Partnership Interests by Estates and Trusts
Special issues related to distributions revealed.
by Tom Bottiglieri/The Tax Adviser
With the popularity of family limited partnerships, it is not uncommon to find a partnership interest held by an estate or trust. However, the estate or trust must eventually distribute the partnership interest. The complex rules governing the tax treatment of distributions from estates and trusts are further complicated when a partnership interest is distributed.
When an estate or trust distributes cash or property, the distribution is taxed to the beneficiary to the extent that the trust or estate has distributable net income (i.e., generally taxable income not including capital gain) (Sec. 662). This means that the beneficiary, rather than the estate or trust, is taxed on the entity’s income up to the amount of the distribution. In the case of property, the distribution amount is the lesser of the property’s tax basis or its fair market value (FMV) (Sec. 643(e)(2)). Nevertheless, regardless of how the property distribution is measured, the beneficiary’s tax basis in the property will be the same as the estate or trust’s cost basis prior to the distribution.
In addition, there are situations in which an estate or trust will recognize gain as a result of the distribution of appreciated property, which will require an adjustment to the property’s basis: (1) the property is distributed in satisfaction of a specific pecuniary bequest; (2) the property is subject to liabilities in excess of basis; or (3) the fiduciary elects (under Sec. 643(e)(3)) to treat the distribution as a sale to the beneficiary for the property’s FMV. Further, if the property distributed is a partnership interest and the estate or trust has a negative tax capital account (this occurs when the liabilities of the partnership allocable to the interest exceed the estate or trust’s share of the partnership basis of its assets), then a gain will be recognized equal to the negative capital as a result of the requirement of Sec. 752(d) to include the partner’s liabilities in the amount realized.
Sec. 761(e) provides that any distribution of an interest in a partnership that is not otherwise treated as a sale or exchange, as discussed above, will still be treated as a sale or exchange for purposes of Secs. 708 and 743.
While the legislative history of this provision indicates that the IRS might issue regulations providing that estates and trusts would not be subject to this provision, no regulations have been issued to date. It seems relatively certain that any distribution by an estate or trust is a sale or exchange for Secs. 708 and 743.
Not all transfers of partnership interests to a beneficiary are treated as distributions. For example, a transfer of a partnership interest specifically bequeathed to a beneficiary is not a distribution and is therefore not subject to Sec. 761(e).
Under Sec. 708(b)(1)(B), a partnership terminates if 50 percent or more of the total interest in partnership capital and profits is sold or exchanged in any 12-month period. If the partnership terminates, the old partnership is deemed to contribute its assets and liabilities to a new partnership in exchange for a partnership interest and immediately distributes the new partnership interest in liquidation of the old partnership.
A partnership’s termination can result in both favorable and unfavorable tax consequences. The termination of the old partnership results in the creation of a new partnership that can choose its own tax accounting method and tax year end and does not inherit the old partnership’s elections (e.g., Sec. 754).
One particularly bad consequence of a termination for partnerships containing a significant amount of depreciable property is that the step-into-the-shoes rule of Sec. 168(i)(7) does not apply in the case of a Sec. 708(b)(1)(B) termination. As a consequence, the adjusted basis of the depreciable property would be depreciated over the applicable asset life as if it were newly acquired property. This provision is a trap for the unwary, but if recognized it can be easily avoided by ensuring that distributions are planned over a greater than 12-month period so as not to violate the 50 percent-or-more rule.
A distribution of a partnership interest by a fiduciary is treated as a sale or exchange for purposes of Sec. 743. Therefore, if the partnership has a Sec. 754 election in place, the transfer of the interest will require the partnership to adjust the basis of partnership property for the benefit of the transferee partner (i.e., beneficiary).
However, if the partnership does not have a Sec. 754 election in place, it will need a thorough review of inside basis of the partnership assets and their estimated FMVs to determine if a Sec. 754 election should be made or if the partnership has a substantial built-in loss that requires negative basis adjustments under Sec. 743(b). If Sec. 743(b) applies, then consideration should be given in these circumstances not to make a Sec. 754 election, since the election would affect future transfers of partnership interest.
Sec. 1245 Recapture
Sec. 1245(a)(1) requires taxpayers to recapture depreciation on tangible personal property as ordinary income on disposition of the property, not withstanding any other provision. Sec. 1245(b) provides exceptions to this general rule. One of the exceptions applies to “transfers at death,” but distributions from estates and trusts are not on the list. Applying the general rule of Sec. 643(e), without the Sec. 643(e)(3) election, should result in the estate or trust’s not recognizing recapture income. Regs. Sec. 1245-4(b) states that the transfer-at-death exception applies if the basis of the property to the beneficiary is determined under Sec. 1014. However, as discussed above, the beneficiary’s tax basis for in-kind distributions is determined under Sec. 643(e).
The uncertainty of distributions of Sec. 1245 assets held directly by the estate or trust is compounded when the recapture property is owned by a partnership. This determination will involve whether the aggregate theory of partnership taxation should be applied. Under this theory, each partner would be viewed as the owner of a direct undivided interest in each partnership asset. This is an issue that the IRS needs to clarify for taxpayers.
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Tom Bottiglieri, CPA, New York, NY is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.