Death of a partner

[gleight]

I have an LP with 10 limited partners.  Two of them (my parents) both passed away in 2021.  When completing my 1065 in 2021, I indicated they both passed and it would be their final k-1.  Now in 2022, they dropped off the partner list (as expected).  However the beginning Capital amount does not match the 2021 Ending Capital because my parent's capital "disappeared"?  Is that ok?  Or should I override the beginning 2022 with the ending 2021?  Or should I add their ending 2021 Capital into my Capital account in 2022?  No money changed hands upon their death - I received everything from their estate.

[Mike9241]

sorry for your loss but something should have been done with their ending capital accounts. don't know what the partnership agreement says about death of a partner. that's the first place to look. but I wouldn't be surprised if there was no such agreement. with no agreement, if they died intestate (no will) the state's laws would dictate what happens to their interest. If they had a will that would dictate.  if held in their "living" trusts that would dictate. you may need to see a lawyer because that 2021 return may be incorrect. they can review the documentation and indicate how to  proceed. 

in short, someone(s) inherits their interest. certain adjustments made need to have been made. 

[gleight]

Thanks for the response.  A few clarifications:  The partnership agreement allows limited partners to gift/bequeath their interest to their descendants or other partners; and I was the executor and sole heir to my parent's estate.  The other partners and myself all were in agreement that I would "inherit" my parent's interest in the partnership.

Given all that, I still don't know the answer to my original question -- what do I do with their Capital balance at the end of 2021 that did not transfer to 2022?  I appreciate any insight.  

[Rick19744]

You have three issues to address:

• The capital account matter is straight forward.  You just "transfer" your parents capital to your K-1.
  • This is just an internal "bookkeeping" matter
  • On your parents final K-1 you would show a decrease on the respective K-1 in Section L other increase (decrease) line; a decrease.
  • On your K-1 you would show this same amount on your K-1 same line; an increase.
  • This should keep your balance sheet in balance.
• The bigger issue (2nd issue) is updating your tax basis (outside basis).
  • Because you inherited this interest from your parents, you need to adjust your tax basis for the FMV of the interest that you inherited.
  • Since you will need to support this adjustment, this means that you technically need to value the partnership.
• Since the taxpayer has the burden of proof, it's best to have this done ASAP.  
• You may want to contact a tax professional who can give you some recommendations on who can handle this valuation matter for you.
• The third issue is determining the timing of this transaction.
  • This will require an understanding of the "inheritance" process.
  • What legal documents were drafted
  • What do these documents say; when and how property is disbursed
  • Does the estate get a k-1 until the partnership interest is transferred
  • All this means potentially a few short period K-1's

[KevinP1]

I have a similar issue, and understand what needs to be done; just not sure how to do it in TT Business. 1 of our 11 limited partners died, and his share has now gone to his spouse.Our partnership owns land with pine trees, so both the land and the trees get a FMV adjustment .  How do you reflect the FMV basis adjustment, such that when we cut/sell some trees, her K1 reflects a lower capital gains than the other partners?

[RobertB4444]

If the partnership owns the property and the income is earned at the partnership level then capital gains are determined by percentage of ownership.  If you want her capital gains to be less than the other partners then you want her percentage to be lower.  There isn't any other way to change that.

You can change the amounts paid out and paid in by partner.  You can also adjust each partners basis in the partnership.  You do all those things at the 'partner information' level.  But that won't adjust capital gains.  That's not the way partnerships work, unfortunately.

@KevinP1 

[KevinP1]

I guess I should’ve been more specific. What I need to change is her cost basis in the trees, for example. Due to the death of her spouse, her cost basis would now be the fair market value of the trees on the date of his death, whereas everyone else must use the original cost basis. So when we sell some of those trees, her net capital gain would be less than theirs, but I don’t know how to adjust just her cost basis.

[RobertB4444]

On the death of her spouse she receives a step up in cost basis of everything that he owned on his death.  The thing is he didn't own the trees.  The partnership did.  He owned a share of the partnership.

So what you need to adjust is her basis in the partnership.  That adjusts to the fair market value at his date of death.  And if she were to sell that partnership interest then she would be able to use that stepped up cost basis.  You adjust this through the partner information section of TurboTax.

Determining the fair market value of your partnership will probably involve using the calculation you have for the land and the trees.  It will also involve whatever else the partnership owns.  But it won't change her share of the net capital gains.

@KevinP1 

[KevinP1]

Thanks so much for your detailed responses, and while it makes perfect sense, it still raises questions. Let's assume the following: 10 partners, each with a 10% share. Only assets are land and trees, with book values of $100k and $0k respectively, and FMV of $300k and $300k. So, his partnership capital account/basis is $10k, but her FMV basis is now $60k. If we were to clear cut the trees and receive $300k, each of the other partners would have a $30k net capital gain. Would she also? 

And taking it one step further, assume the partnership keeps the cash, and sells the entire partnership for $600k, its FMV. She has no net gain overall, so does she pay taxes on the tree capital gain, and then have a $30k loss on the partnership sale? That doesn't seem logical to me.

[RobertB4444]

Any activity inside the partnership is divided on a percentage basis.  So, in your example, the trees are clear cut and each of the 10 partners receives $30K - including her.  She receives the same as her spouse would have had he lived and she is taxed exactly as all of the other partners are.

The clear cutting of the trees may reduce the value of the partnership and reduce everyone's basis but that would be an issue for another day, I suppose.

But the second part of the example is the one that is important.  The entire partnership is sold for $600K, netting each partner $60K.  All of the partners have a capital gain on the sale of the partnership of $50K - $60K minus their basis of $10K - except her.  Her basis was increased to $60K at his date of death so the sale of her partnership interest is a wash - she pays no taxes.  

That is the tax benefit that she received from his death.  It doesn't change the activity inside the partnership at all.

@KevinP1 

[KevinP1]

So, to summarize, if we sell the partnership for $600k without cutting trees, she receives $60k and pays no taxes. But if we cut trees, keeping the money inside the partnership and then sell the land for $300k, she also receives $60k total, but pays taxes on $30k due to cutting the trees?

[Rick19744]

@KevinP1 

This becomes somewhat complicated and I can't tell you how to do that in TT since I am not in a Windows environment.

A number of things that occurred here:

• What has happened here is that the spouse inherited her husband's inside basis in the partnership.
• The spouse also received a step-up in the partnership basis to the FMV at the date of death.
• This creates a discrepancy between inside and outside basis.
• The partnership needs to make a Section 754 election
• There also needs to be information reporting (statements) for the requirements of Section 743
• Using your example, the partnership will need to step-up the trees and the land accordingly
  • The land step-up will most likely just sit on the books until you eventually sell it.  At this time the spouse will receive a normal allocation of the capital gain, and then, a capital loss for the step-up component.  This will need to be specially allocated on her K-1 currently box 13 code V (along with some notes indicating that this is a Section 754 step-up allocation).
  • The trees step-up will be handled the same way, although this will be more complicated.  You know the total step-up, but you will then need to determine the step-up portion of the trees that are sold.  Once this is determined, the special allocation is handled just as noted in the land bullet.
• Since the taxpayer always has the initial burden of proof, you will need to make sure that you have documentation as to how the step-up was computed and then the methodology of the split between land and trees.
• You may need to assistance from a tax professional to get you aligned on the right path for the current year and going forward. 

[KevinP1]

Rick, thank you for the detailed explanation. I am aware of the 754 and 743 requirements. So, if we were to clear cut the trees, she would report the same gain as with other partners in box 9a (LTCG) but that would then be partially offset by the Box 13 code V amount? 

[Rick19744]

Correct.

That is how Section 754 works.  Over time, the inside and outside basis for the trees component will equalize; when the Section 754 portion has all been taken, which is when all the trees are sold or the property is sold.

[KevinP1]

Thanks.