Opportunities and challenges are abounding when optimizing basis and transferring wealth with partnership transactions. Partnerships serve as a popular estate planning tool in the current tax environment. Some of the benefits conferred include valuation discounts, creditor protection, ownership continuity, and family wealth management opportunities. Specifically, in the context of mixing bowl transactions, the IRS attempts to deny gain deferral under the default rules for contributions of property to partnerships. Assuming the taxpayer can meet all the requirements of a successful mixing bowl strategy, the benefits include continued gain deferral and basis optimization for step-ups upon death or acquisition of interests under §743(b).
The Tax-Free Monetization of Equity
An asset’s value, in its most fundamental definition is derived from either 1.) the liquidation value of the asset, and 2.) a projected stream of future cash flows. Two parties may have different liquidity preferences and wish to obtain ownership in assets held by the other. Each party may have different tax exposure in a hypothetical sale of the assets it holds, with one or both being averse to gain/loss recognition. This sets the table for mixing bowls, pun intended. There are many business reasons to engage in a mixing bowl transaction with unrelated parties. This article explores the potential opportunity to swap assets in a mixing bowl to achieve a desired result for legacy planning. When one layers on the practical applications of lifetime gifting at discounted valuations, related party debt, 754 basis adjustments, and basis step-ups at death under IRC 1014, the mixing bowl can play a key role in alleviating some of the tax burden saddled on a second-generation by their parent’s effective estate planning, and perhaps enhance the future cash flow potential of generation-skipping gifts.
The Recipe to Avoid the Mixing Bowl and Disguised Sales
For starters, the transfer of property must avoid the characterization of a disguised sale under §1.707-3(b). There is an important two-year window where substantial distributions/redemptions to a contributing partner have a presumption of a disguised sale, which would accelerate gain recognition. Subsequently, there is a seven-year period in which there must exist a bone fide partnership, prior to the distribution of the precontribution gain or loss property. Ultimately, the anti-abuse rule of §1.704-4(f)(1), ensures the tax result is consistent with the intent of §704(c)(1)(B). In applicable cases, anti-avoidance rules for intercompany transactions under §1.1503-13, further restrict the planning opportunities. The following planning traps also need to be addressed by the tax advisor:
- The existence of a valid business purpose for the partnership and transactions in totality do not provide estoppel against the IRS’ anti-abuse arguments under §1.704-4(f)(1).
- The anti-abuse rule under §704(c)(1)(B), §1.704-4(f)(1), applies, for example, where a partnership shifts substantially all of the economic risks and benefits of an asset to a partner to avoid the gain that would occur if such asset were actually distributed to the partner. Also be aware of the debt-financed disguised sale rules.
- The only exception to the mixing bowl treatment under §704(c)(1)(B), pertains to like-kind property. The contributing partner may receive a distribution of property which is like-kind property if both the asset transferred, and the asset receive meet the definition of like-kind property. In such a case, the gain recognition is calculated a little differently, potentially allowing for some gain deferral to remain.
Seven Years Could Seem Like an Eternity
If contributed property is distributed within seven years of the date of contribution to any partner other than the partner who contributed such property, the contributing partner must generally recognize a taxable gain or loss in the year of distribution. In an attempt to minimize any precontribution gain recognition, tax advisors may seek to merge the partnership into another partnership prior to the proposed break-up or distribution of contributed property.
Utilizing the Regulatory Form of the Merger Statutes
By utilizing the transactional form required by §708, the assets-over form provides a method of postponing the recognition of gain under the general principals of §721, but the new partnership basically steps-in-the-shoes of the old partnership with respect to transferred property subject to §737 precontribution gain rules. The goal is yet to be accomplished, as all the same rules apply with respect to the contributed asset(s) titled in the new partnership. Also, a transfer of partnership interest other than by sale or exchange would cause the transferee to “inherit” the proportionate share of precontribution gain deemed transferred. The merger transaction can provide important estate and income tax planning opportunities including but not limited to modifying rights and obligations of the owners, merging in new assets to increase partners’ basis, shifting depreciation/amortization deductions with new 704(c) layers, and removing the partnership from a high tax state.
Estate Planning Applications
In this illustration, let us assume that A is the Non-GST Exempt Marital Trust of a surviving spouse, 3P is a 3rd party creditor, and B is the credit shelter trust (CST) of the first-to-pass spouse. The partnership (P) uses cash contributed by B, to acquire the debt of the Marital Trust. During the seven year period, the Marital Trust receives an unfavorable 704(c) allocation of depreciation (presumably under the remedial method), and the CST receives the favorable 704(c) allocation, providing a tax shield for its share of economic income.
What if the spouse dies within the seven year period? There is a back-up plan. The Marital Trust should hold the interest of the partnership in another SMLLC (Holdco LLC). Holdco LLC becomes a partnership in the hands of the Marital Trust beneficiaries (assuming multiple) and makes a 754 election. The precontribution gain continues in the hands of the Holdco LLC partnership. The beneficiaries also receive an assignment of the debt owed by the Marital Trust. Since the mixing-bowl partnership (P) does not have a 754 election in place, it is unaffected by the death of the spouse. The note will still have low basis but qualifies for non-recognition treatment upon distribution from the liquidating partnership after the seven year period expires. The desirable effect of this technique is to reserve the Martial Trust’s basis step-up for the intended asset, the installment note, and to avoid the tiered partnership applications of IRC 743(b) which would mitigate the effectiveness of the basis transferred to business A in the mixing bowl transaction.
If the combined estate is large enough, the CST (B) should be able to utilize leverage to maximize the wealth and basis transfer. Preferably the CST would use another trust within the family as a lender, such as the first to die’s ILIT after the insurance policy pays out. The larger the business interest acquired by the CST, the larger the 732(b) adjustment upon liquidation, commonly known as a basis step-up.
There are many different scenarios in which partnership transactions are appropriate to maximize business continuity, gain deferral, and basis transfers. Subchapter K is mired with traps for the unwary to trigger gain recognition such as mixing bowl transactions, transfers involving hot assets (beyond scope of this article), liability allocation provisions, and other anti-abuse regulations which seek to maintain equity amongst partners with respect to tax liabilities and economic interests. Many estate planning strategies are contingent on a future event, a play on probabilities, but the best plans are implemented with a pre-installed back-up plan which assures plan effectiveness.