The gift of a partnership interest generally does not result in the recognition of gain or loss by the donor or the donee. A gift is, however, subject to gift tax unless the gift qualifies for the annual gift tax exclusion or reduces the donor's lifetime gift tax applicable exclusion amount. (Since the lifetime gift tax exclusion for 2016 is $5.45 million, most gifts will not be taxable.) Practitioners should note that if the general partner has unfettered discretion to make or withhold distributions, any gift of an interest in the partnership may be treated as a gift of a future interest not qualifying for the annual gift tax exclusion (TAM 9751003).
If gift tax is imposed, it is calculated on the fair market value (FMV) of the gifted property less the amount of debt from which the donor is relieved. In the context of a gift of a partnership interest, the FMV involved is the FMV of the donor's interest in partnership property, and the debt involved is the donor's share of partnership liabilities. If the debt relief exceeds the donor's basis in his partnership interest, the debt relief is treated as an amount realized in a deemed sale transaction, and the donor must recognize gain (Regs. Sec. 1.1001-2(a)). Gain recognition usually occurs when the partner has a negative tax basis capital account. Some of this gain may be ordinary, depending on whether the hot asset rules of Sec. 751 apply. Any capital gain on the deemed sale may be short-term or long-term under the applicable rules.
Example:J is a partner in I Investments Partnership. His tax basis capital account is $(100,000), and his share of the partnership's liabilities is $150,000. The FMV of his interest in partnership assets is $200,000. J approaches his practitioner about gifting the partnership interest to his son, R. J's tax consequences are shown in the exhibit below.
A partner acquiring an interest by gift generally has a basis equal to the donor's basis plus, in some instances, a portion of the gift tax paid (Secs. 742 and 1015). The increase is equal to the gift tax paid on the net appreciation of the transferred interest, but the basis may not exceed the interest's FMV (Sec. 1015(d); Regs. Sec. 1.1015-5(a)). Net appreciation is the amount by which the FMV of the transferred interest immediately before the gift exceeds the donor's basis. Accordingly, the donee increases the basis by the following amount: (Net appreciation ÷ FMV of gift) × gift tax paid.
If the donor recognizes gain on the transaction, as in the example, the amount of the gain is added to the donor's basis in his interest for determining the donee's basis. The donee then has a basis equal to the amount realized (the amount of debt relief) in the deemed sale (Regs. Sec. 1.1015-4(a)). However, if the FMV of an interest is less than the partner's basis at the time of the gift, for purposes of determining the donee's loss on a subsequent disposition, the donee's basis in the interest is the FMV of the partnership interest at the time of the gift (Sec. 1015(a)).
If the donor partner recognizes a gain on the deemed sale of an interest in a partnership and the partnership made a Sec. 754 election, the partnership should adjust the basis of its assets to reflect the gain.
Any transfer of an interest in a partnership to a family member is subject to the family partnership rules of Sec. 704(e). Because partnerships can be used to shift income and property appreciation from higher-bracket, older-generation taxpayers to lower-bracket children and grandchildren, these rules are designed to enforce two principles. One is that income produced by capital should be taxed to the true owner of that capital. The other is that income derived from services should be taxed to the person performing the services. If these principles are circumvented, the IRS may reallocate income between partners or may even determine that one or more of the partners are not partners at all, at least for income tax purposes.
Warning: Gifts of partnership interests to family members are frequently valued at a discounted amount because of discounts for lack of marketability or minority discounts. Practitioners should be aware of IRS examination and litigation activities when structuring the gift of a family partnership interest.
The substitution of an assignee partner with full rights to participate in management may require the unanimous consent of the nontransferring partners under state law or the terms of the partnership agreement. Consequently, an individual receiving a gift of a partnership interest may have no right to participate in the partnership's management until that consent is obtained.
This case study has been adapted from PPC's Tax Planning Guide—Partnerships, 29th Edition, by William D. Klein, Sara S. McMurrian, Linda A. Markwood, Cynthia Zatopek, Sheila A. Owen, and M. Andrew Vance, published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2015 (800-431-9025; tax.thomsonreuters.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.