As the recent case of Estate of Jack Willard Williams1 demonstrates, the Internal Revenue Service continues to monitor partnerships aggressively and carefully. Failure to structure partnerships correctly and administer them consistently with the structure and pursuant to a non- tax purpose results in awkward and potentially bad outcomes. Among those results alleged in Williams and similar partnership cases are the return of lifetime taxable gifts at date-of-death values, loss of a portion of the marital deduction and full inclusion of the partnership assets in a decedent’s estate—not only those owned by the decedent at death.
Increased Stakes
In the past, partnership planning revolved primarily around the level of discounts and how much effort clients were willing to contribute to partnership formalities. Now, the estate tax stakes have increased, as have the income tax negatives of a discounted partnership.
These income tax negatives may militate against partnership planning in many cases and shouldn’t be overlooked. Specifically, estate tax savings will later be offset by higher income taxes on the ultimate beneficiaries of the family limited partnership (FLP) interests.
While the discounted value of a marketable asset partnership (MAP) interest may produce estate tax savings of 40 percent for each dollar of discount, such discounted value impacts the income tax basis to the beneficiaries of the MAP interest they receive on the client’s death.
At death, beneficiaries typically take a basis equal to the fair market value (FMV) of the assets received,2 referred to as “step-up basis,” not the decedent’s basis. If the FMV of a MAP interest is discounted for estate tax purposes, the basis in the MAP interest received by the beneficiaries will be equal to that discounted value.3 By definition, that discounted value will be less than the FMV of the underlying assets held by the MAP. That difference causes the beneficiaries to recognize gain for income tax purposes on the post-mortem liquidation of the MAP. Such gain may also generate Medicare taxes. The income and Medicare taxes resulting from the gain offset some, perhaps much, of the estate tax savings.
Example 1: Assume that a client, Mom, holds marketable assets in her own name with an FMV of $2 million and an income tax basis of $100,000 at the time of her death. The equal beneficiaries of her assets, her two children, would take a collective step-up basis for income tax purposes equal to $2 million. If the children were then to immediately sell the assets for $2 million, they would experience no realized gain or loss on the sale and, thus, they would experience no income or Medicare tax consequences.
What if, instead, Mom transferred the marketable assets to a MAP? Now, the underlying value of the assets in the MAP would be $2 million, and Mom’s income tax basis in the MAP interest (“outside basis”) would be $100,000. However, suppose that a 35 percent discount is appropriate in valuing her MAP interest for estate tax purposes ($2 million x .35 = $700,000). The MAP interest included in her gross estate would be valued at only $1.3 million ($2 million – $700,000 valuation discount).
At a 40 percent estate tax rate, this would produce estate tax savings of $280,000 ($1.3 million x .40 compared to $2 million x .40).
On Mom’s passing, the two children decide to liquidate and dissolve the MAP.4 The estate tax valuation of $1.3 million becomes the children’s collective outside basis in the MAP interest for income tax purposes. When the MAP makes a pro-rata distribution of its assets, worth $2 million collectively, to the children, they’ll experience a collective realized gain of $700,000, but none of this may be recognized due to a special rule underlying liquidating distributions from investment partnerships. The children will take a basis in the assets distributed in the MAP equal to the outside basis of the children’s interests in the MAP, collectively $1.3 million, reduced by any actual money distributed to them in the same transaction, here assumed to be zero, or $1.3 million.
If the children were to then sell all of the distributed assets for FMV, they would generate a collective realized and recognized gain of $700,000 ($2 million amount realized – $1.3 million adjusted basis). The gain would be capital in nature because the assets were held for investment.5 As inherited assets, the holding period of the capital assets would be deemed to be long term,6 resulting in long-term capital gains (LTCGs). LTCGs are subject to a maximum preferential tax rate, which varies depending on the taxpayer’s normal marginal income tax rate.
Suppose that the children both had a normal marginal rate of 39.6 percent, such that the preferential rate on the $700,000 of LTCGs generated by the liquidating distribution is 20 percent. This means that the children would collectively pay $140,000 ($700,000 x .20) of additional income taxes as a result of the estate tax discount.
Estate tax savings will also likely be offset by the burden of additional Medicare taxes imposed on unearned income.7 Since LTCGs are a form of unearned income,8 the $700,000 potentially would be subject to a Medicare tax of 3.8 percent or $26,600 ($700,000 x .038).
Further, if the beneficiaries are subject to state income taxes, the LTCGs would be subject to state income taxes. So, for example, suppose that both of the children resided in a state with no estate tax (thus, the $700,000 estate tax discount would have produced no state estate tax savings), but with a flat income tax rate of 5 percent. The LTCGs would result in additional state income taxes of $35,000.
The grand total of additional income and Medicare taxes on the children would be $201,600 ($140,000 + $26,600 + $35,000).
While the estate tax savings of $280,000 due to the discounted MAP interest seem impressive when viewed in isolation, they seem much less so once you consider the eventual impact of the income and Medicare taxes on the children.
One may conclude, “Well, this is just an opportunity cost, it’s a loss in a step-up in basis, not the same as a real cost.” But, negative results occur even with portfolios with no appreciation and with an already substantial income tax basis.
Partnership Gain or Loss
Under Internal Revenue Code Section 731(b), the partnership recognizes no gain or loss on liquidation distributions. Under IRC Section 731(a), the partner recognizes no gain on the distribution except to the extent that cash distributed exceeds the partner’s outside basis immediately before such distribution.9 The partner recognizes loss only on the receipt of money, unrealized receivables and inventory.10 For reasons not relevant to this discussion, marketable assets, often considered “cash” in the partnership setting, shouldn’t be considered “cash” with regard to a family investment partnership.
Pursuant to IRC Section 732(b), the basis of property (other than money) distributed by a partnership to a partner in liquidation of the partner’s interest is equal to the adjusted basis of such partner’s interest in the partnership (reduced by any actual money distributed in the same transaction). The effect is that the basis of the distributed assets to the beneficiaries in the liquidation of a MAP will be reduced to the discounted value used for estate tax purposes.
Example 2: Assume that Mom transferred marketable assets to a MAP. At the time of Mom’s death, the FMV of the underlying MAP assets and Mom’s outside basis in the MAP interest are both equal to $2 million. That is, there’s neither appreciation nor depreciation in value. If a 35 percent estate tax valuation discount is achieved, Mom’s MAP interest will be included in her gross estate at a value of only $1.3 million, and the children will take a collective outside basis in their MAP interests of $1.3 million (as in Example 1).
On liquidation, if the special rule for nonrecognition related to investment partnerships applies, the children will report no gain as a result of the distribution of the MAP assets even though the deemed cash distributed, $2 million, exceeds the children’s collective outside basis, $1.3 million. They’ll take a collective basis in such assets equal to their collective outside basis immediately before the distribution, $1.3 million, less any actual cash distributed to them, here assumed to be zero, or $1.3 million. So, even though the assets in the MAP had no built-in gain (that is, basis and FMV were both $2 million), because of the estate tax discount, the children will take a basis in such assets of $1.3 million, resulting in a built-in gain of $700,000 ($2 million FMV – $1.3 million basis).
As in Example 1, once the children sell such assets, this gain will result in LTCGs subject to income taxes and Medicare taxes. Undoubtedly, this gain will come as quite the shock to the children, as it would to the vast majority of beneficiaries of any MAP.
Planning Steps
With our current tax environment, when the estate tax exemption is at an all time high, estate tax rates are relatively low and income tax rates are higher than in past decades, a planning discussion with a client considering an FLP strategy including a MAP should highlight the important fact that income taxes and Medicare taxes may result when the assets are sold, anticipated to be after the MAP is liquidated and dissolved. The rate arbitrage between federal estate and income tax rates may be sufficiently compressed that, when coupled with the increased IRS scrutiny evidenced in Williams and similar cases, many clients will now choose to forego discounted partnership planning. Importantly, for those clients with existing partnerships, consideration should be given to unwinding partnerships that aren’t needed because of the increase in estate tax exemptions.
Endnotes
1. U.S. Tax Court petition filed Dec. 19, 2013, settled in 2016 with the taxpayer paying a portion of the asserted deficiency.
2. Internal Revenue Code Sections 1014(a) and 1022.
3. Carroll Janis v. Commissioner, 98 A.F.T.R.2d 2006-7836; Conrad Janis v. Comm’r, 98 A.F.T.R.2d 2006-6075. For an analysis of these cases and a discussion of the matching of asset values for income and estate tax purposes, see Gary Rider and Darlene Pulliam, “Matching Asset Value for Income and Estate Tax,” Journal of Accountancy (September 2007).
4. A number of factors may trigger this decision. One such factor, for example, may be that the two children develop irreconcilable differences regarding the investment strategy for the marketable asset partnership.
5. See IRC Section 1221(a).
6. IRC Section 1223(11).
7. The additional 3.8 percent Medicare tax is imposed on the unearned income of individuals, estates and trusts. IRC Section 1411. For individuals, the tax is 3.8 percent of the lesser of: (1) net investment income (NII), or (2) the excess of modified adjusted gross income (AGI) over $250,000 for married taxpayers filing jointly ($125,000 if married filing separately) and $200,000 for all other taxpayers. Section 1411(a)(1). For estates and trusts, the tax is 3.8 percent of the lesser of: (1) undistributed NII, or (2) the excess of AGI over the dollar amount at which the highest estate and trust income tax bracket begins. Ibid. Generally, NII includes interest, dividends, annuities, royalties, rents and net gains from the sale of investment property, less expenses deductible in generating such income. Section 1411(d).
8. Ibid.
9. IRC Section 731(a)(1).
10. Section 731(a)(2).