One person has the money. The other has the know-how or desire to work. They go into business together. The money partner puts up all the capital and the other partner does the work. It is one of the most common deals in small business, real estate, and investing.
Now add a twist. To keep things fair, the working partner agrees to share the downside. If the venture loses money, he owes his partner half of the losses. He signs a promissory note to back it up and pledges his assets as collateral. On paper, he has real skin in the game.
Then the venture loses millions. The working partner is on the hook for his half. So can he deduct his share of the losses on his tax return?
The tax court addressed this question in West v. Commissioner, T.C. Memo. 2026-105. The case provides an opportunity to consider why agreeing to cover losses is not the same thing as having tax basis in a partnership.
Facts & Procedural History
Mr. West was a Texas businessman. He owned several small companies of his own. He also ran a number of anohter businessman’s companies and managed his commodities trading accounts.
In 2014, the two of them changed the arrangement for the trading accounts. They signed three documents. The first was a trading agreement. The second was a promissory note from the taxpayer to the businessman. The third was a security agreement that pledged all of the taxpayer’s assets. The parties agreed that this created a partnership for tax purposes.
With this arrangemet, the businessman contributed the trading accounts. The taxpayer contributed his work. At the end of each year, the businessman would pay the taxpayer half of any profits. If there were losses, the taxpayer owed the businessman half of the losses up to $5 million. His share of any losses was automatically treated as money borrowed from the businessman under the promissory note.
The taxpayer never contributed any cash or property. This led to the central tax issue in the case.
The partnership lost about $13 million in 2014, its first year. It made back about $3 million in 2015. It closed in early 2016 with a net loss of over $11 million. The taxpayer’s half was about $5 million.
The businessman claimed the entire 2014-year loss on his own tax return. The IRS did not challenge that as it likely missed the time limit to do so.
The IRS audited the taxpayer’s 2015 and 2016 returns. The IRS audit focused on his Schedule C businesses. IRS agents found unreported income and a long list of unsubstantiated deductions. The IRS issued a notice of deficiency for about $470,000 in tax, plus penalties.
The taxpayer petitioned the U.S. Tax Court to contest this determination. He then amended his petition to raise a new argument. He claimed an ordinary loss of about $7 million for 2016 from the trading partnership with the unused portion carried back to 2015. If he was right, the loss would wipe out the tax deficiencies entirely.
From the taxpayer’s perspective, he signed a note. He pledged everything he owned. He was personally liable for millions. Why shouldn’t he get a deduction?
How Partners Deduct Partnership Losses
A partnership does not pay income tax. Its income and losses flow through to the partners. The partners then report their shares on their own returns. That is the basic famework and it is why partnerships are so popular.
But the tax code puts a ceiling on the losses a partner can deduct. Under Section 704(d), a partner can deduct partnership losses only up to his “basis” in his partnership interest. Basis is, roughly, the amount the partner has invested in the partnership. Any loss above that amount is suspended. It is not lost forever. It carries forward and can be deducted later if and when the partner builds up more basis.
The logic is fairly intuitive. A tax deduction for a loss is supposed to reflect money you actually lost. If you never put money in, it is hard to say you lost any money.
This is not the only loss limit. There are also the at-risk rules and the passive activity loss rules. A partner has to clear each one in turn. But basis is the first gate. If a partner has no basis, the other rules never come into play.
Where Does Partnership Basis Come From?
Under Section 722, a partner starts with a basis equal to the cash and the adjusted basis of any property he contributes to the partnership. A partner who puts in $100,000 in cash starts with $100,000 of basis.
Basis then moves up and down over time. It goes up with the partner’s share of partnership income. It goes down with his share of losses and with distributions. It also goes up when the partner takes on economic responsibility for partnership debt. If the partnership borrows from a bank and a partner personally guarantees the loan, that partner may get basis for his share of the debt.
What doesn’t create basis? Labor. A partner who contributes only services, what people often call “sweat equity,” starts with zero basis. That is the case even if his work is worth a lot to the partnership. The tax code does not give basis for time and effort. This no-basis rule surprises a lot of business owners who view their work as their investment.
So in the present case, the taxpayer started with zero basis. The question was whether something else in the deal gave him basis.
Does Signing a Note Create Basis?
The taxpayer’s first argument was that he contributed his promissory note to the partnership, and that the note gave him basis. This is a common arrangement to boost basis.
The tax court rejected the argument on the facts and the law. On the facts, the taxpayer did not sign the note in favor of the partnership. He signed it in favor of the businessman personally. The tax court basically said that you cannot contribute to a partnership something that was never given to the partnership.
On the law, the tax court said that the result would have been the same anyway. The tax court has long held that a partner’s contribution of his own note is not the same as contributing cash. The court cited one of its prior cases for this point. The reason is that the note costs the partner nothing when he signs it. His basis in his own promise to pay is zero. We have written before about this zero-basis rule for contributed notes. There are cases, mostly involving contributions to corporations, that have gone the other way. But this is the general rule for partnerships, and the tax court applies it consistently.
What About Being Liable for the Losses?
This was the taxpayer’s stronger argument. He was not just a partner who did the work. He was personally liable to cover half the losses. He pledged all of his assets. That looks like real economic risk.
The tax court agreed that the taxpayer’s overall situation involved economic risk. But it said that is a far cry from proving that the promissory note created basis under the rules that apply.
The tax court looked at the regulations under Section 752. They describe when a partner is treated as bearing the economic risk of loss for a partnership liability, including when a partner pledges his own property as security. The problem was the word “partnership.” The regulation covers a partner who pledges property to secure a debt of the partnership. Here, the partnership had no debt. The taxpayer pledged his assets to secure his own debt to his partner. That is a different thing according to the tax court, so the regulation did not apply.
The tax court added that even if the regulation did apply, it would not help. The same regulation says that a partner’s own promissory note contributed to a partnership is ignored unless it is readily tradeable on an established securities market. The taxpayer’s note obviously was not.
The court also pointed to the at-risk rules in Section 465. Under those rules, money a taxpayer borrows can count as at risk. But borrowed amounts do not count if the lender has an interest in the activity. The lender here was the businessman—the other 50 percent partner. So even under the at-risk framework, the taxpayer’s liability under the promissory note would not count.
Put simply, the taxpayer’s promise ran to the wrong person. It ran to his partner, not to the partnership.
Who Really Bore the Loss?
This is the part of the case that explains the result. The money that was lost in the trading accounts was the businessman’s money. He contributed all of it. He claimed the first-year loss on his own return, and the IRS let it stand. The taxpayer had not paid anything toward the losses.
So naturally, there is an argument that allowing the taxpayer a $6 million deduction would have let two people deduct the same dollars. Our tax laws generally are intended to not allow that. The loss follows the person who actually parted with the money–or property.
The taxpayer tried one more angle. In 2015 he transferred a group of assets to the businessman. He argued this was a payment on the note, which would mean the loss had been “repaid” and could now be deducted. The tax court found that the transfer had nothing to do with the note. It was a separate sale for about $4.5 million. The sale agreement never mentioned the trading accounts, the note, or the security agreement.
That leaves an open question the court did not need to answer. What happens if the taxpayer actually pays his partner under the note someday? The tax court noted that Section 704(d) allows a suspended loss “at the end of the partnership year in which such excess is repaid to the partnership.” A payment to the other partner personally, years after the partnership ended, does not fit neatly into that language. The taxpayer might have an argument for some type of deduction at that point. Whether it would be a partnership loss, a capital loss, or something else is unclear. This also means that how the deal is papered matters. Had the taxpayer’s obligation run to the partnership itself, and had he actually paid it, the analysis could look very different.
The Takeaway
Sweat equity partnerships are common. They are also easy to get wrong for tax purposes. A partner can deduct partnership losses only up to his basis, and basis comes from money and property, not effort. This case shows that a promise to cover losses does not change that.
Here, the taxpayer’s note ran to his partner rather than the partnership, he never paid on it, and his partner had already claimed the loss. If you are the working partner in a deal like this, do not count on deducting losses you have not paid. If the deal calls for you to share losses, structure it so your obligation runs to the partnership, and know that the deduction will likely follow the cash. These issues come up in tax litigation often.
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