Executive Summary
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A trust partner must separately account for its share of partnership depreciation deductions, when doing so would result in a different tax liability than if not separately accounted.
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Sec. 167 provides that the depreciation deduction is to be apportioned between the estate and its heirs, legatees and devisees on the basis of estate income allocated to each.
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Most partnerships do not separately state depreciation, because the only partners with potentially different income tax liabilities would be trusts or estates.
Many trustees do not know that an unfortunate income tax consequence may arise when a trust owns an interest in a partnership that owns depreciable assets. This consequence is detrimental to the trust and its beneficiaries, because it may result in a larger combined income tax burden on the trust and its beneficiaries than might otherwise result if the trust directly held the depreciable assets. This is due to the way in which the Code allocates a depreciation deduction between a trust and its beneficiaries.
This article reviews how depreciation from a partnership is allocated between a trust and its beneficiaries and highlights the potential trap the allocation can cause when the depreciation deduction flows through a partnership. In general, this treatment will also apply to estates holding interests in partnerships that own depreciable assets. The article will also point out situations in which the treatment differs for estates.1 This treatment is also generally the same for amortization and depletion deductions that pass through to a trust.2
Throughout this article, the following example is used to illustrate the potential problem that may occur:
Example: Trust T was created by A for the benefit of his four children and their descendants. T is a complex trust for Federal income tax purposes whose governing instrument provides that during A’s life, Trustee E, in her sole discretion, may distribute as much of T’s income for a given year for the benefit of A’s four children as she deems necessary for their comfort and support. Any T income not so distributed is to be added to T principal.
On A’s death, T is to be separated into four separate shares, one for the benefit of each of the four children. T is required to distribute all trust income at least annually. On the death of any of the children, the remaining assets of such child’s separate share in T are to be distributed to such child’s descendants.
T is silent as to how E is to allocate receipts between income and principal. It further fails to provide for a reserve for depreciation or the allocation of depreciation. T is governed by state law, which has adopted the Uniform Principal and Income Act (UPIA) in its entirety. T’s sole asset is a 50% limited interest in Partnership P. Other interests in P are owned by various members of A’s family. P primarily owns and operates car dealerships. Neither T nor its beneficiaries materially participate in P’s activities.
For 2006, P filed a Federal income tax return, reflecting the following items of income and expense:
Ordinary business income: $40 million
Depreciation: $40 million
Other expenses: $10 million
P issued a Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., to T, reflecting its share of income and expenses. It listed the following items of income and expense:
Ordinary business income: $15 million
(($40,000,000 – $10,000,000) × 0.5)
Depreciation: $20 million ($40,000,000 × 0.5)
The Schedule K-1 also reflected that P made a $5 million distribution to T. E distributed the $5 million to A’s four children, one-quarter to each, during the year.
Under these facts, many trustees might assume that T, after completing its income tax return for the year, is not required to pay tax, because it had a $5 million loss as a result of its P ownership interest. However, these trustees would be surprised to discover that, after completing T’s income tax return for the year, it will have taxable income of $10 million.
Treatment of Depreciation from a Partnership
An understanding of why T has an income tax liability for the year begins with examining how partners must account for their partnership interests for income tax purposes. In general, Sec. 702(a) provides that a partner, in determining his or her income for the tax year, shall take into account separately his or her distributive share of certain classes of the partnership’s tax attributes. Sec. 702(a) lists eight classes of partnership income, gain, loss, deduction and credit that must be taken into account separately.
In particular, Sec. 702(a)(7) provides that a partner must take into account separately his or her share of “other items of income, gain, loss, deduction, or credit, to the extent provided by regulations prescribed by the Secretary.” Regs. Sec. 1.702-(a)(8)(ii) requires that a partner take into account separately any partnership item that, if separately taken into account, would result in an income tax liability for the partner, or for any other person, different from that which would result if that partner did not take the item into account separately. The phrase “or for any other person” was added to the regulations and applies to tax years beginning after July 22, 2002. It makes clear Treasury’s and the IRS’s position that a separate statement is required when it affects the tax liability of the partner or “any other person.” Thus, in the case of a trust, even when an item, if separately stated, does not affect the trust’s tax liability, a separate statement is required if the item affects the tax liability of one of its beneficiaries (i.e., “any other person”).
Application to Trusts
Citing Sec. 702(a)(7) and the regulations thereunder, the Service ruled, in Rev. Rul. 74-71,3 that a trust that is a member of a partnership must separately take into account its distributive share of the partnership’s depreciation deductions, when such treatment would result in a tax liability for the trust different from that which would result if such deductions were not taken into account separately. The IRS further ruled that, for purposes of allocating the partnership depreciation between a trust and its beneficiaries, the trust is deemed to hold a share of the partnership’s depreciable property.
The reason for the separate statement of depreciation for purposes of Sec. 702(a)(7) is the unique way the Code allocates depreciation between a trust and its beneficiaries. Under Sec. 642(e), a trust is permitted a depreciation deduction only to the extent it is not allowable to the trust’s beneficiaries under Sec. 167(d). In general, when a trust is entitled, as a member of a partnership, to a portion of that entity’s depreciation deduction, its distributive share of such deduction must be apportioned between the recipient trust and its income beneficiaries as prescribed by Sec. 167(d).4
Sec. 167(d) provides, in part, that for property held in trust, the allowable deduction is apportioned between the trust and its income beneficiaries in accordance with the pertinent provisions of the instrument creating the trust or, in the absence of such provisions, in accordance with the trust income allocable to each. However, no effect is given to a provision in a trust instrument that gives any beneficiary or trustee a share of the depreciation deduction greater than such person’s pro-rata share of trust income.5 Regs. Sec. 1.167(h)-1(b) indicates that the term “trust income” refers to income as determined under local law (i.e., the law of the state with jurisdiction over the trust).
Under Regs. Sec. 1.167(h)-1(b), the allocation of the Sec. 167 deduction between the trust and its income beneficiaries, based on the income allocable to each, is superseded if the trust’s governing instrument (or local law) requires or permits the trustee to maintain a reserve for depreciation in any amount. In this case, the deduction is first allocated to the trustee to the extent that income is set aside for a depreciation reserve. Any part of the deduction in excess of the income set aside for the reserve is then apportioned between the trust and its income beneficiaries on the basis of the allocation of trust income.
The apportionment of the depreciation deduction, however, is not limited by the amount of income derived from the depreciable property. In Rev. Rul. 74-530,6 the IRS National Office was asked for advice on the computation and apportionment of the allowable deductions for depreciation between a trust and its income beneficiaries. It ruled that before apportioning the depreciation deduction under Sec. 167(d), such deductions first must be computed by the trust based on the properties it holds in its capacity as a separate taxable person. In so concluding, the Service reasoned that, although the depreciation deduction is apportioned on the basis of trust income allocable to the trust and its beneficiaries, the deduction is not limited by the amount of such income.
A partnership must separately state depreciation when one of its partners is a trust because of the way the Code requires the depreciation deduction to be allocated between a trust and its beneficiaries. This allocation is determined by the trust’s governing instrument and/or state law.
Trust income differs from taxable income, gross income and distributable net income (DNI), which are terms that pertain to the taxation of a trust. Trust income is defined by the trust’s governing instrument and state law. It is generally the amount of money or its equivalent available to income beneficiaries. In certain instances, trust income will differ from a trust’s taxable income and/or DNI. Because the depreciation deduction follows trust income, the problem highlighted by this article may occur.
Application to Estates
As to estates, Sec. 167(d) provides that the depreciation deduction is to be apportioned between the estate and its heirs, legatees and devisees on the basis of the estate income allocable to each.7 There is no provision in the regulations for a depreciation reserve,8 although there appears to be no reason why such a reserve may not be established by a will, especially when such will allows income distributions to be made during estate administration.
While Sec. 167(d) seems straightforward, it can be difficult to apply in certain instances—for example, when the depreciable property is left to a testamentary trust that has not yet been funded, but a distribution of the income from such property is made during estate administration to the trust’s income beneficiaries. In general, the trustee of a testamentary trust to which property is bequeathed or devised is regarded as a legatee or devisee of the estate. But does such status extend to an income beneficiary of such trust?
Nissen: The Fourth Circuit considered this issue in Est. of Nissen.9 Pursuant to a will, the executor of the decedent’s estate was authorized to make discretionary distributions of income to two beneficiaries of two trusts that were the residuary legatees of the decedent’s estate. The beneficiaries had no other interest in the estate. The Fourth Circuit noted that the deduction was allowed to benefit the heirs, legatees and devisees, because the ultimate owner of the estate’s property should share in any allowable tax benefit that tends to reduce or offset a loss attributable to waste or depreciation of his or her own property during estate administration. It held, however, that the estate was entitled to the depreciation deduction, because the persons to whom the income distributions were made were not heirs, legatees or devisees of the estate (but were beneficiaries of legatees (i.e., the residuary trusts)).
Lamkin: In Lamkin, 10 the decedent’s will did not specifically provide for the distribution of income during estate administration. The executor, however, distributed the income from certain real property owned by the estate to the income beneficiaries of a testamentary trust to which the real estate was to be distributed (the testamentary trust had not yet been funded). The court concluded that the income beneficiaries were entitled to the depreciation deduction from such real property, under two alternative theories. First, the income beneficiaries qualified as devisees of the real property for purposes of being allocated the depreciation deduction. Second, the income distribution was constructively made from the estate to the trust, then by the trust to the income beneficiaries.
The Fifth Circuit distinguished its holding from that of the Fourth Circuit in Nissen because, in Nissen, the will authorized income distributions, thus creating beneficiaries of the estate’s income who were not the legatees or devisees of the estate property. In Lamkin, the court noted that the only way the income beneficiaries could receive a distribution from the estate was by virtue of their status as beneficiaries of the testamentary trust. There is little more on the subject; however, the Tax Court’s Nissen opinion (which was reversed by the Fourth Circuit) concluded the same as the Fifth Circuit in Lamkin on the issue.
Applying the Authorities to Example
Returning to the above example, the Schedule K-1 that T receives from P reflects $15 million of ordinary business income. The Schedule K-1 also separately states depreciation of $20 million (as required under Sec. 702(a)(7)).
T’s governing instrument does not have a provision allocating depreciation, nor does it provide for a depreciation reserve. Absent such provisions, the allocation of depreciation defaults to the allocation of trust income as determined by local law. The state having jurisdiction over T has adopted the UPIA. Under UPIA Section 401(b), a trustee is required to allocate funds received from a partnership to income.11
During the year, T received a $5 million distribution from P. Under state law, T is required to allocate this distribution to trust income. Also during the year, T distributed $5 million to the present income beneficiaries of T (A’s four children)—$1.25 million to each. At the end of the year, E is surprised to realize that T has taxable income of $10 million. T’s fiduciary income tax return contains the following income tax items:
Total income $15,000,000
Distribution deduction (5,000,000)
Taxable income $10,000,000
T is not afforded the benefit of offsetting the depreciation deduction it received from P against P income it must recognize, because the benefit of the depreciation deduction follows the distribution of trust income.12 Because all trust income was distributed to A’s four children, they are entitled to the depreciation deduction ($5 million to each). As a result, the Schedule K-1 each of A’s children will receive from T will reflect $1.25 million of ordinary business income, a $5 million depreciation deduction and a $1.25 million distribution.
T will pay income tax of $3,499,079 after 2006. The distribution of $1.25 million from T to each of A’s four children will not result in taxable income to them, as such distribution will be offset by the depreciation deduction. A’s four children each will have an excess depreciation deduction of $3.75 million. To the extent the children are not otherwise able to use such deductions, they will be lost.
If depreciation is not separately stated on the Schedule K-1 T receives from P, the Schedule K-1 will reflect a $5 million ordinary business loss from P. Because T does not actively participate in P, such loss would be a passive activity loss (PAL) under Sec. 469, which will remain with T until used in the future.13 As a result, the Schedule K-1 that each of A’s four children receive from T will show no taxable income from T and a $5 million distribution.
The above change in facts results in no tax liability to either T or its beneficiaries. Thus, the difference in the tax liability of T and its income beneficiaries if depreciation is separately stated on T’s Schedule K-1 from P results in a net income tax liability of $3,499,052, payable by T.
One might argue that if A’s four children and T are both in the highest marginal tax bracket and the children have sufficient “other taxable income” (in excess of their distributions from T) to use the depreciation deduction, T’s tax liability will be largely offset by the tax benefit the children receive as a result of the depreciation. While in theory this may be true, it is more likely that the depreciation deduction will be lost, because T’s income beneficiaries will not have sufficient “other income”— especially if the partnership is a closely held family limited partnership (FLP). Also, in many instances, a trust’s income and principal beneficiaries are not the same persons and, thus, the tax burden unfairly falls on the principal beneficiaries.
Would the result change if the trust held the depreciable asset directly? The answer is generally “yes,” assuming the Code would not otherwise tax as a partnership the operation that generates the depreciation deduction.14 While Secs. 642(e) and 167(d) will apply in the same manner, the trust income and the taxable income from the activity are likely to approximate each other (assuming both the activity and the trust use the cash method of accounting). If the activity is owned outright by the trust, trust income and taxable income are determined by the receipts from the activity. If the activity is owned through a partnership, taxable income to the trust is still determined by the partnership’s receipts; however, trust income is determined by partnership distributions.
Practical Application
In practice, most partnerships do not separately state depreciation; the only partner who might have an income tax liability different from that which would result if such partners did not take depreciation into account separately would be a trust or estate. This is especially true of large partnerships with several unrelated partners; the partnership may not be aware that some of its partners may be trusts or estates. Even when a large partnership may be aware that its partners may include trusts or estates, such partnerships rarely comply with Sec. 702(a)(7), due to the administrative burden. In these in-stances, most trusts or estates simply rely on the Schedules K-1 issued from the partnership in determining taxable income.15 The IRS is aware that many partnerships do not comply with Sec. 702(a)(7), but has not taken any action.
The Service’s restraint may not apply to an FLP that has depreciation as a recurring expense. In a typical FLP arrangement, a trust may hold most, if not all, of the limited interests in the FLP. The general partners in these arrangements cannot ignore the application of Sec. 702(a)(7). Sec. 702(a)(2) and the allocation of depreciation deductions will increasingly be an issue for FLPs as FLP creators incorporate operating businesses into their asset allocations to establish legitimate, nontax reasons for creating the FLP.16
Possible Solutions
There is no easy solution to the problem, especially for a trustee who is required to distribute trust income currently. However, trustees must at least be aware of the problem, to attempt to minimize the combined income tax burden of the trust and its beneficiaries. In the end, the trust may be forced to divest itself of the partnership interest or, in the case of a closely held partnership and/or FLP, have the partnership divest itself of the depreciable asset if the income tax burden cannot be efficiently managed.
One possible solution is for the trustee to make sure that income distributed from the trust is sufficient to carry out all of the trust’s taxable income in the calculation of its distribution deduction (i.e., trust income distributed to the trust’s beneficiaries should at least equal DNI). This may be difficult if the depreciation deduction for income tax purposes exceeds the trust’s receipts for trust income purposes. In this case, a trustee with the discretion to distribute trust income could withhold the distribution such that the depreciation deduction would be allocated to the trust. The income beneficiaries, however, will probably not be happy with this solution.
If the partnership is closely held and/or is an FLP, the general partner should be mindful of trusts that are its partners. In this case, the general partner and the trustee can work together to minimize the problem. To the extent possible, the general partner should make distributions from the partnership sufficient to carry out the trust’s taxable income through its distribution deduction. This, however, may be contrary to an FLP arrangement created for estate planning purposes (which generally limits distributions from an FLP).
Another possible solution is for the trust’s governing instrument to provide for a depreciation reserve or allocation of the depreciation deduction. The amount of the reserve or allocation should be left to the trustee’s discretion, to provide flexibility in minimizing the combined income tax burden of the trust and its beneficiaries. If the trust instrument provides for the allocation of the depreciation deduction, such allocation cannot exceed the trust’s pro-rata share of trust income.17 To the extent that trust income is reserved for depreciation, the trust’s depreciation deduction is first allocated to such reserve.
Conclusion
Trustees of trusts that own interests in a partnership must be aware of the potential income tax consequences of the partnership’s ownership of depreciable assets. If it is anticipated at the time of the trust’s formation that the trust may own depreciable assets through a partnership, the trust instrument should contain a provision that determines how a depreciation deduction should be allocated. The failure to address the issue could saddle a trust with an unintended tax burden.
Notes
1 Although a “partnership” is discussed throughout this article, the discussion is equally applicable to a limited liability company (LLC). This analysis is also generally applicable to estates and certain trusts (defined in Sec. 1361(2)(A)(ii) and (iii)) that hold S corporation stock.
2 See Secs. 642(e) and 611(b) on the depletion deduction. Under Sec. 642(f) and Regs. Sec. 1.642(f)-1, the principles governing the apportionment of depreciation and depletion deductions also apply to the amortization deduction.
3 Rev. Rul. 74-71, 1974-1 CB 158.
4 See Rev. Rul. 61-211, 1961-2 CB 124, modified by Rev. Rul. 74-71, note 3 supra.
5 See Regs. Sec. 1.167(h)-1(b). In the case of depletion, the deduction is allocated based on the trust income “from such property,” indicating that the deduction must be traced to the specific property; see Regs. Sec. 1.611-1(c)(4).
6 Rev. Rul. 74-530, 1974-2 CB 188.
7 In the case of depletion, the deduction is allocated based on the trust income “from such property,” indicating that the deduction must be traced to the specific property; see Regs. Sec. 1.611-1(c)(5).
8 See Regs. Sec. 1.167(h)-1(c).
9 Est. of Ida Nissen, 345 F2d 230 (4th Cir. 1965), rev’g 41 TC 522 (1964).
10 W.H. Lamkin, 533 F2d 303 (5th Cir. 1976).
11 Specifically, UPIA Section 401(b) provides: “Except as otherwise provided in this section, a trustee shall allocate to income money received from an entity.” UPIA Section 401(a) defines “entity” to include a partnership.
12 As required by Secs. 642(e) and 167(d). In general, the determination of trust income under the UPIA does not take into consideration depreciation, as such term is generally based on the cash receipts and disbursements.
13 Sec. 469 and the regulations thereunder have failed to address how Sec. 469 applies to a trust and its beneficiaries. Thus, this article assumes that a loss from a trust activity in which the trust does not materially participate is a PAL as to the trust and remains at the trust level to be used by it in the future.
14 In the example, the answer would be “no,” because the business would still be taxed as a partnership due to the ownership interests of other persons; see McKee, Nelson and Whitmire, Federal Taxation of Partnerships & Partners (Warren Gorham Lamont, 4th ed., 2007), ¶ 3.03, discussing the meaning of the term “business entity” under the Sec. 7701 regulations.
15 A trust or estate may request that the partnership restate its Schedule K-1 items when it is aware that the partnership has depreciation allocable to its partners. The partnership, however, may not be inclined to comply with such a request.
16 The IRS has used the lack of a legitimate, nontax reason for creating an FLP to argue that assets transferred to an FLP are includible in an estate under Sec. 2036; see Wayne C. Bongard, 124 TC 223 (2005). The Fifth Circuit has cited as a legitimate, nontax reason certain business decisions associated with operating a trade or business; see David A. Kimbell, 371 F3d 257 (5th Cir. 2004). For a discussion, see Eyberg and Raasch, “FLP Planning after Strangi, Kimbell and Thompson,” 35 The Tax Adviser 750 (December 2004), and Satchit, “Bongard: Tax Court Incorrectly Expands Sec. 2036(a)’s Application,” 36 The Tax Adviser 476 (August 2005).
17 See Regs. Sec. 1.167(h)-1(b). This provision applies to an allocation of depreciation.
