Family limited partnerships and charitable deductions.

Husband H and wife W form a family limited partnership, FLP, to which they contribute their marketable securities portfolio in exchange for interests in FLP. Because the portfolio is highly appreciated, it is "built-in gain" property. Thus, H and W have low outside bases in their partnership interests. The couple, who file jointly, have made gifts of limited partnership interests to their children. When evaluating their year-end tax plans, H and W decide that they would like to make a sizable gift to charity using appreciated capital assets, but the charity does not wish to hold an interest in FLP. Since the couple no longer holds any securities directly, they must transfer some of the securities currently held by FLP to the charity.

For H and W to benefit from the entire charitable deduction, the donation should be structured in one of two ways:

1. FLP distributes the securities to H and W, who subsequently donate them to charity; or

2. FLP donates the securities directly to charity.

Partnership's Donation

A partnership does not deduct charitable contributions in determining its taxable income. Instead, the charitable deduction is a separately stated item deducted by the partners (Sec. 702(a) (4), which ensures that the deduction is subject to limits applied at the partner's level. Even though the partnership claims no deduction, each partner's outside basis must be reduced by his share of nondeductible partnership expenditures pursuant to Sec. 705(a) (2) (B). The partners' collective outside basis reduction equals the tax basis of the property donated, not its fair market value (FMV). (See Rev. Rul. 96-11 and "Even Charitable Contributions by Partnerships Can Be Complex!," 8 Journal of Partnership Taxation 80 (Spring 1991).)

Tax attributes associated with charitable deductions must be allocated to the partners. Sec. 704(c) requires partnerships to allocate income, gain, loss and deduction attributable to the pre-contribution increase or decrease in the value of contributed property (the built-in gain or loss) to the contributing partner, as shown below.

Example: Partner A contributes security X to FLP. The security is worth $10 on the date of contribution and has a $2 tax basis. Partner B contributes security Y with a $10 FMV and a $7 tax basis. If FLP immediately donates X to charity, the tax results would be as follows:

Forming the partnership

* A's outside basis is $2 and B's outside basis is $7 (under Sec. 722).

Partnership donation

* A's outside basis is reduced by $2 to $0 (under Sec. 705(a) (2) (B)).

* The charitable deduction is allocated entirely to A (under Sec. 704(c)).

* B's outside basis is unchanged.

Partnership Distribution Followed by Partner's Donation

If the security's FMV is unchanged from the date of its contribution to the partnership, the tax results would be identical if security X were distributed to A, who makes the donation himself; the distribution would reduce A's basis by FLP's basis in the distributed security and A would claim a charitable deduction equal to the security's FMV.

(This identical result reflects the fact that partnership transactions involving built-in gain property are taxed in accordance with the aggregate theory of partnership taxation.)

Caveats

* Subsequent appreciation: If an asset further appreciates between the time it is contributed to a partnership and the time it is donated to charity, the tax results between these alternatives may differ. A distribution of the security to a partner before its donation presumably allocates all of the post-contribution appreciation to the distributee partner and, hence, the entire charitable deduction. In contrast, absent a special allocation under Sec. 704(b), a partnership-level donation would split the post-contribution appreciation among all of the partners and the allocation of the charitable deduction would reflect this split.

* Partner's death: If a partner dies before the partnership's tax year ends the decedent's successor-in-interest usually reports that partner's entire share of the partnership's income and loss for the year of death on the successor's return, including activity occurring before death. The decedent reports none of the activity on his own return. This may lead to unexpected and undesirable results. For this reason, it is important to plan for the possible death of a partner. Otherwise, the benefits of deductions accruing ratably throughout the year, or before the decedent's death, may be denied to the decedent (Est. of Applebaum, 724 F2d 375 (3d Cir. 1983)).

If H dies before the partnership's tax year-end, there are several planning techniques available to ensure that he benefits from the charitable deduction. These include establishing a buy-sell agreement (before H's death) so that H's partnership interest is sold, thus closing the partnership's tax year; distributing H's partnership interest to W; or designating (before H's death) W as H's successor to the partnership interest. Since two of these options require action before death, they may be of limited practical use. These ideas are more fully explored in Tax Clinic, "Planning for Distribution of Partnership Interest at Death," TTA, Oct. 1995, p. 601.

As described, Sec. 704(c) requires partnerships to allocate deductions associated with donations of built-in gain property to the contributing partner. Further, a decedent's share of partnership income and expense generally must be reported by his successor. Absent advance planning, this mandatory allocation denies charitable deductions to a partner who dies in the year a partnership donates built-in gain property that he contributed to the partnership; the deceased partner's share of the charitable deduction is reported entirely by his successor.

Section 11581 of H.R. 2491 would have amended Sec. 706(c) (2) so that a partnership's tax year would close on a partner's death; this amendment would have rectified the hardship imposed by the current rules, effective for partnership tax years beginning after 1995. However, H.R. 2491 was vetoed by President Clinton on Dec. 6, 1995.

Summary

The tax results of a partnership-level donation are identical to a distribution of the asset to a partner, followed by a partner-level donation (subject to the exception for subsequent appreciation noted above), provided that the partner lives through the partnership's tax year-end. In contrast, the tax results differ markedly if a partner dies during the partnership's tax year. Therefore, tax considerations may dictate that donations of built-in gain property be accomplished through a partnership distribution followed by a partner-level donation, when the built-in gain is significant or a partner's health is questionable and the contributing partner wishes to ensure that he will benefit from the entire deduction.