarded entity received from the owner and then contributed to a newly formed partnership in exchange for an interest in the partnership.

Background

CSC Computer Sciences GmbH (CSC Germany) was a holding company incorporated in Germany that wholly owned German subsidiaries engaged in an active information technology services business. One of its wholly owned subsidiaries was CSC Financial GmbH (CSC Financial). In March 2001, CSC Germany issued a note to CSC Financial with an issue price of more than $600 million. The note specified that CSC Germany would pay more than $1.1 billion to its holder in August 2009, an amount that reflected the issue price and deferred interest.

The Continental Grand Limited Partnership (CGLP), which was organized in Nevada on March 23, 2001, owned computer equipment and related property that it leased to affiliates within the CSC consolidated group. On March 26, 2001, CSC Financial contributed the note to CGLP as consideration for a limited partnership interest in CGLP. Beginning March 26, 2001, and until March 19, 2009, CGLP had three partners: CSC Financial, Century Credit Corp., and Century Subsidiary Corp. (Century, CGLP’s tax matters partner).

On April 12, 2002, CSC Financial elected to be disregarded as an entity separate from CSC Germany, effective March 23, 2001. Therefore, when CFC Financial contributed the note to CGLP, it was a disregarded entity of CSC Germany.

On March 16, 2009, CSC Germany, CGLP, and CSC Financial entered into an addendum to the note. Under the addendum, CSC Germany agreed to prepay its obligations under the note by transferring more than $1 billion to CGLP. The transfer took place the same day. Also on that day, CSC Financial liquidated its interest in CGLP. In the liquidation, CGLP distributed more than $1 billion to CSC Financial.

CGLP filed Form 1065, U.S. Return of Partnership Income, for 2009. The IRS audited CGLP’s return and issued a notice of final partnership administrative adjustment (FPAA) on Nov. 1, 2021. The IRS took the position that CSC Germany should be treated as having had zero basis in the note; CSC Germany should be treated as having zero basis in its interest in CGLP as of the date of the note’s contribution to CGLP; and CGLP should be treated as having zero basis in the note as of the date of CSC Germany’s contribution to the partnership.

Century, as CGLP’s tax matters partner, timely petitioned the Tax Court for review of the FPAA. In Tax Court, the IRS moved for partial summary judgment on three issues: (1) CSC Germany’s adjusted basis in the note when it was contributed to CGLP; (2) CSC Germany’s basis in the partnership interest immediately after the contribution; and (3) CGLP’s basis in the note immediately after its contribution.

The Tax Court’s holding

The Tax Court granted the IRS’s motion for partial summary judgment. The court held that CSC Financial’s election to be disregarded as an entity separate from CSC Germany caused CSC Germany’s issuance of the note to CSC Financial to be disregarded and CSC Financial’s contribution of the note to CGLP to be treated as CSC Germany’s contribution of its own note to CGLP. The court further held that CSC Germany’s adjusted basis in the note when it contributed the note to CGLP was zero. Thus, it also held that CFC Germany’s basis in its interest in CGLP immediately following the contribution was zero, and CGLP’s basis in the note immediately following the contribution was zero.

Effect of election to be disregarded

The Tax Court first discussed the effect of an election to be disregarded. The court explained that the tax treatment of a business entity turns, in part, on what type of entity it is, and the “check–the–box” regulations in Regs. Secs. 301.7701–1 to –3 provide the rules for classifying business entities. Under the regulations, entities that are not classified automatically as corporations can elect their tax treatment. As relevant to CGLP’s case, a foreign entity with a single owner may elect to be treated as an association (and thus a corporation) or to be disregarded as an entity separate from its owner.

When an entity previously classified as an association elects to be disregarded, the association is deemed to distribute all of its assets and liabilities to its single owner in liquidation of the association, and afterward, the association’s activities are treated in the same manner as a sole proprietorship, branch, or division of the owner (Regs. Secs. 301.7701–3(g)(1)(iii) and 301.7701–2(a)). A disregarded entity is not, however, invisible for all federal tax purposes, and the regulations provide for certain circumstances (not applicable in CGLP’s case) in which a disregarded entity is treated as an entity separate from its owner.

Application of election to CSC Financial

When CSC Financial (which was classified as an association) made its election, effective March 23, 2001, to become a disregarded entity, it was deemed to have liquidated and distributed its assets (including its cash) and liabilities to CSC Germany. This meant, subsequent to the election, any cash CSC Financial loaned to CSC Germany belonged to CSC Germany for tax purposes, and any activities of CSC Financial were treated as the activities of a branch or division of CFC Germany.

As a result, the Tax Court found that the issuance of the note on March 26, 2001, was required to be disregarded for federal tax purposes. Because CSC Financial was at that time a disregarded entity of CSC Germany, its contribution of the note to CGLP was treated as if it were undertaken by a branch or division of CSC Germany. Therefore, from a federal tax perspective, the court viewed CSC Germany as having contributed its own note to CGLP in exchange for a partnership interest.

Basis of CSC Germany’s partnership interest

As the Tax Court explained, Sec. 705(a) provides that the adjusted basis of a partner’s interest is the basis determined under Sec. 722 or Sec. 742, increased or decreased by certain amounts (including the partner’s distributive share of partnership income and losses). Sec. 722, which applies to “an interest in a partnership acquired by a contribution of property, including money, to the partnership,” provides that the basis of such an interest is:

• The amount of the money and the adjusted basis of the property to the contributing partner at the time of the contribution; increased by
• The amount (if any) of gain recognized under Sec. 721(b) to the contributing partner at the time of the contribution.

The IRS argued that the contribution of the note was not a “contribution of property” within the meaning of Sec. 722. Century countered that the note was “property” within the meaning of Secs. 722 and 723.

The Tax Court stated, citing its opinion in Norwest Corp., 108 T.C. 265, 301 (1997), that debt is considered property in the hands of the holder. However, it found that it is less immediately clear whether a promissory note is property in the hands of the writer. The court found, though, that it did not have to answer that question. Assuming, as Century urged, for purposes of the motion, that the contribution of the note was a “contribution of property” within the meaning of Sec. 722, the court concluded that it still must grant the IRS’s motion.

Under Sec. 722, according to the Tax Court, the basis of CSC Germany’s interest in CGLP was equal to the adjusted basis of the note in the hands of CSC Germany at the time of the contribution. Under Sec. 1011(a), except as otherwise provided in Subchapters C, K, and P of the Code, the adjusted basis of property is the property’s basis, determined under Sec. 1012 and adjusted as provided in Sec. 1016. Sec. 1012(a) provides that the basis of property is its cost, except as otherwise provided. Regs. Sec. 1.1012–1(a) provides that the cost of property is the amount paid for it.

In this case, the Tax Court found that the note in the hands of its maker, CSC Germany, had no cost because CSC Germany paid no amount in money or property to create the note and did not “engage to pay or give” anything to someone else in exchange for that third person’s help in making it. Therefore, as it had held in multiple similar cases, (e.g., Oden, T.C. Memo. 1981–184) the Tax Court concluded that the note’s adjusted basis in CSC Germany’s hands was zero. Consequently, its basis in CGLP after its contribution of the note to the partnership was zero.

CGLP’s basis in the note

Under Sec. 723, the basis of property contributed to a partnership by a partner is “the adjusted basis of such property to the contributing partner at the time of the contribution increased by the amount (if any) of gain recognized under section 721(b) to the contributing partner at such time.” Because, as the Tax Court had already determined, the adjusted basis of the note to CSC Germany at the time of the contribution was zero, and CSC Germany recognized no gain with respect to the contribution, the court concluded that the basis of the note in the hands of CGLP was zero.

Reflections

According to Century, the basis determinations at issue in the case were central to the computation of a foreign currency translation loss under Sec. 987 that CSC Germany claimed in 2009. However, the computation of that loss was not addressed in the IRS’s motion, so the Tax Court did not discuss it in its opinion.

Continental Grand Limited Partnership, 166 T.C. No. 3 (2026)

Contributor

James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser’s tax technical content manager. For more information about this column, contact thetaxadviser@aicpa.org.