Northern Trust's Paul Lee’s aptly titled presentation at the 58th annual Heckerling Institute on Estate Planning in Orlando this week delivered partnership-based solutions for common estate planning issues. Through a series of examples, Lee proposed basis-efficient structures for common situations including charitable contributions, marital trust funding, divorce and death with an outstanding promissory note from a grantor trust.
Lee’s first series of examples sought to maximize the basis step up at death through staggered distributions and selective use of the section 754 election. Assume that A and B each contribute $10 million worth of marketable security Z to a new partnership. A has zero basis in their stock, whereas B has $4 million basis. Nonetheless, no gain is triggered because there is no diversification. Assume that each partner’s interest is valued at a 30% discount, or $7 million. What happens when Partner A dies the day after the partnership is formed?
If a 754 election were made, A’s inside basis would be increased to the $7 million outside basis. This may be an appropriate result—unless the beneficiary intends to dispose of a portion (but not all) of the underlying property.
In this example, beneficiary C wishes to give half of their share to charity. When the partnership makes a liquidating distribution, C receives the $10 million stock with a basis of $7 million. C gives half that amount to charity and sells the other half. C has effectively only used half of the basis adjustment and has wasted the other half.
Lee posits that a better solution would be to stagger distributions and avoid a 754 election. In year one, the partnership will make a current (non-liquidating) distribution of $5 million of Z to C. Because this is a current distribution, C’s basis in Z will be the lesser of the outside basis and the inside basis. Absent a 754 election, the inside basis is zero. C can now give this portion to charity. In year 2, the partnership will liquidate and distribute the remaining $5 million of Z to C, with a basis equal to the outside basis, or $7 million. The net result is a $2 million capital loss on sale, rather than a $1.5 million capital gain.
In another common scenario, Lee suggests that a partnership structure might increase the efficiency of a traditional A/B marital deduction plan. All other things being equal, the marital deduction trust might be funded with the low basis assets, and the bypass trust with higher basis assets (being mindful of Revenue Procedure 64-19). If there are insufficient assets to fully accomplish this, the marital trust may issue a promissory note to the bypass trust.
When assets pass to the next generation, partnerships may be structured to swap interests in different properties. Assume parent invested in three rental properties of approximately equal value. Parent purchased the properties 5, 10, and 15 years ago respectively. Immediately after parent’s death, each of parent’s three children has a 1/3 interest in each property partnership. If the children wish to unwind with each taking one property, they must be mindful of the anti-mixing bowl rules under 704(c), which trigger gain if contributed property is distributed to another partner within seven years. The children can instead merge the three partnerships into one using the assets over method, and then they need only wait two years (so that the most recently invested property will have been held seven years). After that, they can then unwind and distribute all three properties.
Pivoting, Lee contemplates the situation of divorce after implementation of a SLAT. Assume that SLAT A owns private equity valued at $10 million with a $4 million basis, and $6 million in high dividend equities also with a $4 million basis. Assume SLAT B owns rental real estate worth $12 million and growth equities worth $6 million, each with a zero basis. The first step in dividing assets may be to equalize values (since SLAT A has $2 million more than SLAT B) by decanting $2 million to a trust for benefit of descendants only. The result is two $16 million SLATs with completely different assets, each of which is wholly grantor. If all SLAT property is contributed to a partnership, the result is equal ownership with each spouse deemed to have contributed one-half of every asset. Each spouse then has an identical holding.
Lee touched briefly on “basis shifting” in the investment context assuming that partners are willing to hold the partnership interest for seven years. Lee’s outline goes into more detail on accomplishing this through partnership divisions and to diversify out of concentrated stock positions.
Lee stressed that his final scenario was one that he wishes more estate planners would implement. In the case where low basis stock is sold to an intentionally defective grantor trust in exchange for a promissory note, gain may be triggered if grantor trust status terminates while debt exceeds basis. In spite of the nonrecognition at death rules, if the trust collateralizes a note and the note is greater than basis, gain is triggered at death. This can be avoided by having the grantor and the trust contribute the promissory note and underlying assets respectively to an LLC. The LLC will be a two-person entity respected for state law purposes, but disregarded for income tax purposes during life. At the death of the grantor, the estate and the trust will become partners in a partnership. Revenue Ruling 99-5 provides that conversion of a disregarded entity to a partnership is treated as if each partner purchased one-half the assets from the other and immediately contributed it to a partnership. Lee suggests that the estate should therefore be entitled to claim a step up in basis for 50% of the value of the assets in the LLC – a significantly better result than without the LLC.
Lee’s presentation effectively convinces that partnerships are a required tool for the estate planner. Fortunately, he provides understandable guidance on implementation.