INCOME TAX PROBLEMS WHEN THE ESTATE OR TRUST IS A PARTNER

Transcription

1 INCOME TAX PROBLEMS WHEN THE ESTATE OR TRUST IS A PARTNER By Carol A. Cantrell Briggs & Veselka Co West Loop South #700 Bellaire, Texas [email protected] For ALI-ABA Planning Techniques for Large Estates Chicago, IL May 16-20, 2011

2 INCOME TAX PROBLEMS WHEN THE ESTATE OR TRUST IS A PARTNER I. INTRODUCTION... 1 II. INVENTORY ON DATE OF DEATH... 1 A. Inside Basis and Value of Partnership Assets... 1 B. Pre-Contribution Gains and Losses under Sec. 704(c) The General Rule Partnership Interests Acquired by Gift Contributions of Built-in Loss Property Disproportionate Capital Contributions... 6 C. Income in Respect of a Decedent (IRD) Statutory IRD of a Deceased Partner Judicially Created IRD Reporting Requirements... 9 D. Ownership by an Intentionally Defective Grantor Trust (IDGT) Unpaid Installment Note at Death Income in Respect of a Decedent (IRD) Basis of Property in the IDGT III. THE SECTION 754 ELECTION A. Who Can Make the Election B. Mechanics: The Hypothetical Sale C. Applying Partnership Discounts D. Community Property E. When Not to Make the Election F. Mandatory Basis Adjustments for Substantial Built-in Loss Property The $250,000 Threshold The Mechanics Partnership Discounts and the $250,000 Threshold G. Recordkeeping Responsibility H. Impact of 754 on Other Partners I. Making the Election Late Elections Revoking the Election Division or Constructive Termination J. The Duty of Consistency K. Consequences of Overstating the Basis L. Valuation Discounts for the Election M. Partnerships Owned by a Marital Trust N. Partnerships Included under IV. TAXATION OF DISTRIBUTIONS A. General Rules When Distributions are Deemed to Occur Basis of Property Distributed Holding Period B. Distributions that Require Mandatory Basis Adjustments... 33

3 1. Mechanics Effect of a Section 754 Election C. Distributions Within Seven Years of Contribution Distributions of Contributed Property - 704(c)(1)(B) Distributions of Other Property to a Contributing Partner D. Distributions of Marketable Securities - 731(c) Marketable Securities Defined Reduction in the Amount Treated Like Money Impact of Valuation Discounts Statutory Exceptions E. Liquidating Distributions V. DISTRIBUTING PARTNERSHIP INTERESTS TO BENEFICIARIES A. Closing the Partnership Books Transfers By Gift Closing Methods B. Constructive Termination on Change in Ownership C. Gain or Loss on Funding D. Triggering IRD Recognition E. Carrying Out DNI When Funding with a Partnership Interest The Separate Share Rule Pecuniary Bequests and DNI Carryout Income from Pass-Through Entities Special Rule for IRD Included in DNI VI. HOLDING PARTNERSHIP INTERESTS IN TRUST A. Prudent Investor Act B. 3.8 Percent Surtax on Unearned Income of Estates and Trusts C. Passive Activities D. Determining Trust Income From a Partnership QTIP Trusts The 20-Percent Rule E. Taxes on Undistributed Partnership Taxable Income F. When Can Partnership Capital Gains Be Included in DNI What the Regulations Say Crisp Holds That Partnership Capital Gains are Included in DNI Carrying Out Capital Gains from a Unitrust G. Investment Advisor Fees and the 2-Percent Rule The Supreme Court s Holding in Knight Proposed Regulation Unbundling Administrative Expenses From Passthrough Entities Legislative Change VII. CONCLUSION Exhibit A Mixing Bowl Flowchart for Partnership Property Distributions Exhibit B Section 754 Decision Tree Exhibit C When Trust Capital Gains are Included in Distributable Net Income

4 INCOME TAX PROBLEMS WHEN THE ESTATE OR TRUST IS A PARTNER I. INTRODUCTION Executors and trustees face many income tax issues when they own partnership interests. They must not only understand the income tax rules that apply to estates and trusts, but they must also be familiar with partnership income tax rules. Failure to understand the interaction between trust income taxes and partnership income taxes can lead to costly mistakes. Therefore, it is critical that fiduciaries and their advisors team up with an expert on income tax matters early in the estate administration when the estate owns a partnership interest. II. INVENTORY ON DATE OF DEATH One of the first things an executor should do is size up the basis and market value of assets owned by the partnership. The estate is entitled to adjust the basis of a decedent s partnership interest to the date of death value and the holding period of the partnership interest automatically becomes long-term. 1 However, the basis of partnership assets is not adjusted unless the partnership makes a Section 754 election. 2 Nor do the partnership assets receive a new holding period because of the decedent s death. Therefore, the partnership must still meet the one-year holding period in order to achieve long-term capital gain treatment, even for assets on hand on the date of the decedent partner s death. A. Inside Basis and Value of Partnership Assets Despite the general rule that a partnership does not adjust the basis of its assets to fair market value upon a partner s death, the executor still needs this information for several other purposes. It helps him know whether it is desirable for the partnership to make a Section 754 election to adjust the basis of the partnership assets to date of death value with respect to the decedent. 3 It also helps him determine whether the partnership is subject to the new mandatory basis adjustment rules enacted by the American Jobs Creation Act of Therefore, the partnership should provide the executor information about the basis and fair market value of each partnership asset on the date of death. In addition, the partnership will need to allocate discounts for minority and lack of marketability among the various partnership assets. B. Pre-Contribution Gains and Losses under Sec. 704(c) 1. The General Rule Each time a partner contributes property to a partnership, IRC 704(c)(1)(A) requires the partnership to measure the difference between the property s cost basis and its fair market value. The difference is hereafter referred to as pre-contribution gains and losses or interchangeably, built-in gains and losses. Pre-contribution gains and losses must be tracked on a property by 1 IRC 1223(11). 2 See discussion at III. 3 See discussion at III. 4 P.L , 833, Treatment of Partnership Loss Transfers and Partnership Basis Adjustments. 1

5 property and a partner by partner basis. 5 When the partnership disposes of any property that contains pre-contribution gain or loss, such pre-contribution gain or loss must be specially allocated to the contributing partner before any remaining gain or loss is allocated to all partners according to their partnership interests. The purpose of this rule is to prevent artificial shifting of tax consequences among the partners. 6 EXAMPLE Dad contributes his Dell Computer stock with a tax basis of $1 and a market value of $10,000 in return for a 50 percent interest in the DS Family Limited Partnership. Son contributes land worth $10,000 with a basis of $10,000. Dad s built-in gain on the date of contribution is $9,999 ($10,000 - $1). If the partnership sells the stock for $12,000, the pre-contribution gain of $9,999 is allocated to Dad. The remaining $2,000 post-contribution gain is allocated between Dad and Son. 7 To ameliorate some of the recordkeeping with multiple partners, properties, and transactions, the regulations allow certain types of property to be aggregated. These include depreciable property other than real estate, zero basis property, inventory and other property designated by the Service in rulings from time to time. 8 The regulations also allow the partnership to ignore small disparities between value and basis. 9 A small disparity exists when the total difference between the basis and fair market value of all property contributed by a single partner in a tax year is no more than 15 percent of the tax basis of all such property and that total difference for all properties is no more than $20,000. The small disparity and limited aggregation exceptions are little help to the typical family limited partnership that consists primarily of investment assets and the disparity is nearly always greater than the 15 percent or $20,000 safe harbor. If the partnership has or will make a 754 election when a partner dies, it may seem pointless to keep track of pre-contribution gains and losses for the decedent. Upon a partner s death, the 754 election adjusts the decedent s basis in partnership assets to the date of death value, effectively eliminating any difference between the deceased partner s inside and outside basis and any resulting gain or loss. In effect, the 754 election wipes out any allocation of pre-contribution gain or loss under 704(c) with respect to the deceased partner. 10 However, the 754 election has no effect on the other partners. 11 Therefore, it is important to keep track of their pre-contribution gains and losses. Distributions and other transactions with the partnership continue to have direct tax consequences for them. 2. Partnership Interests Acquired by Gift When a partner gifts a partnership interest to a family member, the donee succeeds to the donor s outside and inside basis, including any pre-contribution gains and losses. 5 Reg (a)(2). 6 Reg (a)(1). 7 Reg (b)(5), Example 13(i). 8 Reg (e)(2). 9 Reg (e)(1). 10 Reg (j). 11 Reg (j)(1). 2