Partnership Terminations: Breaking Up is Hard to Do

The Internal Revenue Service’s attacks on family partnerships are testaments to their popularity and value as estate planning vehicles. As is true of revocable trusts, family partnerships follow a life cycle of formation, funding, operation and dissolution. Not too many years ago, the Delaware Tax Institute’s sessions on family partnerships focused on the birth of family partnerships, addressing formation and funding issues. Recent professional commentary, including that presented at this Delaware Tax Institute, has largely shifted to the difficult teenage years. Family partnership “parents” are being forced to defend the family partnership from the seemingly relentless barrage of Internal Revenue Service theories devised to overcome valuation discounts.

The successful defense of the family partnership is not the end of the road. At some time, our clients’ family partnerships will mature and no longer serve the objectives for which they were formed. Or, perhaps, for whatever reason, a family member will withdraw from the family partnership. This material is directed to the tax consequences of terminating interests in family partnerships. As tax sage Neil Sedaka once wrote, “breaking up is hard to do.”

Consider a common case. Surviving parent established a family partnership to hold significant wealth, in the form of real estate and marketable securities. During surviving parent’s life, surviving parent made gifts of interests in the family partnership to surviving parent’s two children. Following the death of the surviving parent, the Internal Revenue Service examined the parent’s federal estate tax return. The examination concluded with an agreed 30 percent discount from net asset value for the partnership interests included in surviving parent’s estate. During the course of the estate administration, the children begin to develop irreconcilable differences concerning the investment strategy for the family partnership. Following receipt of the closing letter, the children decide to terminate the partnership and distribute the assets to themselves.