Oftentimes a partner in a partnership or a member to a limited liability company (that is taxed as a partnership) does not possess sufficient liquidity to meet a capital call. The other partners, wanting the illiquid partner to nonetheless put some “skin in the game,” will demand that the illiquid partner contribute his own promissory note.
A recent United States Tax Court opinion has clarified existing law that contributing one’s own promissory note to a partnership is a valid contribution of property to the partnership (either as an initial contribution or as a capital contribution), but it carries unique tax consequences. Unlike a partner who personally assumes liability for existing partnership debt, a partner who contributes his own promissory note takes a zero basis in his partnership interest for the contribution, and the partnership itself takes a zero basis in the note. Only payments of principal toward the note create basis in the note (and in the partner’s partnership interest). Moreover, the IRC Section 704(b) capital account regulations provide that a partner who contributes his or her own note to the partnership does not receive capital account “credit” for the unpaid principal portion of the note.
For more information, please contact John E. Dawson in our Las Vegas, Nev. office at 702-550-4463.