Tax Rules for a Partnership Interest in an Estate or Trust

When a partnership interest is transferred to an estate or trust upon a partner’s death, a fiduciary is appointed to manage its tax implications. This executor or trustee must navigate the intersection of partnership operations, estate tax law, and fiduciary income tax rules. The estate or trust does not operate like an individual partner, and the fiduciary must understand the specific path income and tax liabilities will follow. These responsibilities cover the initial transfer, ongoing management, and eventual distribution or sale, with each stage having distinct tax consequences.

Initial Consequences Upon a Partner’s Death

The death of a partner closes the partnership’s tax year for the decedent on that date. As a result, the decedent’s share of partnership income, gains, losses, and deductions is prorated. The portion of these items up to the date of death is reported on the decedent’s final personal income tax return, Form 1040. The share of items for the period after the partner’s death is reported by the successor, such as the estate or trust.

Legally, the partnership interest transfers to the decedent’s estate for probate administration unless it was previously titled in a trust. The fiduciary, whether an executor or trustee, steps into the shoes of the deceased partner and becomes the new partner for tax and legal purposes, assuming all rights and responsibilities associated with that interest. The partnership agreement is a governing document in this transition, and the fiduciary must review it to understand provisions like mandatory buyout clauses or restrictions on successor partners, as it dictates many subsequent actions.

Tax Basis Implications for the Estate or Trust

The estate or trust must establish the tax basis of the inherited partnership interest, which involves two types: outside and inside basis. The outside basis is the fiduciary’s basis in the partnership interest itself and is adjusted to the fair market value on the partner’s date of death. This “step-up” in basis can eliminate the built-in capital gain on the appreciation of the interest up to that point.

While the outside basis is adjusted, the inside basis, which is the partnership’s tax basis in its assets, is not automatically changed. A disparity arises when the estate has a high, stepped-up outside basis, but the partnership operates with a low, historical inside basis. This mismatch can create adverse tax consequences, as the sale of a partnership asset could generate a large taxable gain that flows through to the estate.

To resolve this disparity, the partnership can make a Section 754 election. This election is made by the partnership, not the estate, by attaching a statement to its tax return, Form 1065, for the year the partner died. Once made, the election allows the estate or trust to benefit from a special basis adjustment that increases the inside basis of the partnership’s assets, but only for the inheriting partner.

The effect of this adjustment is to align the estate’s share of the inside basis with its new outside basis. For example, an estate inherits a 50% interest in a partnership valued at $1 million. The partnership owns a property worth $2 million with a tax basis of $500,000. Without the election, a sale of the property would create a $1.5 million gain, with $750,000 flowing to the estate. With a Section 754 election, the estate’s share of the inside basis is adjusted from $250,000 up to $1 million, eliminating its share of the taxable gain. The election is binding for future years, so the decision to make it should be considered carefully by the partnership’s management.

Taxation of Partnership Income to the Fiduciary

Each year, the estate or trust holding a partnership interest receives a Schedule K-1 from the partnership. This form details the fiduciary’s share of the partnership’s income, deductions, and other items, which must be reported on the estate or trust’s income tax return, Form 1041. The taxation at the fiduciary level is governed by the concepts of Income in Respect of a Decedent (IRD) and Distributable Net Income (DNI).

A portion of the partnership interest’s value may be classified as IRD. This refers to income the decedent was entitled to but had not received before death, such as accounts receivable for a cash-basis partnership. A key characteristic of IRD is that it does not receive a step-up in basis at the date of death. Consequently, when the estate or trust receives payments for IRD items, it is fully taxable as ordinary income.

The income reported on the Schedule K-1, including any IRD, becomes a component of the estate or trust’s DNI. DNI is a calculation that determines the maximum amount of taxable income that can be passed from the fiduciary to the beneficiaries in a given year. When the fiduciary makes distributions, that DNI is carried out, making the distributions taxable to them. If no distributions are made, the income is taxed at the trust or estate level, which has compressed tax brackets that reach the highest marginal rate much faster than for individuals.

Fiduciaries also face challenges with the passive activity loss (PAL) rules. If the partnership is engaged in a trade or business in which the fiduciary does not “materially participate,” any losses generated may be suspended. For a trustee or executor to meet the material participation standard, their involvement must be regular, continuous, and substantial, which can be a difficult threshold to meet.

Distributions from the Estate or Trust

The fiduciary has the authority to make distributions to the beneficiaries, and the tax consequences depend on what is being distributed—cash or the partnership interest itself. The trust document or will provides instructions for when and how these assets should be passed to the beneficiaries.

Distributing Cash

When the fiduciary distributes cash to a beneficiary, the taxability of that distribution is determined by the estate or trust’s Distributable Net Income (DNI). If the estate or trust has DNI, the cash distribution will carry that taxable income out to the beneficiary. The beneficiary will receive a Schedule K-1 from the estate or trust, not from the partnership, detailing the income they must report. The estate or trust receives a distribution deduction on its Form 1041. This mechanism ensures the income is taxed only once, either at the fiduciary level or the beneficiary level.

Distributing the Partnership Interest (In-Kind)

Instead of distributing cash, the fiduciary might distribute the partnership interest itself. This in-kind distribution is a non-taxable event for both the estate or trust and the beneficiary, with no gain or loss recognized at the time of the transfer. The beneficiary who receives the interest takes it with the same tax basis that the estate or trust had, a concept known as carryover basis. The beneficiary then becomes the direct partner and will begin receiving the annual Schedule K-1 from the partnership.

Sale or Liquidation of the Partnership Interest

If the fiduciary decides to dispose of the partnership interest rather than distribute it, there are two primary methods: selling it to a third party or having the partnership liquidate it. The tax consequences are determined by comparing the proceeds received against the fiduciary’s adjusted outside basis in the interest.

In a sale to an outside party, the fiduciary calculates the gain or loss by subtracting the adjusted outside basis from the sale price. The character of that gain or loss is capital. However, a portion of the gain may be recharacterized as ordinary income if the partnership holds “hot assets,” which include unrealized receivables and substantially appreciated inventory.

Alternatively, the partnership can liquidate the estate’s or trust’s interest directly. Payments made in liquidation are divided into two categories: payments for the interest in partnership property and other payments. Payments for property are treated as distributions, which can result in capital gain or loss. Other payments are treated as either a distributive share of partnership income or as guaranteed payments, both of which result in ordinary income to the recipient. The structure of a liquidation can offer more flexibility than a sale, but the tax outcomes can be more complex.