It took some review but got it to work. Your suggestion about modifying type to Operating System did help. It was also required modifying the sqlcmd input (final version 'for now'):

sqlcmd -i E:\test\query.sql -o E:\test\queryout.txt

This was it. The debug effort started with a command line prompt. Starting my testing here, believing if I can't run it here, SSMS won't work as well. Used a simple SQL script which included the USE database along with a select clause. Keep it simple.

Once that worked (still in command prompt), then used the above syntax with the addition of a "-d databasename" syntax. This worked as well. I then went to SSMS and tried it - this promptly failed (type was T-SQL). I realized the USE database was in the SQL script so "-d database" seemed extraneous. Removed it, re-ran and it still failed. Then changed type from T-SQL to Operating System and it worked.

Thank you for your help...