| P R O B A T E & P R O P E R T Y May/June 2007 Vol. 21 No.3 Other articles from this issue |
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Essential Steps to Take After “Finishing” the Estate Plan
Part 2—Post-mortem Planning
By John J. Reddy Jr. and Marc S. Bekerman
John J. Reddy Jr. is counsel to the Public Administrator of New York County and a partner in the New York City firm of Bekerman & Reddy, LLP. Marc S. Bekerman is a partner in the New York City firm of Fleischman & Bekerman, LLP and a member of the Section Council.
In Part 1 in the March/April issue, the authors examined a number of items that should be attended to during the client’s lifetime as part of the creation and implementation of his or her estate plan. In Part 2 the authors will address issues that arise after the client’s death.
Elections Under Code §§ 754 and 732
When a decedent dies owning an interest in a partnership, there may be income tax ramifications relating to the step-up in basis in the decedent’s partnership interest under Code § 1014. This area can be extremely complicated. Therefore, for purposes of this article, the authors will take a somewhat simplified view of the elections available under these Code sections.
A partner’s basis in his partnership interest (“outside basis”) will often differ from the partnership’s basis of the partner’s pro rata portion of the underlying property (“inside basis“). At the time of a partner’s death, his estate will be required to step up (or step down) the estate’s outside basis in the partnership interest under Code § 1014. The partnership is generally not permitted, however, to adjust its basis in its property as a result of the partner’s death. This can create undesirable results when the estate’s new outside basis in the partnership interest differs greatly from the partnership’s inside basis in the underlying property, the effect of which can deprive the estate of the advantages connected with the step-up in basis. These advantages often include a reduction in capital gains on the sale of the partnership interest and deductions related to the depreciation of the partnership’s underlying depreciable property.
Code § 754 allows for the partnership to elect to equalize the “inside basis” with the “outside basis” for this partner only. This is best illustrated by the following example:
Example : Jane contributes $10,000 for a 10% interest in a partnership with underlying assets of $100,000. When Jane dies five years later, the underlying partnership assets are now worth $200,000, resulting in her interest being valued at $20,000 for estate tax purposes (ignore any discounts for minority interests, lack of marketability, and so on). The partnership’s basis in its assets, however, remains at $100,000 (the increase in value is attributable entirely to unrecognized gains). Under these facts, the estate would use its basis of $20,000 to determine its gain or loss if selling its interest to a third party. If the partnership simply sells underlying assets, however, it will recognize capital gain on the sale, and 10% of these gains will be passed through to the estate on Schedule K-1 issued by the partnership in the year of sale. This result would eliminate the primary advantage in allowing the step-up in basis permitted under Code § 1014. By making the Code § 754 election, the partnership’s inside basis also would be adjusted only for the interest held by Jane‘s estate and, as such, no gain would be recognized by the estate on the sale of the underlying assets.
Code § 754 elections are useful tools in many situations. They are especially powerful when the partnership interest consists of depreciable property, such as rental real estate. The Code § 754 election permits the partnership to begin depreciating the property again using the higher basis for the deceased partner, creating additional income tax deductions that then can be used by the estate and its beneficiaries. In short, this election is often beneficial to the estate, and it will generally be in the estate’s interest to seek to have the partnership make the election.
If no Code § 754 election is in effect, the partnership makes the election by filing a statement with its Form 1065 for the taxable year in which the partner’s death occurred. The partnership may decline to make the Code § 754 election, usually based on the increased administration costs incurred as a result of the Code § 754 election because the election will require the partnership to maintain an additional set of books each time a partner dies (the Code § 754 election remains in effect for all partners until it is terminated).
As a result, promptly after the decedent’s death, it is important to
• ascertain whether a Code § 754 election is appropriate for any assets in the estate;
• consult with the partnership to determine whether a Code § 754 election is in effect for the partnership;
• confirm whether the election is desirable based on the appraised value of the interest and the underlying assets of the partnership;
• determine whether the partnership will make the Code § 754 election, if no election is in effect and the estate would benefit from such an election;
• determine whether the partnership will revoke its existing Code § 754 election, if an election is in effect and the estate would be hurt by the election; and
• follow up with the partnership and review the partnership filings with the IRS as appropriate to confirm that the actions taken are both timely and appropriate.
If the partnership does not have a Code § 754 election in effect at the time of the decedent’s death, and the partnership does not intend to make such an election, the estate can make an election under Code § 732 on its own behalf. A Code § 732 election does not require the consent of the partnership, or of the other partners, nor does it have any effect on the partnership or the other partners.
A Code § 732 election applies to any partnership property distributed to the estate within two years of the decedent’s death and will provide a similar result to the Code § 754 election, if that had been made. It is important to note that a Code § 732 election is not as advantageous to the estate, because it only applies to distributions of partnership property to the estate and is not used for purposes of computing the estate’s share of depreciation or gain or loss on a sale of partnership property by the partnership.
The estate makes the Code § 732 election on its appropriate fiduciary income tax return. If the distribution includes depreciable property, the Code § 732 election is made in the year the distribution is received. If the distribution does not include any depreciable property, the Code § 732 election is made in the first year in which the basis of any distributed property is pertinent in determining the transferee’s income tax return. Again, it is important to keep in mind that the Code
§ 732 election only applies to distributions made by the partnership to the estate within two years of the decedent’s death.
Finally, it is important for practitioners to become familiar with Code § 732 because the special basis rules provided therein may apply regardless of whether a Code § 732 election is made and whether the distributions of partnership property are within the two-year period. The basis adjustments provided for in Code § 732 will apply if certain circumstances are present at the date of the partner’s death, such as when the fair market value of all partnership property (other than money) exceeds 110% of its adjusted basis to the partnership.
Appraisals
Early in the estate administration process, it should be determined whether any assets are difficult to value and will require the services of a professional appraiser. If any such assets are identified, the attorney for the estate should become intricately involved in assisting the fiduciary to determine the appropriate appraiser for the property interest and for prompt retention of the expert.
The type of property interest will often determine the type of appraiser. The attorney should also consider how specialized a proposed appraiser should be. Finally, the attorney should review the qualifications of the appraiser with the client. For example, if the estate has an interest in an operating business, the estate should certainly use an appraiser familiar with valuing operating businesses. In addition, the attorney should determine whether, on the facts and circumstances present, it is advisable to identify an appraiser with a specific expertise in the particular area of the business involved.
Certain property interests may require the retention of more than one appraiser to value the interest. For example, if a family limited partnership owns real estate, the underlying real estate must be appraised by a qualified real estate appraiser. Along with the appraisal of the underlying real estate, it is usually appropriate to retain an expert to value the partnership interests owned by the estate, especially if discounts will be sought for minority interests and lack of marketability. Few qualified real estate appraisers are also qualified business appraisers.
Prompt retention of appropriate experts is crucial. Numerous times the authors have reviewed an appraisal, only to have subsequent discussions with the appraiser regarding the report and to ask that a revised appraisal be prepared. Always allow sufficient time for the expert to conduct his or her required research and to prepare a draft of his or her report. Provide the attorney and the fiduciary an appropriate amount of time, as well, to review the proposed report and comment on the draft and, if necessary, allow for sufficient time for revisions to the appraisal. This is especially true when certain appraisals affect other aspects of the administration of the estate, such as when one appraisal is dependent on another appraisal, as detailed above.
Review and Revision of Business Documents
The attorney should review the appropriate business documents early in the estate administration process. These documents include certain filings with the state (certificates of incorporation, for example), agreements between the business and the owners (operating agreements and so on), agreements between the owners (buy-sell agreements, among others), and such other items that are usual in the course of the businesses involved. There are numerous reasons for this review, including determining the implications of the decedent’s death on the business and whether there are any restrictions on the estate’s ability to distribute or sell the interest in the business.
If the decedent was active in the business, it may be necessary to formally replace the decedent in his or her role. For example, if the decedent was a sole manager in a limited liability company, the company may be restricted in its ability to conduct further business until a new manager is appointed. Only by a thorough review of the documents can the attorney determine whether a successor manager is provided for in the operating agreement or, in the alternative, the method for appointing a successor manager. Further, in this situation, it may be appropriate to revise the company’s operating agreement to take into account the decedent’s death (and other important events that have occurred since the existing operating agreement was executed).
Depending on the type of entity and the terms of the governing agreement, the decedent’s death may serve as a terminating event for the entity or require that the entity be terminated if certain actions are not taken within a specific time frame. The attorney needs to ascertain the effect of the decendent’s death as quickly as possible to advise the fiduciary on the appropriate actions to be taken to protect the estate’s interest in the business.
During this review of the business documents, it is also important that the attorney take into account what may be the estate’s ultimate disposition of the business interest. The estate may be limited in its ability to sell an interest by a buy-sell agreement or a right of first refusal. Further, recipients of the interest (either by sale or by bequest) may have certain restrictions placed on their rights as owners. The appraiser should be advised of any such limitations because they may have a dramatic effect on valuation.
At the appropriate time (either during the estate administration or after transfer of the business interest to a beneficiary), the attorney should confirm that any business documents are revised appropriately to take into account any changes of management or ownership.
Conclusion
The estate planning process does not end with the execution of documents and creation of entities. A good attorney will ensure that all necessary steps are taken to ensure the estate plan is effective by frequent follow-up with the client.
