Disregarded Entity's Basis in Promissory Notes from Parent Is Zero

(Parker Tax Publishing March 2026)

The Tax Court held that, where a disregarded entity received a promissory note from its owner and then contributed that note to a newly formed partnership in exchange for an interest in that partnership, the note was treated as though it was contributed from the owner directly to the partnership and thus the owner has no basis in the note at the time of contribution. The Tax Court rejected the taxpayer's argument that the court should look behind the disregarded entity's elected status and concluded that there was a substantial basis in the promissory note at the time of its contribution. Continental Grand Limited Partnership v. Comm'r, 166 T.C. No. 3 (2026).

Facts

CSC Computer Sciences GmbH (CSC Germany) was a holding company that wholly owned German subsidiaries engaged in an active IT services business. CSC Germany was incorporated in Germany and one of its wholly owned German subsidiaries was CSC Financial GmbH (CSC Financial).

On March 26, 2001, CSC Germany issued to CSC Financial a promissory note (Note). The Note provided that its issue price was approximately $610 million and Computer Sciences Corp. (CSC), the ultimate U.S. parent of CSC Germany and CSC Financial, guaranteed the Note. The Note specified that CSC Germany would pay approximately $1.1 billion to the holder of the Note on August 17, 2009. That amount reflected the issue price and deferred interest. The Note was a legal, valid, and binding obligation of CSC Germany and was enforceable against CSC Germany. The fair market value of the Note on March 26, 2001, was its issue price of approximately $610 million.

Continental Grand Limited Partnership (Continental Partnership) was organized as a limited partnership under Nevada law as of March 23, 2001. It owns computer equipment and related property that it leases to affiliates. Beginning March 26, 2001, and until March 19, 2009, Continental Partnership had three partners: CSC Financial, Century Credit Corp., and its tax matters partner, Century Subsidiary Corporation (Century).

On April 12, 2002, CSC Financial elected under Reg. Sec. 301.7701-3(c) to be disregarded as an entity separate from CSC Germany. This election was effective March 23, 2001. Thus, the election was retroactively made effective to a time before CSC Financial contributed the Note to the Partnership.

On March 16, 2009, CSC Germany, Continental Partnership, 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 approximately $1.073 billion to Continental Partnership. That same day, CSC Financial liquidated its interest in Continental Partnership and, to effect the liquidation, Continental Partnership distributed almost $1.081 billion to CSC Financial.

After auditing Continental Partnership's tax return for 2009, the IRS concluded that (1) CSC Germany should be treated as having had zero basis in the Note; (2) CSC Germany should be treated as having zero basis in its interest in Continental Partnership as of the date of the contribution; and (3) Continental Partnership should be treated as having zero basis in the Note as of the date of the contribution. Century disagreed and the case ended up in the Tax Court.

Before the Tax Court, the IRS sought rulings on three issues: (1) CSC Germany's adjusted basis in the Note when the Note was contributed to Continental Partnership; (2) CSC Germany's basis in the partnership interest immediately after the contribution; and (3) Continental Partnership's basis in the Note immediately after its contribution.

In Reg. Secs. 301.7701-1 through -3, the IRS issued what are referred to as the "check-the-box" regulations to provide rules for classifying business entities. Under Reg. Sec. 301.7701-3(a), entities that are not classified as corporations can elect their tax treatment and 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.

Century raised several arguments in support of its claim that the adjusted basis of the Note in CSC Germany's hands was equal to its fair market value of $610 million. First, Century cited the Supreme Court's ruling in Comm'r v. Tufts, 461 U.S. 300 (1983), in arguing that "the common and ordinary meaning of 'cost' includes amounts engaged to be paid" and that requires the court to, under Code Sec. 1012, include in its basis in the Note the amount of CSC Germany's obligation. Century also pointed to the decisions in Lessinger v. Comm'r, 872 F.2d 519 (2d Cir. 1989), and Peracchi v. Comm'r, 143 F.3d 487 (9th Cir. 1998), rev'g T.C. Memo. 1996-191, as indicators that CSC Germany should have received some basis in its partnership interest.

Analysis

The Tax Court agreed with the IRS and held that CSC Germany's adjusted basis in the Note at the time of contribution was zero and, under Code Sec. 722, CSC Germany took a zero basis in its partnership interest as well.

Code Sec. 723, the court observed, sets out the rule governing the basis of property contributed to a partnership by a partner and, under that rule, such basis 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 Code Sec. 721(b) to the contributing partner at such time. The court concluded that because the adjusted basis of the Note to CSC Germany at the time of the contribution was zero, CSC Germany recognized no gain with respect to the contribution. Thus, the basis of the Note in the hands of Continental Partnership was zero.

The court then addressed CSC Financial's election to be disregarded as an entity separate from CSC Germany and said that making that election required CSC Financial to treat CSC Germany as though it contributed the Note directly to Continental Partnership. The court found the consequences of that treatment for the basis of CSC Germany's interest in the Continental Partnership, and the basis of the Note in the hands of Continental Partnership, to be straightforward: CSC Germany took a zero basis in its partnership interest, and Continental Partnership took a zero basis in the Note.

The court rejected Century's argument that the Tufts decision required it to include the amount of CSC Germany's obligation in the basis in the Note under Code Sec. 1012. Code Sec. 1012, the court countered, involves considering the cost paid by a taxpayer to acquire property as increasing a taxpayer's basis in the real property and was not appropriate in this case.

With respect to Century's reliance on the court decisions in Lessinger and Peracchi as indicators that CSC Germany should have received some basis in its partnership interest, the court said these decisions were inapplicable because both cases arose in the context of corporations and involved the application of Code Sec. 357(c), a Code provision different from the ones at issue in this case. The Tax Court also noted that the situation in Peracchi was inapplicable because that case addressed a taxpayer who contributed a promissory note to a closely held corporation in order to comply with a state regulation and the Ninth Circuit specifically stated that it was not talking about partnership or S corporation issues, but only contributions to C corporations.

For discussions of the basis of property contributed to a partnership and the check-the-box regulations, see Parker Tax ¶22,740, ¶24,650, and ¶20,160.

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