Family Limited Partnership Terminat

INCOME TAX CONSEQUENCES OF LIQUIDATING AN FLP
AND OTHER SIMILAR TRANSACTIONS

 

FizerBeck
Fizer, Beck, Webster, Bentley & Scroggins
a professional corporation
1330 Post Oak Boulevard, Suite 2900
Houston, TX 77056-3022
713-840-7710
www.fizerbeck.com
 

 

  1. Introduction

    Family Limited Partnerships (“FLPs”) are typically created for creditor protection and estate planning reasons. Most practitioners and clients do not spend much time considering the income tax issues involved other than the investment company rules that are primarily pertinent on formation. FLPs are generally considered to be tax-neutral during the years of operation and upon dissolution. However, as discussed below, FLP distributions can give rise to income tax issues that are often unexpected by the family. Discussions in this outline about FLPs are also applicable to limited liability partnerships, general partnerships and limited liability companies.

    This outline is limited to the issues surrounding FLP liquidations and other similar transactions (such as terminating the interest of a single partner and distributing specific assets to the partners). This outline does not cover all partnership income tax issues, including the investment company rules and the laws applicable to income and expense allocations during the operation of the FLP. Additionally, the outline assumes that an FLP has no unrealized receivables or inventory (“hot assets”), both of which can trigger income tax consequences upon distribution to a partner.

  2. General Rule on FLP Distributions

 
  1. Internal Revenue Code (“IRC”) §§731(a) and 731(b) generally provide that neither the partner nor the partnership recognizes gain or loss on a distribution to a partner.

  2. However, IRC §731(a)(1) provides that a partner must recognize capital gain to the extent that the money distributed exceeds the partner’s basis in his or her partnership interest. For purposes of IRC §731, marketable securities are generally treated as money. [IRC §731(c)]

  3. A partner can recognize capital loss only in connection with a complete liquidation of such partner’s interest in the partnership. Capital loss is allowed only to the extent that the partner’s basis (after adjustment for other distributed property) exceeds the money distributed to the partner. [IRC §731(a)(2)] For purposes of calculating the capital loss, if any, marketable securities are not treated as money.

  4. The treatment of marketable securities as money is modified in various cases.

   
  1. The amount of the marketable securities treated as money is reduced to the extent of the recipient partner’s share of the unrealized gain that he or she receives on the distribution. [IRC §731(c)(3)(B)] The example below from the Treas. Regs. explains this reduction.

     

Example 2 from Treasury Reg. §1.731-2(j):

(i)      A and B form partnership AB as equal partners. AB subsequently distributes Security X to A in a current distribution. Immediately before the distribution, AB held securities with the following fair market values, adjusted tax bases, and unrecognized gain or loss:

  Value Basis Gain (Loss)
Security X 100 70 30
Security Y 100 80 20
Security Z 100 110 (10)

(ii)      If AB had sold the securities for fair market value immediately before the distribution to A, the partnership would have recognized $40 of net gain ($30 gain on Security X plus $20 gain on Security Y minus $10 loss on Security Z). A's distributive share of this gain would have been $20 (one-half of $40 net gain). If AB had sold the remaining securities immediately after the distribution of Security X to A, the partnership would have $10 of net gain ($20 of gain on Security Y minus $10 loss on Security Z). A's distributive share of this gain would have been $5 (one-half of $10 net gain). As a result, the distribution resulted in a decrease of $15 in A's distributive share of the net gain in AB's securities ($20 net gain before distribution minus $5 net gain after distribution).

(iii)      Under paragraph (b) of this section, the amount of the distribution of Security X that is treated as a distribution of money is reduced by $15. The distribution of Security X is therefore treated as a distribution of $85 of money to A ($100 fair market value of Security X minus $15 reduction).

   
  1. Marketable securities are not treated as money if the FLP distributes the securities to the partner who contributed such securities to the FLP. [IRC §731(c)(3)(A)(i)] No authority exists for a transferee partner to be treated as the contributing partner (in place of the transferor partner) for these purposes, but many commentators believe that such treatment is proper.

  2. A marketable security is not treated as money if the security was not a marketable security when acquired by the partnership. [IRC §731(c)(3)(A)(ii)]

  3. Marketable securities are not treated as money when distributed by an “investment partnership” to an “eligible partner”. [IRC §731(c)(3)(A)(ii) and Treas. Reg. §1.731-2(e)] An FLP qualifies as an “investment partnership” if the FLP has never been engaged in a trade or business and if substantially all of the FLP assets have always consisted of investment type assets listed under IRC §731(c)(3)(C)(ii). An “eligible partner” is one who has never contributed any non-investment type assets to the FLP. Treas. Reg. §1.731-2(c)(3) provides that for purposes of Treas. Reg. §1.731-2, substantially all means 90% or more.

 
  1. IRC §752(b) treats any reduction in a partner’s share of partnership liabilities as a “deemed” distribution of money to that partner.
   
  1. Example: XYZ, Ltd. owns 2 tracts of real estate. One tract has a fair market value of $1,000,000 with no debt on such tract. The second tract has a fair market value of $2,600,000 with a debt of $600,000 on such tract. Each partner (X, Y and Z) has a basis of $150,000 in his FLP interests. Each partner owns 1/3 of the FLP and is allocated 1/3 of the FLP debt. X’s interest is fully liquidated when XYZ, Ltd. distributes tract one to X in exchange for all his partnership interests.

  2. X must recognize a $50,000 capital gain on the liquidation as he is deemed to have received $200,000 in money.

  1. IRC §704(c)(1)(B) Gain

 
  1. General rule under IRC §704(c)(1)(B): If a partner contributes appreciated property (“built-in gain property”) to a partnership and such property is distributed to another partner within seven years of the original contribution, the contributing partner must recognize gain or loss as if the built-in gain property was sold at its fair market value on the date of distribution. IRC §704(c)(1)(B)(i) provides that the gain or loss is limited to the amount that would have been specially allocated to the partner under IRC §704(c)(1)(A).

  2. Treas. Reg. §1.704-4(d)(2) provides that a transferee partner “steps into the shoes” of the transferor partner for purposes of IRC §704(c). Accordingly, if partner A transfers built-in gain property to ABC partnership and ABC transfers the same property to A’s heirs (who inherited A’s partnership interests upon A’s death) four years later, no gain under IRC §704(c)(1)(B) is recognized on such distribution.

  3. If the distributed built-in gain property is marketable securities, gain or loss is determined first under IRC §704(c)(1)(B) and then under IRC §731. [Treas. Reg. §1.731-2(g)(1)].

  1. IRC §737 Gain

 
  1. General Rule under IRC §737: If a partner contributes built-in gain property to a partnership and the contributing partner receives other partnership property within seven years of the contribution, the contributing partner must recognize gain equal to the lesser of:

   
  1. i. the excess, if any, of the fair market value of property (other than money) received over the adjusted basis of the partner’s interest in the partnership immediately before the distribution; and

  2. ii. the partner’s “net pre-contribution gain”.

 
  1. Treas. Reg. §1.737-1(c)(1) provides that a partner’s “net pre-contribution gain” is equal to the gain that would be allocated to the distributee partner under IRC §704(c)(1)(B) if all of the built-in gain property contributed by the distributee partner was distributed to another partner.

  2. Treas. Reg. §1.737-1(c)(2)(iii) seems to provide that a transferee partner “steps into the shoes” of the transferor partner for purposes of IRC §737. It reads as follows,

    “The transferee of all or a portion of a contributing partner's partnership interest succeeds to the transferor's net pre-contribution gain, if any, in an amount proportionate to the interest transferred. See §1.704-3(a)(7) and §1.704-4(d)(2) for similar provisions in the context of section 704(c)(1)(A) and section 704(c)(1)(B).”

    However, some commentators disagree and conclude that the regulations do not provide for such treatment. It seems unreasonable that a transferee partner should “steps into the shoes” of the transferor partner for purposes of IRC §704, but not for purposes of IRC §737, as both provisions are designed to stop disguised sales through partnerships.

  3. IRC §737(e) provides that for purposes of computing the amount distributed under IRC §737, any marketable securities treated as money under IRC §731(c) are ignored.

  4. Pursuant to Treas. Reg. §1.731-2(g)(1)(i), if a distribution results in the application of IRC §§731(c), 704(c)(1)(B) and 737, gain or loss is determined first under IRC §704(c)(1)(B), then under IRC §731(c) and finally under IRC §737.

  1. IRC §754 and Related Sections

 
  1. Upon the death of a partner, the outside basis in his or her partnership interests is adjusted to the fair market value of such interests on the partner’s date of death (or on the alternate valuation date). [IRC §1014(a)(1) and Treas. Reg. §1.742-1]

  2. Unless the FLP already has an IRC §754 election in place or makes an IRC §754 election following the death of the partner, the inside basis of the FLP assets remain unchanged following a partner’s death.

  3. An IRC §754 election allows a deceased partner’s heirs to increase (or decrease) their share of the inside basis of the FLP assets by the difference between the new adjusted outside basis and the inside share of basis in the FLP assets [IRC §743]. Such increase or decrease affects the gain or loss recognized by the deceased partner’s successors upon the sale of property in the FLP and also affects the depreciation deductions claimed by such successors. Upon the death of a partner, the inside basis of the other partners is not affected by the IRC §754 election. Additionally, if a partner recognizes gain upon a sale of his or her FLP interests, the IRC §754 election allows the purchaser of the FLP interests to increase (or decrease) his or her inside basis in the FLP assets. Finally, pursuant to an IRC §754 election, upon distribution of FLP assets to a partner, the partnership must increase (or decrease) its adjusted basis in its assets due to the gain (or loss) recognized by the distributee partner on such distribution [IRC §734].

  4. The basis step-up pursuant to an IRC §754 election reduces the net pre-contribution gain attributable to a partner.

  5. An IRC §754 election may be revoked only with the consent of the IRS. [Treas. Reg. §1.754-1(c)] Thus, once the election is in place, it affects all other partners when a partner dies or when a partnership distribution to another partner is made.

  6. Due to the valuation discounts typically attributed to the FLP interests of a decedent, an IRC §754 election is often undesirable (unless the FLP owns property with low basis relative to fair market value).

  7. An IRC §754 election is made by attaching a statement, signed by any one of the partners, to the partnership’s timely filed tax return for the year in which the partner dies or the transfer occurs. [Treas. Reg. §1.754-1(b)]

  8. Rev. Rul. 79-124 provides that the IRC §754 basis adjustment applies to the entire partnership interest owned as community property.

  9. Alternative to an IRC §754 election: IRC §732(d) – allows a distributee partner to elect to calculate the basis of any distributed partnership property as if the partnership had an IRC §754 election in place when the partner acquired his or her interest in the partnership. Such election is only available for distributions within two years of the distributee partner obtaining his or her partnership interest. IRC §732(d) is needed only with respect to non-liquidating distributions in which IRC §732(a)(1) provides that the partner receives a carryover basis from the partnership. IRC §732(b) provides that in liquidating distributions, the basis of a partner’s partnership interest becomes his or her basis in the distributed property (making an IRC §732(d) unnecessary).

  1. Comprehensive Example 1 – Liquidation of entire FLP after founder’s death (pro rata distributions)
 
  1. Facts: Mother (M) forms FLP in 1998 and contributes Exxon stock ($1,000,000 FMV and 0 basis) and real estate ($1,000,000 FMV, $500,000 basis and 0 debt) to the FLP. From 1998-2002, M gifts 10% of the FLP interests to daughter (D) and 10% to son (S). M dies in 2002 while owning 80% of the FLP interests with the children owning 20% of such interests. M’s Will leaves her FLP interests, in equal shares, to D and S. A 40% valuation discount was successively claimed on the estate tax return. In year 2004, D and S desire to liquidate the FLP by distributing the assets pro rata. The balance sheets on date of death and date of liquidation are shown below. The FLP made a timely IRC §754 election subsequent to M’s death.

  2. Date of Death Balance Sheet (Prior to Basis Adjustments)

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 0 1,000,000 1,500,000
    Real Estate 500,000 500,000 1,500,000
    Totals 500,000 1,500,000 3,000,000
           
    Partners      
    M 400,000 1,200,000 2,400,000
    D 50,000 150,000 300,000
    S 50,000  150,000 300,000

       

  3. Date of Death Balance Sheet (After Basis Adjustments)

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 720,000 280,000 1,500,000
    Real Estate 820,000 180,000 1,500,000
    Totals 1,540,000 460,000 3,000,000
           
    Partners      
    M’s Estate 1,440,000 160,000 2,400,000
    D 50,000 150,000 300,000
    S 50,000 150,000 300,000

     

  4. Date of Distribution Balance Sheet

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 720,000 280,000 2,000,000
    Real Estate 820,000 180,000 2,000,000
    Totals 1,540,000 460,000 4,000,000
           
    Partners      
    D 770,000 230,000 2,000,000
    S 770,000 230,000 2,000,000

     

  5. IRC §704(c)(1)(B) Gain: Since D and S “step into the shoes” of M for purposes of IRC §704(c), no gain is triggered under IRC §704(c)(1)(B) on the liquidation of the FLP. The property is treated as having been returned to the contributing partner.

  6. IRC §731(c) Gain: Generally, Exxon stock would be treated as money for purposes of IRC §731(c). Accordingly, D and S would each recognize gain of $230,000 upon receipt of the Exxon stock ($1,000,000 less $770,000).

   
  1. However, although no express authority provides that D and S “step into the shoes” of M for purposes of IRC §731(c), some commentators believe that such result is proper and would allow D and S to avoid gain recognition (under the exception to the treatment of marketable securities as money if the recipient partner contributed such securities to the partnership).

  2. Alternatively, pursuant to IRC §731(c)(3)(B), the amount of the stock treated as money is reduced to the extent that a partner’s share of unrealized gain in the securities is reduced by the distribution. D and S each had unrealized gain in the securities of $640,000 ($2,000,000 less $720,000, divided by 2) prior to the liquidation and zero afterwards. Accordingly, only $360,000 ($1,000,000 less $640,000) of the stock distributed to each partner should be treated as money. Since each partner’s basis exceeds $360,000, no gain should be recognized under §731(c).

 
  1. IRC §737 Gain: Assuming that D and S are treated as having “stepped into M’s shoes”, no gain should be recognized under IRC §737 since no property is being distributed to a partner other than the contributing partner. However, if D and S are not treated as having “stepped into M’s shoes”, the result would be different. Since the liquidation is occurring within seven years of the property contribution by M, §737 is applicable. The lesser of the excess distribution ($2,000,000 less $770,000 or $1,230,000 each) and net pre-contribution gain ($230,000 each) would be income to each of D and S. D and S would both get a $230,000 increase in basis in the FLP property received upon liquidation. [IRC §737(c)(1)]

  1. Comprehensive Example 2 – Liquidation of entire FLP after founder’s death (non-pro rata distributions)
 
  1. Facts: Mother (M) forms FLP in 1998 and contributes Exxon stock ($1,000,000 FMV and 0 basis) and real estate ($1,000,000 FMV, $500,000 basis and 0 debt) to the FLP. From 1998-2002, M gifts 10% of the FLP interests to daughter (D) and 10% to son (S). Thus, M dies owning 80% of the FLP interests with the children owning 20% of such interests. M’s Will leaves her FLP interests, in equal shares, to D and S. A 40% valuation discount was successively claimed on the estate tax return. In year 2004, D and S desire to liquidate the FLP by distributing the securities to D and the real estate to S. The balance sheets on date of death and date of liquidation are shown below. The FLP made a timely IRC §754 election subsequent to M’s death.

  2. Date of Death Balance Sheet (Prior to Basis Adjustments)

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 0 1,000,000 1,500,000
    Real Estate 500,000 500,000 1,500,000
    Totals 500,000 1,500,000 3,000,000
           
    Partners      
    M 400,000 1,200,000 2,400,000
    D 50,000 150,000 300,000
    S 50,000 150,000 300,000

     

  3. Date of Death Balance Sheet (After Basis Adjustments)

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 720,000 280,000 1,500,000
    Real Estate 820,000 180,000 1,500,000
    Totals 1,540,000 460,000 3,000,000
           
    Partners      
    M’s Estate 1,440,000 160,000 2,400,000
    D 50,000 150,000 300,000
    S 50,000 150,000 300,000

     

  4. Date of Distribution Balance Sheet

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 720,000 280,000 2,000,000
    Real Estate 820,000 180,000 2,000,000
    Totals 1,540,000 460,000 4,000,000
           
    Partners      
    D 770,000 230,000 2,000,000
    S 770,000 230,000 2,000,000

     

  5. IRC §704(c)(1)(B) Gain: Since D and S “step into the shoes” of M for purposes of IRC §704(c), each of them are treated as contributing one-half of the Exxon Stock and one-half of the real estate. Since seven years have not elapsed since the contribution of the FLP assets, IRC §704(c) applies to the distribution. D is treated as having sold one-half of the real estate to S for its fair market value and S is treated as having sold one-half of the Exxon stock to D for its fair market value.

   
  1. The tentative gain on the sale of one-half of the Exxon Stock is $1,280,000 ($2,000,000 less $720,000). The tentative gain on the sale of one-half of the real estate is $1,180,000 ($2,000,000 less $820,000).

  2. However, IRC §704(c)(1)(B)(i) provides that the gain or loss is limited to the amount that would have been specially allocated to the partner under IRC §704(c)(1)(A). Accordingly, the IRC §704(c)(1)(B) gain recognized by D and S would be limited to $230,000 each. D and S would each receive a basis step-up in the property received from the FLP for the §230,000 gain recognized.

 
  1. IRC §731(c) Gain: As described under Example 1 above, no IRC §731(c) gain is recognized due to IRC §731(c)(3)(B).

  2. IRC §737 Gain: Assuming that D and S are treated as having “stepped into M’s shoes”, no gain should be recognized under IRC §737 since no property is being distributed to a partner other than the contributing partner. However, if D and S are not treated as having “stepped into M’s shoes”, the result could be different. Since the liquidation is occurring within seven years of the property contribution by M, §737 is applicable. The lesser of the excess distribution and net pre-contribution gain would be income to each of D and S. Since all of the net pre-contribution gain was taxed pursuant to IRC §704(c)(1)(B), D and S would have no income under §737. [Treas. Reg. §1.737-1(c)(2)(iv)]

  1. Comprehensive Example 3 – Liquidation of one partner’s interest with marketable securities

 
  1. Facts: Mother (M) forms FLP in 1998 and contributes Exxon stock ($1,000,000 FMV and 0 basis) and real estate ($1,000,000 FMV, $500,000 basis and 0 debt) to the FLP. From 1998-2002, M gifts 10% of the FLP interests to daughter (D) and 10% to son (S). In year 2004, the FLP redeems D’s interest in the FLP by distributing $300,000 of securities to D. The balance sheets on date of distribution are shown below.

  2. Date of Distribution Balance Sheet (Prior to Basis Adjustments)

    Assets Adjusted Basis Pre-Contribution Gain Distribution Fair Market Value
    Exxon Stock 0 1,000,000 1,500,000
    Real Estate 500,000 500,000 1,500,000
    Totals 500,000 1,500,000 3,000,000
           
    Partners      
    M’s Estate 400,000 1,200,000 2,400,000
    D 50,000 150,000 300,000
    S 50,000 150,000 300,000

     

  3. IRC §704(c)(1)(B) Gain: Since D and S “step into the shoes” of M (with respect to their respective FLP interests) for purposes of IRC §704(c), each of them are treated as contributing ten percent of the Exxon Stock and ten percent of the real estate. Since seven years have not elapsed since the contribution of the FLP assets, IRC §704(c) applies to the distribution. M and S are treated as having sold their respective portions of the securities for its fair market value.

   
  1. The distributed securities have built-in gain of $100,000 (10% of $1,000,000). Since S is treated as having contributed 10% of the securities, he has gain of $10,000 under IRC §704(c)(1)(B). Since M is treated as having contributed 80% of the securities, she has gain of $80,000 under IRC §704(c)(1)(B).

  2. S and M increase their basis in their respective FLP interests to the extent of the recognized gain. [Treas. Reg. §1.704-4(e)(1)]

 
  1. IRC §731(c) Gain: As described under Example 1 above, no IRC §731(c) gain is recognized due to IRC §731(c)(3)(B).

  2. IRC §737 Gain: Since the liquidation is occurring within seven years of the property contribution by M, §737 is applicable. No gain should be recognized under IRC §737 for the portion of the property treated as having been contributed by D.

   
  1. If D were treated under IRC §737 as having “stepped into M’s shoes”, D’s excess distribution would be $220,000 ($270,000 less $50,000). The excess distribution is reduced by the $30,000 that D is treated as having contributed. D’s net pre-contribution gain would be $135,000 ($150,000 less $15,000). D must recognize $135,000 of income on the distribution. D’s basis in the distributed securities is increased by the $135,000 recognized gain to $185,000.

  2. If D were treated under IRC §737 as not having “stepped into M’s shoes”, D’s excess distribution would be $250,000 ($300,000 less $50,000). D’s net pre-contribution gain would remain at $135,000 ($150,000 less $15,000). Thus, D would still have to recognize $135,000 of income on the distribution. D’s basis in the distributed securities is increased by the $135,000 recognized gain to $185,000.

           

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