Inherited Partnership Interest

[jgillespie]

I have a client who inherited a partnership interest in a natural gas company in 2018. Apparently the estate reported all income and paid all taxes in 2018. In 2019 the partnership sold all assets and closed the business. This resulted in an ordinary gain being reported to the estate (and subsequently to my client). No my client still retains an owership in a company that has closed. Is there any way to reduce the ordinary income to account for a step-up in basis of the partnerhsip interest and a subsequently worthless partnership interest. I'm grasping at straws trying to find a way to reduce the tax owed.

Thanks in advance.

[qbteachmt]

Does Form 706 apply? It has the alternative valuation provision. Had it been longer than 6 months since death and transfer to closing?

[jgillespie]

I do not believe Form 706 applies, and a separate firm has completed the Trust return, my client has only received a K-1 from the Trust. The assets within the partnership were actually under contract to sell prior to death, but the sale wsa not completed until several months after the death. My client's family member only owned a small percentage in the partnership overall (roughly 3%).

[qbteachmt]

I saw Estate, not Trust, in the original review. Was the asset already in the trust prior to death? Was the trust an "upon death" trust? Did that "inherited" partnership come from the deceased to your client; or through a trust, and not inherited but distributed? Or, not distributed, because it was worthless while still in the trust?

[jgillespie]

I may have typed Estate instead of Trust. The asset was placed into the Trust upon death. My client inherited it upon death and the interests were placed into the Trust. Once the partnerships sold their assets the funds were distributed to my client per the will. The partnership assets did not receive a step-up in basis upon death. What I am trying to do is see if there is a way to consider the currently held partnership interest as worthless now that all assets were sold and the partnership closed. The distribution my client, and other beneficieries, received was sales proceeds. The partnership sold the gas well then distributed the sales proceeds to the various partners, including the Trust. The Trust then distributed the proceeds to my client in accordance with the will. The gas wells were fully depreciated and the sale resulted in ordinary income reported on the K-1 to the Trust and subsequently to my client. Since the asset that was sold did not receive a step-up in basis, I am hoping to recover some of that via writing off the remaining "worthless" partnership interest. Like I said before, I am grasping at straws trying to find a way to reduce the tax liability on this.

[qbteachmt]

"The distribution my client, and other beneficieries, received was sales proceeds"

Then it's not Worthless; it's Closed. It's not Beneficiaries; they were the Partners. It's time to wrap it up, accordingly, for basis and gain. Or, one part went through the trust to multiple beneficiaries? It seems you have a number of data streams, because "The asset was placed into the Trust" would be the partnership interest? "My client inherited it upon death" seems like something that did not go through the trust, but what is the "it" here? The partnership interest went into the Trust, which had one or more beneficiaries? "the funds were distributed to my client per the will" seems like something did not go through the trust. In other words, anything per the will that bypassed the trust has different treatment.

"The gas wells were fully depreciated and the sale resulted in ordinary income reported on the K-1"

Exactly. That means nothing here applies to the trust or your client. This is Partnership activity.

"to the Trust and subsequently to my client" as the trust beneficiary.

"Since the asset that was sold did not receive a step-up in basis,"

But it wouldn't, anyway, since it was inside of the partnership. It seems your Client has not inherited any asset to have step up; the trust replaced the deceased as the partner. The interest in the partnership is what was inherited, or placed in the trust (I'm a bit confused here, sorry).

So far, anyway, that's what I am following.

[jgillespie]

Here is how the transactions occurred, at least to the best of my knowledge as this estate was very complicated with multiple beneficiaries who each received specific assets.

My client was originally under the impression they inherited 28 gas wells. As we have recently found out, what they actually inherited was a partnership interest in 28 companies that each owned a separate gas well. The percentage of ownership for each partnership was 3% or less. My client and another beneficiary received these partnership interests 50/50. These partnerships were under contract to sell their assets prior to the date of death. The sale was not completed until after the date of death. The partnership interests were maintained by the Trust Company (a separate company was hired to ensure the will was executed properly and that all amounts were properly dispersed). Upon the partnerships selling their assets, the proceeds from the sale were distributed to the beneficiaries. 

I know there is an option when inheriting a partnership interest for a step-up of the outside basis (the partnership must elect to step-up the inside basis, which these partnerships did no). My thought has been if my client inherited the partnership interest, the partnership sold the assets, and distributed the funds, there should be a way (hopefully) for my client to take a deduction for their partnership interest which they are still holding, possibly as a capital loss. At least this is what my research has hinted at, but I can't find anything that is clear cut on this matter.

I hope this cleared up my original post. This whole thing has been confusing as the information my client originally provided has proven to be somewhat inaccurate. 

[qbteachmt]

I don't understand why or how the partnerships selling wells before, during or after death applies to your beneficiary or what you are asking. You are not working on the Partnership's return. If there is some consideration to the deceased partner's interest because of the changing status at any point in time of these deals, I don't see it. The partnership simply carried on as usual, and whatever it did is reported on the K-1(s). Is this a red herring or not? Is this being reiterated because it is used to determine something?

On first pass, it seems that the partnership operated as usual, the deceased's interest passed into a Trust, and later the Trust distributed funds from the partnership interests (as it should) and the Trust would still be the partner. It isn't clear if or when partnership interest transferred from the Trust to the two beneficiaries as individuals. Or, a Trust Company was executor of the will, but there never was a Trust.

@PhoebeRoberts 

I am placing this callout to Phoebe, because I cannot determine what the partnership controlled, what the Trust controlled, and what you determine to have been inherited. It's a bit wordy to follow, because I think some of what is in there doesn't matter. Sorry. Let's see if Phoebe can help.

[PhoebeRoberts]

"This whole thing has been confusing as the information my client originally provided has proven to be somewhat inaccurate."

Amen to that. It's unusual (but not unheard of) for an operated well to accept partnership treatment, rather than to elect out of it. It's *very* unusual for all of someone's operated wells to be using partnership treatment. And it's pretty unusual for the well-level partnership to not either dissolve, or (more likely) be the asset that was sold when the well sold. So my guess is that you're still not getting all the facts, and that your client doesn't actually know all the facts. Any chance you can talk to the trust officer who handles the trust for the Trust Company, or to the CPA who prepared the trust's 1041? Usually if the Trust Company will hold / administer mineral interests, they have an in-house person who is pretty familiar with the tax and title issues.

With only the information currently in evidence, I agree with your conclusion. Here's some sample math:
The whole well is worth $1,000 at DOD, as evidenced by the Purchase and Sale Agreement (PSA is O&G lingo for the sale contract). It's the only asset of the operating partnership, which therefore also has a FMV of $1,000 at DOD. The decedent owned a 1% interest, worth $10.

The trust's inherited stepped-up basis in the partnership is $10. The well sells, and the trust gets $10 of taxable gain (which increases basis to $20), and $10 of cash (which decreases basis back to $10). The trust has $10 of cash, which carries out $5 of DNI when each beneficiary gets $5 of cash. The trust maybe also distributed the partnership interests (which don't carry out any DNI because there's no DNI left), and each beneficiary gets a partnership interest with an outside basis of $5 and a FMV approximating zero. When the partnership terminates, each beneficiary will have a $5 capital loss on termination.

Add a bunch of zeros, and you get the unpleasant result of a massive slug of taxable income, and a massive slug of long-term capital loss. If you can manage to have both the sale and the termination of the partnership in the same calendar year, and the taxable income is capital gain (as opposed to 1254 gain on recapture of depletion and IDCs), they'll offset and it's a less ugly answer. But most of the time, either the timing difference or the ordinary vs capital issue gives you a lousy tax answer. Which is why 754 elections are a thing, and why the election out of partnership treatment is a thing. But not things that your guy has a bit of control over, alas.

[qbteachmt]

Sweet; and thanks for the example(s).