Partnership's tax year now terminates for deceased partner.

The Taxpayer Relief Act of 1997 (TRA '97) contained a provision that directly affects the amount of partnership income reportable by a deceased partner and his estate or other successor-in-interest for the year of death. Sec. 706(c)(2)(A) was amended to provide that, when a partner dies, the partnership's tax year will close with respect to the deceased partner for income tax purposes. The partner's share of partnership income up to the date of death will now constitute income reportable on his final income tax return. This change is effective for partnership tax years beginning after 1997.

Before the TRA '97, the tax year of a partnership normally did not close with respect to a deceased partner in the year of death (unless, of course, the partner died on the last day of the partnership's tax year). Thus, a deceased partner's final income tax return ordinarily did not reflect any partnership income for the partnership tax year that began during the partner's tax year of death. Rather, the deceased partner's successor-in-interest (normally, his executor), who was the successor partner for income tax purposes at the end of the partnership's tax year, would report the full year's share of income attributable to the deceased partner on the successor's (estate's) income tax return (Regs. Sec. 1.706-1(c)(3)(ii)).

In the past, this treatment often posed serious problems relating to the deceased partner's final income tax return. For example, the deceased partner may have incurred substantial medical and hospital expenses in the year of death, and, in addition, may have made large payments before death for taxes, interest, charitable contributions and other expenses that could constitute deductions on his final income tax return. These deductions would have been totally wasted, as no partnership income was reported on the deceased partner's final income tax return.

Although the new law eliminates this problem, it may cause the opposite problem--the "doubling-up" or "bunching" of more than one year's partnership income on the deceased partner's final income tax return. For example, when the partnership has a fiscal (rather than a calendar) tax year, the deceased partner's final return could reflect his share of partnership income for the full fiscal year that ended before his death, as well as for the short partnership tax year that now ends on his death.

Under the old law, the partnership's tax year closed with respect to a deceased partner only if the partner's entire interest was sold or exchanged pursuant to an agreement existing at death. By closing the tax year automatically upon death, the new law reduces the need for these agreements.

How is the deceased partner's income calculated for the short partnership tax year ending on his demise? The new law does not suggest how the amount of this income will be determined. Undoubtedly, methods similar to those used to determine the final year's share of corporate income of a deceased S shareholder in the year of death should provide adequate guidance on how to solve this problem--for example, the pro rata daily method or an alternative actual method.