Wednesday, September 15, 2021
In the Part One of this series, I discussed the basics rules governing gifts made during life and the present interest annual exclusion. In Part Two, I expanded the present interest gifting discussion to gifts of entity interests and how to qualify the gifts for present interest exclusions. In today’s Part Three the attention turns to how to report gifts of interests in a partnership for tax purposes.
The tax reporting of gifted partnership interests – it’s the topic of today’s post.
Basic Rules Applied
Often no issues. From an income tax standpoint, the donee does not recognize income (or loss) on the value of gifted property. The gift, however, can trigger gift tax if the amount of the gift exceeds the present interest annual exclusion (presently $15,000 per donee, per year) or is not of a present interest of any amount. In that situation, Form 709 must be filed by April 15 of the year following the year in which the taxable gift was made. But, as noted in Part One, gift tax is often not due because the tax can be offset by unified credit. But remember, even if the credit is used to fully offset gift tax, Form 709 must be filed to show the amount of the taxable gift and the offsetting credit reducing the taxable amount to zero.
Valuing gifts for tax purposes. If gift tax is imposed, it is calculated on the fair market value (FMV) of the gifted property less the amount of debt (if any) from which the donor is relieved. Applying those principles in the partnership context, the fair market value of a partnership interest would need to be determined, as well as the donor’s share of any partnership liabilities. If the gifted partnership interest relieves the donor of more debt than the donor has income tax basis in the partnership interest, the excess is treated as an amount realized in a deemed sale transaction. In that event, the donor must recognize gain. Treas. Reg. §1.1001-2(a).
Gain Recognition on Gift of a Partnership Interest
For gifted partnership interests, gain recognition is common when the donor has a negative tax basis capital account. A partner’s tax basis capital account balance generally equals the amount of cash and tax basis of property that the partner contributes to the partnership, increased by allocations of taxable income to the partner, decreased by allocations of taxable loss to the partner, and decreased by the amount of cash or the tax basis of property distributed by the partnership to the partner. If the result of all of these adjustments is a negative amount, the partner has a negative tax basis capital account and is more likely to have gain recognition upon the gift of a partnership interest.
Note: For tax years ending on or after 2020 partnerships must report each partner’s capital account on a tax basis. For prior years, a partnership could report partner capital accounts on some other basis (such as GAAP) which limited the ability of the IRS to identify potentially taxable situations.
Depending on whether the “hot asset” rules of I.R.C. §751 apply, some of the gain could be taxed at ordinary income rates. IRC §751 requires recognition of gain from "hot assets" as ordinary income. Under §751(b), "hot assets" include unrealized receivables, substantially appreciated inventory and depreciation recapture. Any amount of capital gain triggered by the gifted partnership interest will be either short-term or long-term under the normal rules.
Frank has structured his farming operation as a general partnership. Assume that his tax basis capital account is negative $200,000 and his share of partnership liabilities is $300,000, and the FMV of his interest in the partnership assets is $400,000. For succession planning purposes, Frank wants to gift his partnership interest to his son, Fred. Frank needs to know both the gift tax and income tax consequences of gifting his partnership interest to Fred.
The amount of the taxable gift is the difference in the FMV of Frank’s share of the partnership assets and his share of partnership debt he is being relieved of. Thus, the amount of the gift is $100,000. Assuming that the gift qualifies for the present interest annual exclusion (see Part 2 of this series), the taxable gift would be $85,000. That amount could be fully offset by the estate and gift tax unified credit (assuming Frank has enough currently remaining) resulting in no gift tax liability. Form 709 would need to be filed by April 15 of the year following the year of the gift.
On the income tax side of things, the gift of the partnership interest relieved Frank of his share of partnership liabilities of $300,000. From that amount Frank subtracts the adjusted basis of his partnership interest – that’s Frank’s tax basis capital account value of negative $200,000 plus his share of partnership liabilities of $300,000. Thus, from the debt relief of $300,000, Frank subtracts $100,000. The result is that Frank has $200,000 of gain associated with a deemed sale of the partnership interest.
The amount of gain that Frank recognizes on the gift of the partnership interest is added to Frank’s basis in his interest for determining Fred’s basis. Fred then has a basis equal to the amount realized (the amount of debt relief) in the deemed sale. Treas. Reg. §1.1015-4(a). Fred’s tax basis capital account begins at zero, representing Frank’s negative capital account of $200,000 plus $200,000 gain recognized by Frank. Another way of looking at this is the tax basis of Frank’s share of the partnership assets was $100,000, plus Frank recognized gain of $200,000, reduced by Frank’s share of the partnership debt assumed by Fred of $300,000.
Note: One exception to the general rule of carryover basis is if the donor’s pays any gift tax on the gift. See I.R.C. §§742 and 1015.
Note: If the FMV of a partnership 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. I.R.C. §1015(a).
Basis adjustment. If a gifting partner recognizes gain on the deemed sale of the partnership interest and the partnership had an I.R.C. §754 election in place, the partnership will need to adjust the basis of its assets to reflect the amount of the gain.
Transfer to family members. If a partnership interest is purchased by a family member, the transfer is subject to the family partnership rules of I.R.C. §704(e)(2). For this purpose, a “family member” is defined as the donor’s spouse, ancestors and lineal descendants and any trusts for the primary benefit of such persons. If the rules are triggered, the transfers is treated as if it was created by gift from the seller, and the fair market value of the purchased interest is considered to be donated capital. This rule is designed to bar the shifting of income and property appreciation from higher-bracket taxpayers to lower-bracket taxpayers by requiring income produced by capital to be taxed to the true owner of that capital. The rule is also designed to ensure that services are taxed to the person performing the services. If the IRS deems the rules to have been violated it may reallocate income between partners (or determined that a partner is not really a partner) for income tax purposes.
Valuation discounts. As noted in Part 2, gifts of partnership interests to family members are often subject to valuation discounts to reflect lack of marketability or minority interest. Thus, careful structuring of partnerships and transferring of partnership interests involving family members must be cautiously and carefully undertaken to avoid IRS objection.
Transitioning the farming or ranching business to the next generation is difficult from a technical perspective. But those difficulties should not prevent farm and ranch families from doing appropriate planning to ensure that a succession plan is in place to help assist the future economic success of the family business.