I once heard it said that death keeps no calendar.[i] That may be, but it can sure unsettle a partnership’s advisers when the decedent is one of the partners and their estate chooses to use a fiscal year[ii] for its taxable year. Let’s see why.
We also know that, in determining their income tax liability, each partner is required to take into account separately on their tax return their distributive share, whether or not distributed to them, of each class or item of partnership income, gain, loss, deduction or credit (“Tax Items”), including the taxable income or loss of the partnership,[v] as computed under the partnership’s method of accounting.[vi]
What’s more, the character of any partnership item included in a partner’s distributive share is determined as if the item were realized directly from the source from which it was realized by the partnership, or incurred in the same manner as incurred by the partnership.[vii]
In computing their taxable income for a taxable year, a partner must look to the taxable year of the partnership that ends within or with the taxable year of the partner.[viii]
Thus, in the case of a partnership comprised entirely of individuals – who are “required” to use the calendar year as their taxable year – the items of partnership income, gain, loss, deduction and credit for the partnership’s taxable year that ends on December 31, in the case of a partnership that uses the calendar year, will be taken into account by the partners for their taxable year ending December 31.
If that same partnership had chosen to use a fiscal year instead, one that ends before the partners’ own calendar taxable year,[ix] the Tax Items for the partnership’s taxable year would be taken into account by the partners for their first taxable year ending after such fiscal year.
For example, assume A is an individual partner in partnership P, and that P’s taxable year is the calendar year. For A’s taxable year ending December 31, 2020, A will compute their taxable income by taking into account A’s share of P’s Tax Items for P’s taxable year that ends December 31, 2020.
However, if P used a fiscal taxable year ending, say, on April 30, A would compute their taxable income for A’s taxable year ending December 31, 2020 by including P’s Tax Items for P’s taxable year that began on May 1, 2019 and ended on April 30, 2020; i.e., the taxable year of the partnership that ends within or with the taxable year of the partner. Thus, a portion of A’s distributive share of P’s taxable income that was “earned” in 2019[x] will be reported on A’s income tax return for 2020, and the tax liability therefor will not be due until April 15, 2021[xi] – the recognition of such income is deferred – although A may have to make estimated tax payments on a current basis in order to avoid any penalty attributable to the inclusion of A’s distributive share in their 2020 tax year.
A partner must also include in taxable income for a taxable year any guaranteed payments for services rendered by the partner to the partnership, or for the partnership’s use of the partner’s capital, that are deductible by the partnership under its method of accounting in the partnership taxable year ending within or with the partner’s taxable year.[xii]
Required Taxable Year
Which brings us to the taxable year of a partnership, which figures so importantly in the determination of a partner’s own tax liability.
Under the Code, (i) unless a partnership establishes, to the satisfaction of the IRS, a business purpose for a particular fiscal year desired by the partnership,[xiii] or (ii) unless the partnership elects to use a fiscal year that provides a deferral period of not more than three months,[xiv] the partnership’s taxable year has to be determined by reference to the taxable year of its partners.
Specifically, a partnership must use as its taxable year the so-called “majority interest taxable year.” In general, this is the taxable year, if any, which on the first day of the partnership’s taxable year[xv] constitutes the taxable year of one or more partners having an aggregate interest in partnership profits and capital of more than 50-percent.[xvi]
If partners owning a majority of the partnership profits and capital do not have the same taxable year, the partnership must adopt the same taxable year as all of its “principal partners.” A principal partner is a partner having an interest of 5-percent or more in partnership profits or capital.[xvii]
If the partnership has no majority interest taxable year, and no principal partners’ taxable year, its taxable year will be the one that produces the least aggregate deferral of income to the partners.[xviii]
Change in Required Taxable Year
Because the relationship of a partnership’s taxable year to the taxable years of its partners is integral to determining when the partners will have to include their distributive shares of the partnership’s Tax Items on their separate returns, a change in the partnership’s taxable year may affect the timing of a partner’s recognition of such Tax Items.
The Code does not mandate that a partnership retain its originally determined “required” taxable year. In fact, it contemplates that a partnership will have to change its taxable year upon a change of its majority interest taxable year.
Such a change, which is deemed to have been approved by the IRS,[xix] may occur as a result of the admission of a new partner, the complete or partial liquidation of a partner’s interest, or upon a transfer of interests among the existing partners. As we will see shortly, it appears that it may also occur following the death of a partner.
In the event of a change in the ownership of a partnership, as a result of which its “majority interest” taxable year also changes, the partnership will not be permitted to retain its current taxable year[xx] without obtaining the approval of the IRS.[xxi]
Moreover, in order to prevent partners from indirectly causing the required taxable year of their partnership to change, presumably for the purpose of gaining some tax advantage, the Code provides that a partner may not voluntarily change their own taxable year without securing the approval of the IRS.[xxii]
What about a change that the partner did not, could not foresee? For example, their own death.
Death of a Partner[xxiii]
A lot happens upon the death of an individual partner, including, for example, the following:
- The partnership’s taxable year will close only as to the deceased partner, for purposes of determining the decedent’s distributive share of partnership Tax Items for the portion of the partnership taxable year ending with the date of death;[xxiv]
- The decedent’s estate (or other successor, such as a living/revocable trust, depending upon how the deceased partner held their partnership interest; the “Estate”), will take such interest with an adjusted basis equal to the fair market value of such interest at the date of the partner’s death, increased by the Estate’s share of partnership liabilities on that date, and reduced to the extent such value is attributable to items constituting income in respect of a decedent;[xxv]
- If the partnership has in effect, or if it timely makes, an election under Sec. 754 of the Code, the Estate will receive a special basis adjustment to its share of the partnership’s basis for its assets, derived from the Estate’s basis for its partnership interest at the date of the deceased partner’s death.[xxvi]
But what about the taxable year of the partnership? Does the partner’s death have any effect thereon?
The Estate as a Partner
A deceased partner’s Estate is a new and separate taxpayer that springs into existence, and begins its first taxable year, upon the death of the partner.[xxvii]
What if the estate’s choice of taxable year results in a change of the partnership’s taxable year? This would be the case, for example, where the decedent had a greater than 50-percent interest in partnership profits and capital. The estate’s selection of a fiscal year would produce a new “majority interest” taxable year – a new required year.
What if the estate did not hold any interest in the partnership, and said interest was held, instead, by the decedent’s formerly revocable trust? As indicated earlier, a trust must use the calendar year as its taxable year; thus, with nothing more, the partner’s death would have no impact upon the partnership’s taxable year.
But what if the executor of the estate and the trustee of the trust elect to treat and tax the trust as though it were part of the estate for purposes of the income tax?[xxxiii] In that case, the trust would not be treated as a separate trust for the taxable years of the estate ending after the decedent’s date of death and before the “applicable date.”[xxxiv] Rather, as part of the estate, the trust would take the estate’s taxable year for its own. Consequently, the partnership in which the trust holds an interest may be subject to a change in its majority interest taxable year.
Change of Taxable Year
This situation raises an interesting issue: how will the partnership know that the Estate’s selection of a fiscal year may have resulted in a change of the partnership’s required taxable year? Why would the partners care?
There are a number of concerns.
For one thing, the change may affect the timing of when the partnership’s Tax Items are to be accounted for by the partners in determining their taxable income.
In addition, a short period return (of less than twelve months) will have to be filed, beginning with the day following the close of the old taxable year and ending with the day preceding the first day of the new taxable year.[xxxv] The partnership does not annualize its taxable income for purposes of preparing this short period return; rather, the return for the short period is made as if that period were a taxable year.[xxxvi]
A number of elections must be made on a timely filed tax return.[xxxvii] What if a partnership is unaware of the change to its required taxable year? In that case, it will likely fail to file the necessary short period return, along with any elections that must be made with such return.[xxxviii] It will also fail to have included with the return, or to have separately filed, any other forms that are due at the same time as the partnership’s tax return. This failure may very well result in the imposition of penalties.
Let’s assume the partnership figures out that the fiscal tax year chosen by a deceased partner’s Estate will require a change in the partnership’s own tax year. Let’s also assume that the partnership acts accordingly.
The Estate remains a partner of the fiscal year partnership, at least for tax purposes,[xxxix] until the administration of the Estate is completed. At that point, the Estate will distribute the decedent’s partnership interest as directed by the latter’s will or trust.[xl]
Because the beneficiaries of a decedent’s Estate will almost certainly be individuals who use the calendar year as their taxable year, the partnership may experience another “new” majority interest taxable year, but will it again have to change its own required taxable year?
In general, the answer is yes. However, because the partnership was required to change to a new majority interest taxable year when the Estate selected its fiscal year, then no further change in the partnership’s taxable year will be required for either of the two years following the year of the change;[xli] meaning, if the Estate’s distribution of the partnership interests occurs beyond this “safe” period, the partnership may be required to again change its taxable year, based upon the taxable years of the beneficiaries.
Can a partnership and its partners develop a plan, or a framework, for anticipating and dealing with the issues posed above?
Of course they can.
Well, they can at least try.
For example, the partnership agreement may require that the partners make their estate plans known to the partnership’s management team.[xlii] It may also require that all proposed transfers of a partnership interest be reported to the partnership, whether or not such transfers are “permitted transfers” under the terms of the agreement.
The partnership agreement may also require that the Estate keep the partnership’s management team informed of the Estate’s plans for selecting a taxable year. Query whether it would be appropriate to require that the partnership’s consent be obtained before such a taxable year is chosen, or that the Estate demonstrate that the proposed taxable year will not require a change of the partnership’s own taxable year?
Finally, it may behoove everyone concerned, even without regard to the issue of the taxable year, if the partnership were simply required to redeem the Estate’s interest.[xliii]
[i] Yes, I realize this is supposed to be a festive time of year. Go tell that to any transactional attorney working through Thanksgiving, Christmas and New Year’s Eve. Or to the estate planners who are formulating plans and preparing documents for those who suddenly feel vulnerable just days before the year-end (or just hours before their ski trip – we weren’t meant to go downhill like that – or their trip to Europe). Bah, Humbug, indeed.
[ii] Generally speaking, a twelve month period ending on the last day of any month, other than on December 31. IRC Sec. 441. A taxpayer’s taxable year is often referred to as their annual accounting period.
[iii] IRC Sec. 761; Reg. Sec. 301.7701-3.
[iv] IRC Sec. 701.
[v] IRC Sec. 702(a). See Sch. K-1, Part III, Line 1. This is exclusive of items requiring separate computations – these are partnership items which, if separately taken into account by any partner, would result in an income tax liability for that partner different from that which would result if that partner did not take the item into account separately. Take a look at all those codes on page 2 of the K-1. Oy.
[vi] See IRC Sec. 448 for limitations on the use of the cash method of accounting, as amended by P.L. 115-97.
[vii] IRC Sec. 702(b).
[viii] IRC Sec. 706(a).
[ix] This would be the case where the partners were able to establish to the IRS that there was a valid business purpose for using a fiscal year. See below.
[x] At least for the period from May 1, 2019 through December 31, 2019.
[xi] The due date for A’s income tax return for the tax year ending December 31, 2020.
[xii] IRC Sec. 707(c); Reg. Sec. 1.706-1(a)(1). Thus, a partner may have to include in their gross income for a year the amount of a guaranteed payment that has properly been accrued by the partnership in that year but which will not be received by the partner until the next year.
[xiii] IRC Sec. 706(b)(1)(C). The deferral of income to partners does not qualify as a business purpose.
[xiv] IRC Sec. 444. Where the partnership’s “required’ taxable year ends December 31, the partnership may elect a taxable year ending September 30 to obtain a three-month deferral. This limited deferral comes at a price. Under IRC Sec. 7519, the partnership must pay the IRS an amount that approximates the amount of tax thereby deferred.
[xv] The “testing date.” IRC Sec. 706(b)(4)(A)(ii).
[xvi] IRC Sec. 706(b)(1)(B)(i) and Sec. 706(b)(4).
[xvii] IRC Sec. 706(b)(1)(B)(ii) and Sec. 706(b)(3).
[xviii] Reg. Sec. 1.706-1(b)(3).
[xix] Rev. Proc. 2006-46. See also IRS Form 1128, Application to Adopt, Change or Retain a Tax Year, Part II, Section B.
[xx] Corresponding to its previously required taxable year.
[xxi] Under IRC Sec. 442. Reg. Sec. 1.706-1(b)(9).
[xxii] Reg. Sec. 1.706-1(b)(8)(ii).
[xxiii] OK, you want something more in keeping with the spirit of the season rather than focused on the death of partner, here’s something that accomplishes both:
SCROOGE: Who are you?
MARLEY: In life I was your partner, Jacob Marley.
SCROOGE: Can you . . . sit down?
SCROOGE: Then do it.
MARLEY: You don’t believe in me.
SCROOGE: I don’t.
MARLEY: Why do you doubt your senses?
SCROOGE: Because . . . any little thing affects them . . .
You may be an undigested bit of beef, a blot of mustard, a crumb of
cheese, a fragment of an underdone potato. There’s more of gravy than of grave
about you, whatever you are! Humbug, I tell you! Humbug!
A Christmas Carol, Charles Dickens.
Of course, although the business continued to be operated under the name of “Scrooge & Marley,” after the latter’s death, it was, in fact, a sole proprietorship.
[xxiv] IRC Sec. 706(c)(2)(A). The partnership’s taxable year does not close as a result of the death of a partner. Reg. Sec. 1.706-1(c)(1).
[xxv] Reg. Sec. 1.742-1. See also IRC Sec. 1014, Sec. 752, Sec. 753, and Sec. 691.
[xxvi] IRC Sec. 754, Sec. 743. The adjustment only occurs with respect to the transferee partner (the Estate).
[xxvii] IRC Sec. 1(e), Sec. 641 et seq.
[xxviii] The formerly revocable or living trust that became irrevocable upon the grantor-partner’s death.
[xxix] IRC Sec. 644. There is an exception to this rule for “qualified revocable trusts” under IRC Sec. 645.
[xxx] As distinguished from the “Estate” as defined herein.
[xxxi] There is no rule comparable to IRC Sec. 644 that applies to estates. As a new taxpayer, the estate must determine when its taxable year will end. In general, the estate chooses its taxable year when it files its first income tax return (IRS Form 1041). The estate’s first taxable year may be any period of twelve months or less that ends on the last day of a month.
[xxxii] From Hamlet’s soliloquy on suicide: “To die, to sleep, to sleep perchance to dream: Ay, there’s the rub. For in the sleep of death, what dreams may come.”
[xxxiii] IRC Sec. 645. The trust must be a qualified revocable trust. Sec. 645(b)(1).
[xxxiv] IRC Sec. 645(b)(2) defines the applicable date as follows: if no estate tax return (IRS Form 706) is required to be field, it is the date which is two years after the date of death; if such a return is required to be field, it is the date which is six months after the date of the final determination of estate tax liability.
[xxxv] For example, assume a partnership’s required taxable year ends December 31. One of the partners dies on October 10, 2020. The partner’s death does not, by itself, change or close the partnership’s taxable year. The deceased partner’s estate chooses a fiscal year that ends on September 30; thus, its first tax year will run from October 11 2020 through September 30, 2021. Assume that the estate’s selection of a fiscal year causes a change in the partnership’s required majority interest taxable year from one ending December 31 to one ending on September 30. The partnership will have to file a short period return for the period beginning January 1, 2021 and ending September 30, 2021.
[xxxvi] Reg. Sec. 1.706-1(b)(8); IRC Sec. 443; Reg. Sec. 1.443-1. Basically, a closing of the books.
[xxxvii] Which may also include extensions of the time prescribed for filing.
[xxxviii] Depending upon the election, the automatic relief provision under Reg. Sec. 301.9100-2 may not be available.
[xxxix] Its status as a matter of state law may be that of a mere economic interest holder. It also may be that the Estate has only those partner-related rights that are necessary for settling the decedent’s estate or administering their property. See, e.g., NY’s LLCL, Sec. 608.
[xl] Don’t forget that the distribution may carry out the estate’s DNI. IRC Sec. 662.
[xli] IRC Sec. 706(b)(1)(4)(B).
[xlii] This is not unusual in the case of S corporations and their shareholders, where it is imperative that the corporation’s shares not be transferred to persons who are not qualified to own such shares. See IRC Sec. 1361(b), (c), (d) and (e).
[xliii] IRC Sec. 736. Fa-la-la-la-la, la-la, la, la.