Addressing the Unknown: What to Do When a Partner Passes

When monumental life changes occur, it is all about the transition. Transfers at a partner’s death come in different forms. At the 59th Annual Heckerling Conference, presenter Paul Lee explored the different transitions by comparing ice cream flavors to help visualize transition levels. 

• Plain vanilla – The deceased partner’s interest passes to the decedent’s estate. 
• Chocolate - Intentionally Defective Grantor Trust (IDGT) owns partnership interest; upon the grantor’s death, there is a deemed transfer to a non-grantor trust.
• Chocolate Chunk - Decedent and his IDGT own interests in a disregarded entity as partners. Upon the decedent’s death, the formerly disregarded entity becomes a partnership for income tax purposes, in which the decedent’s estate and the now non-grantor trust are partners.  

Transfers of Partnership Interests  

Some partnership interest transfers (or deemed transfers) result in the recipient receiving an outside basis adjustment under Sec 1014, others are eligible to receive an inside basis adjustment under Sec 743(b), and some can receive both. 

Partnership Interest Under the Decedent’s Name 

When the partnership interest is in the decedent’s name and the partner dies, the interest passes to the decedent’s estate and the outside basis is adjusted to the date of death value under Sec 1014. A Sec. 754 election can also be made to step up the inside basis of the decedent’s allocable share of the partnership assets under Sec 743(b). Furthermore, there is no gain recognized. These same rules apply if the partnership interest is in the decedent’s revocable trust at the time of his death and the interest is a deemed transfer to a non-grantor trust. 

Partnership Interest Owned by an IDGT 

When an IDGT owns a partnership interest, and the grantor dies, there is a deemed transfer to a non-grantor trust. The trust is not entitled to an outside basis adjustment, but it is eligible for an inside basis adjustment under Sec. 743(b). According to Paul Lee’s literal interpretation of the law, since there is no outside basis adjustment at death, gain will be recognized if debt exceeds the basis. 

Partnership Interest Owned by the Decedent and IDGT 

If the decedent and his IDGT own the partnership interest, it is considered a disregarded entity. Upon the decedent’s death, it is a transfer of property, not a transfer of a partnership interest. A partnership forms between the non-grantor trust and the decedent’s estate at death. The estate’s share receives an outside basis adjustment, and the non-grantor trust share retains the same basis it had in the hands of the grantor. Since it is not a transfer of partnership interest, there is no inside basis adjustment or gain recognition. 

Disposition of Property Regulations 

Paul Lee cited the Crane and Tufts cases and several regulatory sections regarding property disposition and the transfer of a partnership interest.  

•  Treas. Reg. Sec. 1.1001-1: States that nonrecourse debt is included in the basis, and the disposition of property with nonrecourse debt over the basis triggers gain recognition. 
• IRC Sec 752(d): Makes clear that the amount realized from the sale or other disposition of a partnership interest includes the amount of partnership liabilities from which the transferor is discharged upon the sale or other disposition.   
• Rev. Rul. 2023-2:  Confirms that when the grantor of an IDGT dies, the trust assets are not entitled to a basis adjustment to the date of death value. 
• Rev Rule 77-402, Treas Reg Sec 1.1001-2(c), Ex5: States that the conversion of a grantor trust to a non-grantor trust while the grantor is living is considered a deemed transfer of the trust property. If the property is encumbered by nonrecourse debt, and the debt exceeds the basis of the transferred property; then the grantor recognizes gain to the extent of that excess.

In Lee’s opinion, when a grantor trust converts to a non-grantor trust because of the grantor’s death, this also triggers gain recognition. 

Outside Basis Under Treas 1.742-1 

Another taxable event occurs when a partnership interest is transferred in a gift when debt exceeds the basis. The transfer is considered part gift/ part sale, and the donor recognizes a taxable gain, for the amount the debt exceeds the basis. 

Outside basis determines the amount of money that can be distributed to a partner without triggering gain, the extent that losses are deductible by the partner, and for this discussion, how much gain or loss a partner will recognize upon a sale or transfer of a partnership interest. 

Lee’s discussion on Sec 743(b) inside basis adjustment focused on the allocation between asset classes, and some problems with the adjustment. The problems include:  

• The administrative burden 
• The irrevocability of the election
•  The possibility of the loss of inside basis.  

A mandatory inside basis adjustment is required if there is substantial built-in loss, defined as a built-in-loss of more than $250,000 of the total fair market value of such property.

Interestingly, the new Final Reg. Sec. 1.6011-18 issued January 10, 2025, requiring reporting of certain partnership related-party basis adjustments in transactions of interest, specifically exclude transfers by reason of the death of the partner.

To learn more about panel discussions at the annual Heckerling Institute conference, visit our insights page.