Allocating partnership depreciation between trusts and beneficiaries: a trust owning depreciable property through a partnership may have a larger income tax burden than if it owned the assets directly. This article reviews how partnership depreciation is allocated between a trust and beneficiaries and the trap that may result.

• Author: Ransome, Justin P.

EXECUTIVE SUMMARY

* A trust partner must separately account for its share of partnership depreciation deductions, when doing so would result in a different tax liability than if not separately accounted.

* Sec. 167 provides that the depreciation deduction is to be apportioned between the estate and its heirs, legatees and devisees on the basis of estate income allocated to each.

* Most partnerships do not separately state depreciation, because the only partners with potentially different income tax liabilities would be trusts or estates.

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Many trustees do not know that an unfortunate income tax consequence may arise when a trust owns an interest in a partnership that owns depreciable assets. This consequence is detrimental to the trust and its beneficiaries, because it may result in a larger combined income tax burden on the trust and its beneficiaries than might otherwise result if the trust directly held the depreciable assets. This is due to the way in which the Code allocates a depreciation deduction between a trust and its beneficiaries.

This article reviews how depreciation from a partnership is allocated between a trust and its beneficiaries and highlights the potential trap the allocation can cause when the depreciation deduction flows through a partnership. In general, this treatment will also apply to estates holding interests in partnerships that own depreciable assets. The article will also point out situations in which the treatment differs for estates. (1) This treatment is also generally the same for amortization and depletion deductions that pass through to a trust. (2)

Throughout this article, the following example is used to illustrate the potential problem that may occur:

Example: Trust T was created by A for the benefit of his four children and their descendants. T is a complex trust for Federal income tax purposes whose governing instrument provides that during A's life, Trustee E, in her sole discretion, may distribute as much of T's income for a given year for the benefit of A's four children as she deems necessary for their comfort and support. Any T income not so distributed is to be added to T principal.

On A's death, T is to be separated into four separate shares, one for the benefit of each of the four children. T is required to distribute all trust income at least annually On the death of any of the children, the remaining assets of such child's separate share in Tare to be distributed to such child's descendants.

T is silent as to how E is to allocate receipts between income and principal. It further fails to provide for a reserve for depreciation or the allocation of depreciation. T is governed by state law, which has adopted the Uniform Principal and Income Act (UPIA) in its entirety. T's sole asset is a 50% limited interest in Partnership P. Other interests in P are owned by various members of A's family. P primarily owns and operates car dealerships. Neither T nor its beneficiaries materially participate in P's activities.

For 2006, P filed a Federal income tax return, reflecting the following items of income and expense:

Ordinary business income: $40 million Depreciation: $40 million Other expenses: $10 million P issued a Schedule K-l, Partner's Share of Income, Deductions, Credits, etc., to T, reflecting its share of income and expenses. It listed the following items of income and expense:

Ordinary business income: $15 million

(($40,000,000 - $10,000,000) x 0.5)

Depreciation: $20 million ($40,000,000 x 0.5)

The Schedule K-1 also reflected that P made a $5 million distribution to T. E distributed the $5 million to A's four children, one-quarter to each, during the year.

Under these facts, many trustees might assume that T, after completing its income tax return for the year, is not required to pay tax, because it had a $5 million loss as a result of its P ownership interest. However, these trustees would be surprised to discover that, Her completing T's income tax return for the year, it will have taxable income of $10 million.

Treatment of Depreciation from a Partnership

An understanding of why T has an income tax liability for the year begins with examining how partners must account for their partnership interests for income tax purposes. In general, Sec. 702(a) provides that a partner, in determining his or her income for the tax year, shall take into account separately his or her distributive share of certain classes of the partnership's tax attributes. Sec. 702(a) lists eight classes of partnership income, gain, loss, deduction and credit that must be taken into account separately.

In particular, Sec. 702(a)(7) provides that a partner must take into account separately his or her share of "other items of income, gain, loss, deduction, or credit, to the extent provided by regulations prescribed by the Secretary." Regs. Sec. 1.702-(a)(8)(ii) requires that a partner take into account separately any partnership item that, if separately taken into account, would result in an income tax liability for the partner, or for any other person, different from that which would result if that partner did not take the item into account separately. The phrase "or for any other person" was added to the regulations and applies to tax years beginning after July 22, 2002. It makes clear Treasury's and the IRS's position that a separate statement is required when it affects the tax liability of the partner or "any other person." Thus, in the...