Accounting for the death of a partner: a partner's death raises several tax issues that practitioners should be aware of when doing pre- and postmortem planning for partners and partnerships.

• Author: Ellentuck, Albert B.

The death of a partner can have many federal income tax implications for the partnership, the partner's heirs, the partner's estate, and the partner's final income tax return. This column reviews the income tax rules that come into play upon a partner's death. Using these rules as background, both pre-mortem and postmortem planning will be reviewed.

Determining the Effect on the Partnership Tax Year

The tax year of the partnership closes for a partner whose entire interest in the partnership is terminated for any reason, including death, sale, exchange, or liquidation (Sec. 706(c)(2)).

Example 1: G was a minority partner in Q Partnership, a cash-method, calendar-year partnership. She died on Sept. 1. The distributive share of partnership income allocable to G's interest through the date of death was $80,000; for the entire year, it was $120,000.

G's death causes the partnership year to close with respect to her interest. Accordingly, $80,000 of income is included in G's final income tax return, and the remaining $40,000 of income for the year is reported by the successor(s) in interest to G's partnership interest. The $80,000 allocable to G also would constitute self-employment income reportable on G's final return.

Allocating Distributive Shares of Partnership Income/Loss in the Year of Death

A decedent partner's distributive share of partnership income or loss will be reported on the decedent's final tax return, and the distributive share for the portion of the year during which the interest was owned by the decedent's successor(s) in interest would be reported by the successor(s) in the same manner as in the case of other transfers of partnership interests.

Computing Self-Employment Income in Year of Death

A decedent's self-employment income attributable to his or her share of partnership income for the year of death will be determined on the same basis as for years prior to death, i.e., based on the decedent's status as a partner (general or limited, etc.) and the character of the income.

Determining Income in Respect of a Decedent

The determination of income in respect of a decedent (IRD) can have significant estate tax and income tax implications for the decedent's estate and successor in interest. In general, IRD is income that was earned by the decedent but was not subject to income tax prior to the decedent's death (Sec. 691). More specifically, IRD includes the following types of partnership income:

1. Income earned by the partnership but not recognized for tax purposes as of the date of the partner's death because of the partnership's accounting methods (such as installment sale income and cash-method receivables), regardless of whether it was earned in the year of the partner's death (Woodhall, 454 F.2d 226 (9th Cir. 1972); George Edward Quick Trust, 444 F.2d 90 (8th Cir. 1971)).

2. Sec. 736(a) payments included in the income of a successor in interest to a deceased partner (Sec. 753).

   Items constituting IRD are included in the estate of the decedent as assets and are subject to income tax when received by the estate or other successor in interest.

   Example 2: G was minority general partner in Q Partnership, a cash-method, calendar-year partnership. She died on Sept. 1, when her distributive share of partnership income was $80,000. The distributive share of income for the entire year that was allocable to her interest was $120,000. G's spouse was designated as her successor in interest, and there was no provision for liquidation of her interest.

   The partnership year closes for G on her date of death, so the $80,000 would be includible in G's final return and would not be IRD. The remaining $40,000 distributive share of income from the year of G's death would be reported to her husband. Her share of any accounts receivable held by the partnership at the date of her death would be IRD and would be reported as income by G's spouse when collected by the partnership.

   Using Buy/Sell Agreements

   Service partnerships, such as law firms and accounting firms, often prohibit the interests of deceased partners from being...