Practical Partnership Panaceas
- Jan 12, 2024
Paul S. Lee of the Northern Trust Company spoke at the 58th Annual Heckerling Institute on Estate Planning, focusing on strategic planning with the flexibility and complexity of partnership taxation.
Mr. Lee addressed planning ides for common circumstances. His focus was on income tax planning strategies including inside and outside basis, partners’ capital accounts, swapping of basis between assets, current and liquidating distributions, and other planning that can be used with the flexibility of partnerships to maximize the tax benefits.
The focal point of partnership taxation is IRC Sec. 704(c) property, which is created when a partner contributes property in a tax-free exchange for an interest in a partnership under IRC Sec. 721 and the fair market value of the property differs from its adjusted basis. He explained how IRC Sec. 704(c)(1)(A) seeks to ensure that the historical tax characteristics at contribution will ultimately be allocated to the contributing partner. He discussed the statutes related to current and liquidating distributions and how they can be used to the client’s tax benefit.
Part of his presentation on distributions included the “anti-mixing bowl” provisions of IRC Sec. 704(c)(1)(B). These provisions can trigger gain when contributed property is distributed to another partner or if other property is distributed to a contributing partner within seven years of contribution.
One take away for the anti-mixing bowl rules is to fund the partnership with cash and have the partnership purchase the investments. This strategy avoids having mixing bowl issues. There is no IRC Sec. 704(c) appreciated property, and there is no seven-year holding period requirement.
A distribution of marketable securities is generally considered as cash (rather than property) for gain recognition purposes. One exception to the gain recognition rule is in the case of securities distributed from an “investment partnership.” Mr. Lee suggested the use of separate partnerships, one that includes only marketable securities so as not to trigger gain on distribution and a separate partnership to hold private equities and venture capital investments.
Mr. Lee then discussed maximizing the basis adjustment under IRC Sec. 1014 on the death of a partner. Typically, the partnership makes an IRC Sec. 754 election to step up the inside basis of the assets under IRC Sec. 743(b). This normally is very useful but he suggested in certain circumstances, it may be more tax advantaged to apply other strategies.
Mr. Lee gave an example of how to maximize the IRC Sec. 1014 basis step up without making the IRC Sec. 754 election. The partnership had two marketable securities, one with low basis and the other with high basis. Upon the death of one of the partners, the beneficiary of the estate who is now a partner wanted to take her half of the securities and give half of that to charity and then sell the other half to diversify her portfolio. Mr. Lee used what he called staggering distributions and made a current distribution in the first year with the low basis stock. The basis of distributed property with a current nonliquidating distribution is the lesser of the tax basis of the asset or the partner’s outside basis. The beneficiary then made a gift to charity with the low basis stock. In the next year, there was a liquidating distribution of the high basis stock. The basis of the property received by the beneficiary was the remaining outside basis, which was then sold reducing the gain.
Another discussion included avoiding gain on a grantor trust conversion to non-grantor status. A commonly used estate planning technique is to have the grantor sell an asset to an intentionally defective grantor trust (IDGT) for an installment note. Since the grantor and the trust are treated for income tax purposes as the same taxpayer, there is no taxable transaction. The grantor trust status terminates at the death of the grantor creating a non-grantor trust. If the promissory note is outstanding at the time of the conversion, gain will be recognized to the extent that the debt is in excess of its tax basis.
Mr. Lee suggests forming an LLC with the IDGT, contributing its assets and debt, and the grantor simultaneously contributing the promissory note. Since the trust and the grantor are considered the same taxpayer, the LLC is disregarded for tax purposes. This could eliminate the gain by extinguishing the debt and provide a step-up in basis on the underlying assets upon the death of the grantor.
Upon the death of the grantor, the grantor trust becomes a non-grantor trust which converts the LLC from a disregarded entity to an entity taxed as a partnership. Under Rev. Rul. 99-5, the conversion of disregarded entity to partnership created by transfer of an LLC interest to another taxpayer is treated as a purchase of the assets and contribution to a new partnership. If the conversion is treated this way, for step-up purposes, the estate is treated as owning its share of the asset (for its membership interest) which is simultaneously contributed to the partnership at death. As such the estate should be able to claim the IRC Sec. 1014(a) step up in basis without losing the valuation discounts that typically apply to partnership interests.
The Heckerling Institute offers practical guidance on today’s most important tax and non-tax planning issues, including planning challenges and opportunities. We’ve aggregated blog posts from highlight sessions here, to share our insights with you.
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Patricia Green is a Tax Director and leads the firm’s South Florida Trust and Estate Practice. She has over 30 years of experience providing tax services to small businesses, individuals and estates.
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