Contribution of A Note to a Subsidiary: The Zero-Basis Rule – Houston Tax Attorneys

Businesses organized through multiple related entities routinely use promissory notes to move money between them. A parent company may issue a note to a subsidiary to capitalize it or fund operations. Affiliates lend to one another as part of ordinary treasury management.

In the partnership context, a partner who wants to demonstrate additional financial commitment—but lacks the liquidity to contribute cash—may turn to a note contribution as an alternative. These arrangements feel like real economic transactions, and in many cases they are.

But about when the note being contributed to a partnership was issued by the contributing partner itself? So say your business issues a note to a subsidiary? Does it matter whether the subsidiary is taxed separately from the parent or if it is a disgregarded entity?

The Continental Grand Limited Partnership v. Commissioner, 166 T.C. No. 3 (2026) case gets into this. It involves a parent that made a loan to a subsidiary but after that, the subsidary made a retroactive election to be treated as a disregarded entity. This fact pattern provides an opportunity to consider the zero-basis rule in the context of intercompany note contributions to partnerships.

Facts & Procedural History

The key parties were a German holding company, its wholly owned German subsidiary, and a Nevada limited partnership.

The German holding company served as a holding entity for an active IT services business. Its German subsidiary was likewise incorporated in Germany and wholly owned by the German parent. The ultimate U.S. parent of both German entities guaranteed the transactions at issue.

In 2001, the German parent issued a promissory note to its German subsidiary for $610 million. The note called for a single balloon payment of $1 billion in 2009. This included the original principal and deferred interest. The parties later stipulated that the fair market value of the note at issuance equaled its issue price. That same day, the German subsidiary contributed the note to the partnership in exchange for a limited partnership interest. The partnership owned computer equipment that it leased to affiliated companies within the same corporate group.

More than a year later, in 2002, the German subsidiary elected under the check-the-box regulations to be treated as a disregarded entity—that is, a branch or division of its German parent—for federal tax purposes. The election was filed retroactively effective to 2001, a date that predated both the issuance of the note and its contribution to the partnership. Because the subsidiary was treated as nonexistent for federal tax purposes throughout the relevant period, the note issuance between the two German entities was disregarded. The subsidiary’s contribution of the note to the partnership was recharacterized as the German parent contributing its own note to the partnership in exchange for a limited partnership interest.

In 2009, the German parent paid more than $1 billion to the partnership in satisfaction of the note and all deferred interest. The subsidiary then liquidated its partnership interest and received a distribution exceeding $1 billion.

The IRS audited the partnership’s 2009 U.S. partnership tax return and issued a Notice of Final Partnership Administrative Adjustment (the “FPAA”) in 2021. The IRS determined that the German parent had zero adjusted basis in the note at the time of contribution, zero basis in its partnership interest immediately after the contribution, and that the partnership itself took zero basis in the note.

The tax matters partner for the partnership petitioned the U.S. Tax Court to challenge those determinations. The IRS filed a Motion for Partial Summary Judgment on all three basis questions, which were the subject of the court opinion.

Partnership Basis: Sections 722 and 723

To follow this case, we have to start with the partnership tax and basis rules.

A partnership does not pay income tax. Its income, losses, deductions, and credits flow through to each partner, who reports those items on their own return. That pass-through is not unlimited, though. This often comes up when the partnership returns reflect losses.

A partner may deduct his allocable share of partnership losses only to the extent of his adjusted basis in his partnership interest—his “outside basis”—at the close of the tax year in which the loss arises. Losses in excess of that threshold are suspended and carried forward, sometimes indefinitely at the partner level. There are other limitations that can cause the loss to be suspended at the partner level too, such as the passive activity loss rules.

Sections 722 and 723 of the tax code set the initial basis figures at the time a partner contributes property to a partnership. Section 722 provides that the basis of a partnership interest acquired by contribution equals the contributing partner’s adjusted basis in the contributed property at the time of contribution, plus any gain recognized on the transfer.

Section 723 is the partnership-level counterpart: the partnership’s basis in the contributed property equals the contributing partner’s adjusted basis in that same property at the same moment.

Both provisions trace directly to the contributing partner’s adjusted basis at contribution date. If that figure is zero, both the partner’s outside basis and the partnership’s inside basis start at zero.

What Does “Cost” Mean Under the Tax Code?

Section 1012 defines what is the adjusted basis of property. It says that the basis of property is its cost.

Treasury Regulation § 1.1012-1(a) defines cost as the amount paid for the property. Cost, in the ordinary sense, means something given up in exchange for something acquired. A taxpayer who borrows money to purchase real estate has a cost basis equal to the purchase price—including the borrowed amount—because the borrowed funds were used to acquire the property. A taxpayer who buys stock pays a cost equal to the purchase price. In each case, value flowed outward in exchange for an asset, and that outflow is the basis.

A promissory note issued by its own maker is different at a fundamental level. The maker of a note does not acquire it through an exchange. The maker creates it. No money or property passes to the maker in order to bring the note into existence. The note simply evidences an obligation to pay in the future. Thus, since the taxpayer incurred no cost in making the note, its basis was zero. Liabilities have no basis in tax law generally or in Section 1012 terms specifically.

A Partner’s Own Note Does Not Create Basis

The courts have applied the zero-basis rule in several court cases–which the court noted in its opinion in this case.

The rule, stated plainly, is that the contribution of a partner’s own note to his partnership is not the equivalent of a contribution of cash, and without more, it will not increase his basis in his partnership interest.

Across the various court decisions, the determining question was never whether the contributed notes were genuine, legally enforceable obligations. A legally valid promissory note can still carry zero basis in the hands of its maker. The relevant question is whether the contributing partner had any basis in the note—not whether the note was real debt.

For this case, it was the retroactive check-the-box election to be a disregarded entity that decided the case. That made this note the partner’s own note.

With the retroactive disregarded entity election in place, the U.S. Tax Court treated the note contribution as the German parent contributing its own note to the partnership. From that point, the analysis flowed directly from the established rule. The German parent paid nothing to create the note. No cost was incurred in making it. Under Section 1012, the adjusted basis of the note in the German parent’s hands was zero. Under Section 722, the German parent’s basis in its partnership interest was therefore zero. Under Section 723, the partnership’s basis in the note was likewise zero.

The tax matters partner raised arguments against this result. First, it argued that the ordinary meaning of “cost” includes amounts a taxpayer is obligated to pay, and that the German parent’s repayment obligation under the note was itself a cost that should factor into basis. The Tax Court rejected that argument by clarifying what Section 722 actually asks. The relevant inquiry is the cost of the note itself—not the cost of acquiring the partnership interest. The German parent did not acquire the note by incurring its repayment obligation. The note simply evidenced that obligation. The taxpayer’s reliance on Commissioner v. Tufts, 461 U.S. 300 (1983), failed for the same reason. In Tufts, borrowed funds were used to purchase real property, and the loan was properly included in the property’s cost basis because an asset had actually been acquired. No such acquisition occurred here.

Second, the tax matters partner argued that the prior tax court decisions should be distinguished because those cases involved notes that lacked the hallmarks of genuine indebtedness and were recharacterized under a substance-over-form analysis. The tax court rejected that reading of its own precedent. It started that those cases never turned on the authenticity of the contributed notes. They applied the straightforward rule that a self-issued note carries zero basis in the maker’s hands regardless of the note’s legal validity or enforceability. The quality of the underlying debt is not the determining factor—the cost incurred in creating the note is.

Third, the tax matters partner pointed to Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989), and Peracchi v. Commissioner, 143 F.3d 487 (9th Cir. 1998), as support for assigning some basis to the note. The tax court found neither applicable. Both arose in the context of C corporation contributions under Section 357(c) which is a different Code provision with different analytical requirements. Peracchi itself explicitly stated that its holding does not extend to the partnership or S corporation context. And Lessinger actually expressed doubt about whether any taxpayer could have basis in his own promise to pay.

Finally, the tax matters partner argued that the tax consequences here were entirely unforeseeable. The foreign currency translation loss arising from the note was not something the parties could have anticipated when the entity election was made years later. The tax court acknowledged the loss may have been a genuine surprise. But unforeseeability does not rewrite the applicable rules. The court held that a taxpayer who organizes its affairs in a particular way must accept the full tax consequences of that choice—including ones it did not anticipate and would prefer to avoid with the benefit of hindsight.

The Takeaway

This case shows how a retroactive election to change the tax status can impact tax basis. Namely, an entity change to a disregarded entity can result in promissory notes issued in the interim to be disregarded. This zero-basis rule for self-issued promissory notes in the partnership context applies with equal force to sophisticated multinational structures as it does to a two-person domestic LLC. Entity classification can change the outcome for this purpose. A partner’s own promissory note carries zero adjusted basis in the maker’s hands under Section 1012, and that zero flows directly to outside basis under Section 722 and to inside basis under Section 723.