The death of a partner can have many federal income tax implications for the partnership, the partner's heirs, the partner's estate, and the partner's final income tax return. This column reviews the income tax rules that come into play upon a partner's death. Using these rules as background, both premortem and postmortem planning will be reviewed.
Determining the Effect on the Partnership Tax Year
The tax year of the partnership closes for a partner whose entire interest in the partnership is terminated for any reason, including death, sale, exchange, or liquidation (Sec. 706(c)(2)).
Example 1: G was a minority partner in Q Partnership, a cash-method, calendar-year partnership. She died on Sept. 1. The distributive share of partnership income allocable to G's interest through the date of death was $80,000; for the entire year, it was $120,000.
G's death causes the partnership year to close with respect to her interest. Accordingly, $80,000 of income is included in G's final income tax return, and the remaining $40,000 of income for the year is reported by the successor(s) in interest to G's partnership interest. The $80,000 allocable to G also would constitute self-employment income reportable on G's final return.
Allocating Distributive Shares of Partnership Income/Loss in the Year of Death
A decedent partner's distributive share of partnership income or loss will be reported on the decedent's final tax return, and the distributive share for the portion of the year during which the interest was owned by the decedent's successor(s) in interest would be reported by the successor(s) in the same manner as in the case of other transfers of partnership interests.
Computing Self-Employment Income in Year of Death
A decedent's self-employment income attributable to his or her share of partnership income for the year of death will be determined on the same basis as for years prior to death, i.e., based on the decedent's status as a partner (general or limited, etc.) and the character of the income.
Determining Income in Respect of a Decedent
The determination of income in respect of a decedent (IRD) can have significant estate tax and income tax implications for the decedent's estate and successor in interest. In general, IRD is income that was earned by the decedent but was not subject to income tax prior to the decedent's death (Sec. 691). More specifically, IRD includes the following types of partnership income:
- Income earned by the partnership but not recognized for tax purposes as of the date of the partner's death because of the partnership's accounting methods (such as installment sale income and cash-method receivables), regardless of whether it was earned in the year of the partner's death (Woodhall, 454 F.2d 226 (9th Cir. 1972); George Edward Quick Trust,444 F.2d 90(8th Cir. 1971)).
- Sec. 736(a) payments included in the income of a successor in interest to a deceased partner (Sec. 753).
Items constituting IRD are included in the estate of the decedent as assets and are subject to income tax when received by the estate or other successor in interest.
Example 2: G was minority general partner in Q Partnership, a cash-method, calendar-year partnership. She died on Sept. 1, when her distributive share of partnership income was $80,000. The distributive share of income for the entire year that was allocable to her interest was $120,000. G's spouse was designated as her successor in interest, and there was no provision for liquidation of her interest.
The partnership year closes for G on her date of death, so the $80,000 would be includible in G's final return and would not be IRD. The remaining $40,000 distributive share of income from the year of G's death would be reported to her husband. Her share of any accounts receivable held by the partnership at the date of her death would be IRD and would be reported as income by G's spouse when collected by the partnership.
Using Buy/Sell Agreements
Service partnerships, such as law firms and accounting firms, often prohibit the interests of deceased partners from being transferred to anyone but an existing partner. To ensure this result, the remaining partners (as opposed to the partnership itself) may be required to acquire the interest from the decedent's estate immediately after his or her death. Similar buy/sell agreements may be entered into by partners in partnerships engaged in other types of businesses to provide a market for a deceased partner's interest or ensure the remaining partners can purchase a deceased partner's interest for a price agreed upon by the partners at some earlier point in time.
In such cases, the partnership's tax year ends with respect to the deceased partner on his or her date of death, and he or she is allocated his or her ratable share of the partnership's income for the portion of the tax year occurring prior to that date. The annual proration or interim closing of the books method can be used to determine the amount of such income required to be reported on the decedent's final tax return.
Note: Because the partnership interest must be included in the decedent's gross estate at fair market value (FMV), a buy/sell agreement that results in the sale of the partnership interest for less than FMV may cause the deceased partner's successor in interest (e.g., his or her estate) to receive an amount of cash that is less than the estate tax assessed on the transferred interest.
A purchase under the terms of a buy/sell agreement can also cause a technical termination of the partnership and a closing of the partnership's tax year with respect to all partners. A technical termination occurs if the deceased partner owned at least a 50% interest in the capital and profits of the partnership (Sec. 708(b)(1)(B)). A technical termination of the partnership also occurs on the decedent partner's date of death if the purchase of the deceased partner's interest along with transfers of other interests during the 12-month period immediately before the partner's death aggregate to 50% or more of total interests in partnership capital and profits. When a technical termination occurs, the partnership's tax year closes for all partners on the date the terminating event takes place (Regs. Sec. 1.708-1(b)(3)(ii)). Accordingly, the partnership's tax year closes for all partners on the date of death.
Death of a Partner in a Two-Person Partnership
The death of a partner in a two-person partnership will terminate the partnership for federal tax purposes if it results in the partnership's immediately winding up its business (Sec. 708(b)(1)(A)). If this occurs, the partnership's tax year closes on the partner's date of death. Similarly, the death of a partner in a two-person partnership generally will cause the technical termination of the partnership under Rev. Rul. 99-6. The regulations, however, provide two exceptions that prevent an immediate termination of the partnership of a two-person partnership upon a partner's death.
A two-person partnership does not terminate upon a partner's death if the deceased partner's successor in interest (usually the estate) continues to share in the partnership's profits or losses (Regs. Sec. 1.708-1(b)(1)(I)). The partnership's tax year does not close, and the partner's distributive share of partnership income from the date of death through the end of the partnership tax year is reported on the tax return of the successor in interest (Regs. Sec. 1.706-1(a)). Likewise, if a partnership begins or continues to make liquidating payments to a deceased partner's successor in interest under the provisions of Sec. 736, the successor in interest is treated as a partner until the deceased partner's interest in the partnership has been completely liquidated (Regs. Sec. 1.736-1(a)(1)(ii)). In a two-person partnership, the partnership does not terminate, nor does the partnership year end (other than the partnership's normal tax year), until the final liquidating payment is made to the successor in interest (Regs. Sec. 1.736-1(a)(6)).
If the clients wish to continue a two-partner partnership after a partner's death, the practitioner should consider making the following recommendations to ensure continuation:
- The operating agreement or the liquidation agreement should indicate the interest of the deceased partner is to be retired by a series of liquidating payments made by the partnership. Ideally, the agreement should state the payments are made under Sec. 736.
- When the interest is retired, the partnership books should reflect the elimination of the deceased partner's interest in capital and the establishment of a payable to the partner's successor in interest. All subsequent payments made to retire the interest should reduce the payable.
- Partnership tax returns should be filed as long as payments are being made to the deceased partner's successor in interest.
- All payments for the deceased partner's interest in the partnership should be made from the partnership's business account and not from the remaining partner's personal account.
Partnership Ceases to Do Business on Date of Death
A partnership is terminated for tax purposes if all of its business activities are discontinued (Sec. 708(b)(1)(A)). It is possible that a partner's death could cause business activities of a partnership to cease, thereby causing the partnership's immediate termination. For example, assume a partnership is in the business of providing a service. The partnership has one partner who provides the service and a number of partners who do not participate in providing services but are investors. If the service provider dies, the partnership's business activities would probably cease on the date of death. Accordingly, the partnership's tax year would close, and the distributive share of partnership income earned by the decedent through the date of death would be reported on his or her final income tax return.
As a general rule, however, the cessation of a partnership's business activities and the resulting termination of the partnership for tax purposes are not considered to occur until all the partnership's assets have been distributed to the partners. In Sargent, T.C. Memo. 1970-214, the courts held that the process of winding up is considered part of an entity's business. Consequently, if the partnership continues to pay its creditors or make distributions to the remaining partners after the date of the service provider's death, the partnership would not terminate until the winding-up activities were complete.
Distribution of Partnership Interest to Estate's Beneficiary
Under trust and estate tax law, the transfer of property to satisfy a pecuniary bequest (i.e., one in which a specific monetary amount rather than specific property is left to a particular heir) is treated as a distribution of the property from the estate to the heir. Under Sec. 761(e), the distribution of a partnership interest is treated as a deemed sale or exchange of the interest for purposes of Sec. 708(b)(1)(B) (the technical termination rules). Therefore, the distribution of a partnership interest representing 50% or more of partnership capital and profits (or resulting in the transfer of 50% or more of the interests in partnership capital and profits when combined with other sales or exchanges that occur within a 12-month period) to satisfy a pecuniary bequest terminates the partnership under the Sec. 708 rules (Regs. Secs. 1.661(a)-2(f) and 1.1014-4(a)(3)).
Preparation pointer: A specific bequest of a partnership interest to a particular heir does not cause a termination of the partnership because the transfer from the estate to the beneficiary is not treated as a distribution of the interest for estate tax purposes (Sec. 663(a)(1) and Regs. Secs. 1.663(a)-1(b)(2)).
When an estate distributes a partnership interest to a beneficiary, the beneficiary generally reports all income or loss for the entire partnership tax year of distribution—provided the distribution satisfies a specific bequest. However, if the distribution satisfies a pecuniary (i.e., a monetary) bequest, the partnership's tax year closes with respect to the estate (or with respect to all partners if the distribution triggers a technical termination) on the date of the distribution, because the distribution to satisfy the pecuniary bequest is deemed to be a sale or exchange of the distributed interest. As a result, the partnership must allocate the year's income or loss between the estate and the beneficiary.
Practitioners who have clients holding substantial interests in partnerships should consider whether it is more desirable for the estate or the beneficiary to report the successor's share of income in the year of death when performing estate planning services for the client. The clients can then address whether the transfer of the passthrough interest should be by specific or pecuniary bequest.
Treatment of Suspended Losses Upon Partner's Death
A taxpayer holding a partnership interest on his or her date of death may have been allocated partnership losses in prior years that were not deductible because of a limitation imposed by the tax laws. Losses may have been disallowed under the at-risk rules, the passive loss rules, or because the partner had insufficient basis in the partnership interest to deduct the loss. Such losses are generally carried over by the partner to subsequent tax years until some event triggers their deductibility. Upon the death of the partner, however, the treatment of those losses is not always as clear.
Losses Suspended Due to Basis Limitation
If a partner has suspended partnership losses at his or her date of death due to the basis limitation rule of Sec. 704(d), those losses should be deductible on the decedent's final return to the extent the partner's tax basis in the partnership interest increased before his or her death (e.g., if the partner made capital contributions). It appears, however, that any remaining losses suspended under these rules disappear. Although not specifically addressed in the Code or regulations, the treatment of those suspended losses upon a partner's death should be similar to their treatment upon a taxable disposition of the partnership interest. A taxable disposition does not enable the transferring member to deduct losses suspended due to lack of basis. Also, there is no carryover of the suspended loss to the transferee partner.
Because the partner's basis has not been reduced by the suspended losses, the loss is essentially recognized in the form of a decrease in the amount of gain (or increase in the amount of loss) recognized on the transaction. Upon the partner's death, the basis of the partner's interest is stepped up to FMV on the date of death (or alternate valuation date, if elected). Based on the rationale that applies to suspended losses upon a taxable disposition, it appears there is no carryover of the suspended loss to the estate or other successor in interest.
Losses Suspended Due to At-Risk Limitations
When a partner dies owning an at-risk activity with suspended losses through a partnership, the treatment of the suspended losses is not clearly spelled out in the regulations. As with losses suspended under the basis limitation rules, at-risk suspended losses should be deductible on the decedent's final return to the extent the partner's amount at risk increased during the portion of the tax year preceding his or her death. However, since at-risk losses are treated as personal to the transferor under Prop. Regs. Sec. 1.465-67(b), it appears that any remaining suspended at-risk losses "disappear" upon the partner's death.
The regulations do, however, address the calculation of the successor partner's amount at risk (Prop. Regs. Sec. 1.465-69). A partner who inherits an interest in an at-risk activity receives an increase in at-risk basis for the positive at-risk basis of the decedent. In addition, the successor in interest receives a step-up in at-risk basis equal to the amount of the step-up to FMV (if any) at the date of death (or alternate valuation date) under Sec. 1014.
Losses Suspended Due to Passive Loss Rules
If partnership losses have not been deducted solely by reason of the passive activity limitations, a casual glance at the rules might suggest that the complete disposition of the partner's interest at death would cause the suspended losses to be deductible on the partner's final Form 1040, U.S. Individual Income Tax Return. If the decedent has passive income on his or her final Form 1040, suspended losses can be used to offset that income. However, any remaining suspended passive activity losses are deductible only to the extent they exceed the difference between the stepped-up basis of the partnership interest in the hands of the successor in interest and the basis of the partnership interest in the hands of the deceased partner (Sec. 469(g)(2)). To the extent the suspended losses do not exceed this difference, they are never allowed as a deduction. In essence, they simply disappear.
Sec. 754 Election to Step Up Basis of Partnership Assets
Sec. 754 provides an election to adjust the inside bases of partnership assets pursuant to Sec. 743(b) upon the transfer of a partnership interest caused by a partner's death. A Sec. 754 election can also be made when a member's interest is sold or upon certain distributions of partnership assets. A basis adjustment is made to eliminate the discrepancy between the outside basis of the partnership interest after its step-up (or step-down) to FMV and the successor in interest's share of the partnership's inside basis in its assets. (A partner's interest in a partnership's inside basis is based on a calculation of "previously taxed capital.") The adjustment benefits only the deceased partner's successor in interest.
To adjust the bases of the underlying assets under Sec. 743(b), the partnership must have a Sec. 754 election in effect or must make the election for the year that includes the deceased partner's date of death. A basis adjustment is required for a transferred partnership interest (including transfers upon the death of a partner) if the partnership has a substantial built-in loss immediately after the transfer (unless the partnership is an electing investment partnership or a securitization partnership). A partnership has a substantial built-in loss if the partnership's adjusted basis in partnership property exceeds the FMV of that property by more than $250,000 (Secs. 743(a) and (d)).
This case study has been adapted from PPC's Guide to Tax Planning for 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.