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Has Your Family Partnership Become a Family Liability?

September 17, 2014 Business & Tax Blog Estate Tax

Non-controlling family partnership interests with limited marketability have long been discounted for federal gift and estate tax valuation purposes, reducing their deemed fair market value and the gift and estate tax attributable to such interests. The income tax tradeoff for a partnership interest held until death is that the income tax basis in the partnership interest is lower to the inheritor because that tax basis is automatically adjusted to fair market value. A lower tax basis potentially creates more taxable gain when the asset is later sold.

The tradeoff was traditionally tolerated because the federal gift and estate tax rate was higher than both ordinary income and capital gain tax rates. Since the federal estate and gift tax exemption increased to over $5 million per individual and over $10 million per married couple a few years ago, however, many families’ estate tax exposure has disappeared. For families with no ongoing estate tax exposure, valuation discounts that once made their family partnerships “tax assets” may now make the partnerships “tax liabilities.” Even though they may no longer have estate tax to avoid, the families are still left with a lower mark-to-market tax basis and potentially more future taxable gain after a family member dies.

Also, with recent changes in the law, the highest marginal federal income tax rate and the federal estate tax rate are now very close. For assets that produce ordinary income when sold for again, this reduces or reverses the estate-income-tax-rate arbitrage even for families with continuing estate tax exposure.

Should families unwind their family partnerships?

For families affected by these factors, it is worth asking the question anew. The question should be evaluated in the context of the many advantages and disadvantages–including non-tax factors–that characterize family partnerships.

In contrast, families with ongoing estate tax exposure whose family partnerships hold assets that will likely produce capital gain when sold are less likely to be affected by these factors. Their family partnerships likely remain effective estate planning tools.

E. John Wagner, II