Small businesses predominate the United States.[1] Many of those businesses operate through entities taxed as partnerships.[2] Those entities may be general partnerships, limited partnerships, LLC’s, or other state law entity types.[3] Many partnerships are formed as part of family and estate planning. Some benefits of the use of partnerships in estate planning include, but are not limited to:
- Organized and consolidated management of partnership assets;
- Reduced asset management costs for consolidated assets;
- Simplified transfer of assets;
- Avoidance of fractionalizing partnership assets among family members;
- Retention of assets in the family through prohibitions on non-family members in partnership agreements;
- Protection of partnership assets from a family member’s creditors (including divorcing spouses); and
- Potential application of valuation discounts, thereby reducing transfer tax costs.
Due to these and other factors, many individuals own partnership interests. As indicated above, even for those without preexisting partnerships, formation of partnerships in the family and estate planning context can serve several client goals. However, estate planning for owners of partnership interests requires an understanding of a number of income tax considerations. Some estate planners are very familiar with partnership taxation while others have little income tax background whatsoever.
Discussion
Regardless of the level of experience with partnership taxation, there are certain income tax concepts that should be understood when engaging in planning involving partnership interests. The purpose of this writing is not to be exhaustive (both in the list of considerations raised and the breadth of coverage under each) or to describe tax planning strategies using partnership interests.[4] Rather, the intention of this writing is to give a summary outline of common income tax consequences about which planners should be familiar.
Gain from Debt Reallocation
Partnerships are unique among taxable entities in that partners receive basis in their partnership interests for debts of the partnership.[5] This is very taxpayer favorable, particularly in that it allows partners to deduct losses or deductions flowing through from the partnership in excess of the cash or basis of assets contributed. This is common for debt financed acquisitions of depreciable property or debt financed distributions.
However, just as partners obtain basis in their partnership interests to the extent debt is allocated to them, they also are treated as receiving a cash distribution to the extent of debt relief including when debt is reallocated to other partners.[6] In the estate planning context, this commonly occurs because of a transfer of partnership interests. To the extent of a cash distribution in excess of basis, gain is recognized and treated as a sale of partnership interests.[7] As such, anytime transfers of partnership interests are being completed, it is critically important to analyze whether partnership debt may be reallocated in a way that results in gain to the transferor partner.
Disguised Sale and Mixing Bowl Rules
Commonly, assets contributed to partnerships have pre-contribution gain or loss. To avoid the use of partnerships to shift pre-contribution gain or loss to other partners, that pre-contribution gain or loss generally must be allocated to the contributing partner when realized by the partnership.[8] In addition to that basic concept, there are other partnership tax consequences to a distribution by partnerships holding assets with pre-contribution gain.
- Disguised Sales. Subject to certain exceptions including those for normal operating distributions and certain debt-financed distributions, when a partner contributes gain property to a partnership and receives other property from the partnership within two years, the partner is treated as having sold the contributed property for the distributed property in a taxable sale or exchange.[9]
- Mixing Bowl Rules. When property is distributed within seven years of contribution of built-in gain property, the mixing bowl rules must be considered. The first of those rules causes gain when gain property contributed by one partner is distributed to another partner.[10] Without this rule, pre-contribution property could be distributed to a non-contributing partner thereby allowing the contributing partner to avoid the required gain allocation when the property is sold. As such, this first rule treats the distribution of pre-contribution gain property as a sale triggering gain to the contributing partner.
The second mixing bowl rule can result in gain when other property is distributed to the contributing partner within seven years after contributing pre-contribution gain property.[11] In this case, gain is calculated based on calculations established by statute and further described in relevant regulation.[12]
Based on these rules, when any distributions of property are being made by a partnership, it is important to know how and when the partnership acquired the property (i.e. was it contributed by a partner at a time when there was preexisting gain or loss within the past seven years). In many contexts, the transferee partner is treated as stepping into the shoes of the transferor partner. As such, in this context, recipients of gifts of partnership interests acquired through the contribution of gain or loss property must be cognizant of the potential for these tax consequences. Also, if the transferor dies within seven years of contributing built-in gain or loss property, his or her beneficiaries may want to liquidate the partnership, redeem one or more partners in exchange for property distributions, or engage in other post-mortem planning. Application of these rules, and considering means of mitigating any unanticipated tax consequences, must be part of those discussions.
Basis Adjustments upon Gift or at Death
As with any asset, it is important that taxpayers know their tax basis in their partnership interests. This can be for a number of reasons, including calculation of gain or loss on disposition or the ability to take passthrough losses. In the estate planning context, it is also important to consider the consequences on basis to transfers during lifetime or at death.
For lifetime transfers, there generally is a transferred basis to the transferee (i.e. the transferee takes the transferor’s basis).[13] However, the allocation of basis among retained and transferred interests when partial gifts are made can create unintended results. Although some planners do not concede that this rule applies to gratuitous transfers, the IRS position appears to be that basis is allocated based on the fair market value of the gifted interest as it relates to the total cost basis of the transferor.[14] Particularly when valuation discounts apply, this can cause distortions. For example, if I hold 50% of the interests in a partnership at a basis of $100 and transfer 10% of my interests (a 5% interest) to my child subject to a 30% valuation discount ($7 value for transfer tax purposes), my child’s basis in the partnership interest may be limited to $7 although my child received 10% of my partnership interests at a time I had a basis in my interests of $100. I retain the additional $93 basis. This can result in a reduced ability of my child to benefit from passthrough deductions and also reduce the ability to obtain a step-up in cost basis at my death (i.e. $3 lower basis adjustment at my death than if 10% of my total basis had been allocated to my child).
At death, assets includable in an individual’s taxable estate receive a cost basis to the beneficiaries equal to date of death fair market value.[15] Although this basis adjustment to date of death fair market value is often referred to as a “step-up” in cost basis, it can also be a “step-down.” In a decedent’s estate, this can be applicable when valuation discounts apply. Using my example above, if I died at a time the basis in my partnership interests of $100 also equaled the undiscounted fair market value of those interests and a 30% valuation discount, the fair market value of those interests at my date of death would equal $70. As such, my beneficiaries would experience a $30 “step-down” in cost basis of those partnership interests.[16]
An additional benefit to partnerships is the ability to receive a basis adjustment to partnership assets when basis is adjusted to partnership interests. Of course, this is only favorable when the adjustment would increase the basis of partnership assets. Generally, the adjustment to partnership assets is elective.[17] However, once that election has been made, it is irrevocable for all subsequent years of the partnership without consent of the Secretary of the Treasury.[18] As such, basis adjustments, up or down, must be made upon all subsequent triggering events. Further, adjustments must be made if the partnership has a “substantial built-in loss” which is when partnership’s basis in its assets exceeds fair market value by more than $250,000 or the transferee partner would be allocated a loss of more than $250,000 if the partnership assets were sold for cash equal to fair market value.[19] Even without an election to make basis adjustments, it may be possible to obtain a similar basis adjustment for property distributed within two years of death.[20]
Phantom Income (Particularly regarding Trusts)[21]
While there is always the potential for “phantom income” of a passthrough entity’s owners, certain issues are particular to non-grantor trusts as owners.[22] Take, for example, a typically marital trust that requires distribution of all income to a surviving spouse but either prohibits distribution of principal or, at least, does not require distributions of principal.[23] If the sole asset of that marital trust is an interest in a partnership, then any distributions from the partnership treated as income generally must be distributed to the spouse-beneficiary even if that distribution does not carry income out to be taxed to the spouse-beneficiary.[24] Although beyond the scope of this writing, these distinctions broadly relate to the distinction between taxable income and trust accounting income.
A simple example includes a situation where a trust holds only partnership interests. The partnership generates $100,000 of taxable income from the sale of a capital assets allocable to the trust and makes a distribution equal to $20,000 (perhaps a “tax distribution” intended to cover income tax attributable to the capital gains from the sale of partnership property). If the trust is at the top income tax bracket and all of the taxable income is taxed at capital gains rates, then the trust would owe $20,000 in tax for the year ($100,000 partnership income multiplied by the 20% capital gains rate, disregarding the net investment income tax). However, since the trust agreement requires a distribution of all income, and all distributions from the partnership are deemed to be income for trust accounting purposes, the trust must distribute all $20,000 to the spouse-beneficiary. However, the capital gains do not carry out to the beneficiary under general tax and fiduciary accounting principles.[25] The result is that the trustee owes $20,000 in tax for the year but has no money to pay that income tax obligation.
Both state law and federal tax regulations allow trustees to make certain adjustments between income and principal in order to remedy this result.[26] However, there are complex requirements to making these adjustments and including capital gains in distributions to the income beneficiary. Further, in certain situations, even including capital gains in income will not carry all income out to the beneficiary (such as where capital gains for tax purposes exceeds trust accounting income). In those cases, the trustee would need to distribute principal to the income beneficiary in order to mitigate the result. The trustee’s decision in this regard must be made considering the trustee’s fiduciary duties to both the income beneficiary and the remainder beneficiaries, who may be overtly adverse to one another.[27] Since income tax is not 100%, making this distribution to the income beneficiary ultimately reduces the amount distributable to the remainder beneficiaries. In this context, both the tax and non-tax analysis must be done in order to achieve a tax favorable result while also avoiding breaching any duties to the beneficiaries.
Family Partnerships
Estate and income tax planning sometimes is motivated by allocating taxable income to family members in lower tax brackets, often children and grandchildren who may inherit from the parent anyway. Gifting partnership interests to children, for example, which will then allocate taxable income to those children, may allow income to be taxed at lower rates. This may especially be helpful when the parent’s taxable income is being used to make gifts to or for the benefit of the child (i.e. why should I pay 37% top bracket income tax on money I am just going to give to my low bracket child anyway).
Understanding that taxpayers will try to assign income to those who did not earn the income, Congress passed laws that prevent many types of this income shifting. One set of such rules is the family partnership statute.[28] Pursuant to these rules, the transferee of partnership interests includes in income their distributive share of income under the partnership agreement. However, the income will not be allocated to the transferee: (a) to the extent determined without allowance of reasonable compensation for services rendered by the transferor; and (b) “to the extent that the portion of such share attributable to donated capital is proportionately greater than the share of the donor attributable to the donor’s capital.”[29] As a result, as long as the transferor partner is reasonably compensated and distributions are pro rata based on capital account balances, allocation of income to the transferee partner should be respected. However, to the extent otherwise, the partnership’s income will be reallocated shifting more to the transferee partner. This is especially the case with partnerships where capital is not a material income producing factor, such as partnerships operating services businesses.
Net Investment Income Tax
In addition to other tax liabilities, a 3.8% net investment income tax (“NIIT”) can apply to passive income.[30] For a trust, this tax applies to the lesser of the trust’s undistributed net investment income, or the excess of the trust’s adjusted gross income over the dollar amount threshold where the highest rate bracket applies (currently $15,200).[31] “Net investment income” generally means the trust’s passive income, income from a trade or business in which the trustee does not materially participate, and gain from the sale of property not held in a trade or business.[32] Given that trusts routinely hold passive investments and, even where active business interests are held such as in an actively managed partnership or S corporation, the trustee does not materially participate in those activities.[33] As noted, this tax only applies to “undistributed” net investment income. Therefore, to the extent “net investment income” is distributed to beneficiaries, application of the NIIT is determined at the beneficiary’s level.
These considerations are especially important for trusts owning interests in partnerships operating a trade or business. When a partnership that constitutes a “trade or business” for tax purposes is held in trust, the trust is not subject to the NIIT if the trustee materially participates in that business.[34] Sometimes other considerations in selection of an appropriate trustee may mitigate against appointment of a trustee who actively participates in the partnership’s trade or business. There are many structures in fiduciary administration with divided roles, delegated duties, and other alternatives. Especially given the compounded effect of an additional 3.8% tax and a fiduciary’s duties to administer a trust in the interests of the beneficiaries,[35] it is important for planners to consider ways of structuring trusts to minimize application of the NIIT and, once trusts are being administered, for trustees to consider minimization of the effect of the NIIT. All of this must be considered in the context of other tax and non-tax issues.
Annual Gift Tax Exclusion[36]
Gift tax statutes provide that there is an annual amount that may be gifted to any person without subjecting the transferor to the obligation of filing a gift tax return, using gift tax exemption, or paying gift tax.[37] Currently, that amount is $18,000. As a result, a parent who wants to maximize tax free gifts to descendants with two children, each of whom have two children, can gift up to $108,000 each year (2 children plus 4 grandchildren (6 beneficiaries) multiplied by $18,000). However, in order to qualify to use this annual exclusion from the gift tax, the gift must be of a “present interest.”[38] This is defined to mean “an unrestricted right to the immediate use, possession or enjoyment of property or the income from property.”[39]
For gifts of partnership interests, the question is whether an interest in a partnership satisfies this present interest requirement. In a series of cases, the IRS prevailed in having partnership interests determined not to satisfy this requirement.[40] Courts have looked to whether there is either present “use, possession or enjoyment” of the partnership interest (i.e. the property gifted) or the income from the partnership interests. Satisfaction of either test is sufficient to constitute a “present interest.”[41] Particularly given the benefits of partnerships for estate planning purposes described above, using partnership interests to make gifts can be very favorable to a direct gift of assets. However, many partnerships hold passive assets, specifically are not intended to make regular distributions (at least in excess of tax distributions), and are structured to give transferees little power over partnership assets and distributions. When that is the case, for clients intending to qualify their gifts of partnership interests for the gift tax annual exclusion, it will be important for partnership interests to be structured to qualify as a “present interest.”[42]
Conclusion
Partnership taxation is notoriously complex and difficult.[43] As such, all estate planners cannot be expected to be experts in partnership tax. However, given the ubiquity of partnerships and the numerous planning benefits of family partnerships in estate planning, it is imperative that estate planners at least have a basic understanding of certain partnership tax concepts.
As stated above, this writing is not intended to be comprehensive in either addressing the scope of partnership tax issues relevant to estate planners or the discussion of the issues raised in this article. Rather, the purpose is to address some of the more common partnership tax issues that estate planners encounter. Missing one or more of these issues can cost clients significantly. Therefore, it is important that estate planners understand these issues and that individuals seek competent counsel in advising them regarding their estate planning.
[1] According to the SBA, 99.9% of all businesses are small businesses, employing 46.4% of all private sector employees. https://advocacy.sba.gov/2023/03/07/frequently-asked-questions-about-small-business-2023/#:~:text=There%20are%2033%2C185%2C550%20small%20businesses,net%20jobs%20created%20since%201995. For the year 2021, the IRS reports that approx. 4.5 million partnership income tax returns were filed representing 30.6 million partners and $50.8 billion in assets. https://www.irs.gov/statistics/soi-tax-stats-partnership-statistics-by-sector-or-industry.
[2] For purposes of this writing, I am referring to partnerships for federal income tax purposes rather than state law partnership entities.
[3] For a discussion of this, see Gray Edmondson, “LLC v. S Corp.: Is that Really the Questions,” July 16, 2021, https://esapllc.com/llc-v-s-corp-is-that-really-the-question/.
[4] For a more thorough discussion that also includes examples of certain planning strategies using partnerships, see Paul S. Lee, “Conquering Subchapter K(ryptonite): Fundamentals of Partnership Taxation for Estate Planners,” Heckerling Institute on Estate Planning, Jan. 10, 2022.
[5] IRC § 752(a) treats debt allocated to a partner (see Treas. Reg. §§ 1.752-1, -2, and -3) as a cash contribution to the partnership which adds to basis of the partnership interest under IRC § 722.
[6] IRC § 752(b).
[7] IRC § 731(a) and Treas. Reg. § 1.1001-2(a). For a treatment of any deemed sale of partnership interests, gain may be taxed at rates applicable after application of IRC §§ 741 and 751.
[8] IRC § 704(c). While there are similar rules for property subject to pre-contribution built-in loss, those rules are slightly different. As such, for the sake of simplicity, I will assume all contributed property is gain property in the remainder of this discussion. To illustrate the reporting of this information to the IRS, see Part II, Lines M and N of IRS Schedule K-1 (Form 1065), https://www.irs.gov/pub/irs-pdf/f1065sk1.pdf.
[9] IRC § 707(a)(2)(B). Note that the two-year period is based on a rebuttable presumption that can treat distributions before the 2 year period expires as not being a disguised sale or, alternatively, distributions after the 2 year period as being a disguised sale. See. Treas. Reg. § 1.707-3.
[10] IRC 704(c)(1)(B).
[11] IRC § 737.
[12] See IRC § 737(a) and Treas. Reg. § 1.737-1.
[13] IRC § 1015.
[14] Rev. Rul. 84-53.
[15] IRC § 1014 and see Rev. Rul. 2023-2 for application to grantor trusts when assets are not taxed in the decedent’s gross taxable estate even where the trust was disregarded as being separate from the decedent during lifetime. Note that I refer to property included in a taxpayers gross taxable estate; however, the statutory language refers to “acquired from a decedent” which may apply in other scenarios as well.
[16] Note too that valuation discounts are not optional to the extent they apply. As such, particularly with substantially increased estate tax exemptions (currently $13.61 million per person), many estates benefit more from a step-up in cost basis than minimizing value subject to estate tax. Additionally, it is important to understand IRC § 1014(f) basis consistency rules that apply to assets passing at death.
[17] IRC § 754.
[18] Id. See also Treas. Reg. § 1.751-1(c) provides when the Secretary may consent to revocation of the election.
[19] IRC § 743. For purposes of this writing, I am discussing only adjustments attributable to transfers of interests. However, similar concepts, applied somewhat differently, apply to distributions triggering gain or loss. See IRC § 734.
[20] IRC § 732(d).
[21] For a more complete discussion of these issues, see Thomas E. Bazley and Marvin D. Hills, “Trusts Owning Partnership Interests,” The Tax Advisor, Sept. 1, 2009, https://www.thetaxadviser.com/issues/2009/sep/trustsowningpartnershipinterests.html, and Carol Cantrell and Gordon Spoor, “Trusts Owning Partnership Interests and the Revised UIPIA,” The Tax Advisor, Dec. 31, 2009, https://www.thetaxadviser.com/issues/2010/jan/trustsowningpartnershipinterestsandtherevisedupia.html.
[22] In using the term “phantom income,” I generally am referring to a situation where an owner receives an allocation of income in excess of distributions thereby potentially having insufficient income to pay tax from ownership of the entity out of distributions from the entity. For trusts, another potential “phantom income” is discussed herein related to distributions of trust income to beneficiaries leaving the trustee with insufficient assets to pay the trust’s income tax liability.
[23] In this context, I am referring to a QTIP marital trust pursuant to IRC § 2056(b)(7).
[24] See Uniform Principal and Income Act, revised as of 2008 (“UPIA”), § 401. While this writing references the UPIA, this is a state law specific items. States may have adopted a non-uniform versions of the UPIA or adopted the Fiduciary Income and Principal Act or prior versions of the UPIA. As such, analysis of these issues must be undertaken considering the relevant state law that applies to trust administration.
[25] IRC § 643(a)(3) and UPIA § 505(a)-(c).
[26] Treas. Reg. § 1.643(a)-3 and UPIA §§ 505(d) and 506. See also comments to the relevant UPIA sections giving examples and a sample formula to use in making the relevant adjustments.
[27] For an example of a recent case where issues involved in calculating the income and principal from entity distributions, the effect of tax consequences on same, and a trustee’s duties in this regard, see Crider Family Share Trust v. Sheffield, 2024 WL 485467 (Miss. 2024).
[28] IRC § 704(e)(1). This same rule applies to partnership interests purchased by one family member from another (family being spouse, ancestors, lineal descendants, and trusts for the primary benefit of such persons) to the same extent as gifted partnership interests. IRC § 704(e)(2).
[29] Id.
[30] IRC § 1411.
[31] IRC § 1411(a)(2).
[32] The more specific definition of “net investment income” is contained in IRC § 1411(c).
[33] For purposes of the NIIT, material participation in a trade or business is determined under the same manner as under IRC § 469. A discussion of the determination of “trade or business” status is discussed in Gray Edmondson, “The Importance of Being a ‘Trade or Business,’” Sept. 12, 2018, https://esapllc.com/the-importance-of-being-a-trade-or-business/.
[34] For a discussion of issues related to determining material participation of the trustee, see Mattie K. Carter Trust, 256 F. Supp. 2d 536 (N.D. Tex. 2003) and Frank Aragona Trust, 142 T.C. 9 (2014).
[35] See, e.g., Restatement (Third) of Trusts § 76(2)(c) and Uniform Trust Code §§ 801-804. This is not to say subjecting a trust to NIIT, even where potentially avoidable, is a breach of duty. There are numerous considerations relevant to trust administration that are much broader than tax consequences.
[36] Although this writing is intended to discuss income tax issues of estate planning with partnership interests, this issue is significant and must be considered in the same situations as many of the income tax considerations discussed herein. As such, I am including this brief discussion in these materials even though not an income tax consideration.
[37] IRC §§ 2503(b) and 6019(a)(1).
[38] Treas. Reg. § 25.2503-3(b).
[39] Id.
[40] Hackl, 118 T.C. 279 (2002); Price, T.C. Memo 2010-2; and Fisher, 105 AFTR2d 2010-1347 (S.D. Ind. 2010), but see Estate of Wimmer, T.C. Memo 2012-157.
[41] Id.
[42] For planning approaches intended to qualify a gift of partnership interests as a present interest gift, see, e.g., Howard Zaritsky, “Tax Planning for Family Wealth Transfers: Analysis with Forms,” ¶ 10.07.
[43] See, e.g., Judge Arnold Raum’s excerpt from Foxman, 41 T.C. 535, 551 n. 9 (1964).
