Marital Trusts and the Sec. 754 Election

Abstract

If either a qualified terminable interest property (QTIP) trust or a marital general power of appointment owns a partnership interest at the time a surviving spouse dies, the partnership will not be eligible to adjust its assets' "inside" basis as a result of the death under Sec. 754. This is because the QTIP is the partner, not the surviving spouse, and a trust cannot die. Nevertheless, the partnership will be able to step up the inside basis of the partnership interest held by the marital trust. An "exchange" that qualifies for a step-up under Sec. 754 will occur when the marital trust distributes the partnership interest to the trust's beneficiaries. The main problem is the often typical, significant time delay. A distribution of the marital trust as soon as possible after the surviving spouse's death is always advantageous.

If either a qualified terminable interest property (QTIP) trust or a marital general power of appointment (GPA) owns a partnership interest at the time a surviving spouse dies, the partnership will not be eligible to adjust its assets' "inside" basis as a result of the death under sec. 754, even though the value of the interest will be included in the spouse's taxable estate under sec. 2044. This is because the QTIP is the partner, not the surviving spouse, and a trust cannot die.

Background

Under sees. 754 and 743, a partnership can adjust the inside basis of its assets on the sale or exchange of a partnership interest or on a partner's death.

Example: Partnership P is owned 60% by J and 40% by K. P owns marketable securities with a $100,000 basis and a $1 million fair market value ( FMV). When J dies, his partnership interest is worth $600,000, creating an additional $540,000 "asset" ($600,000 FMV at death -Js 60% portion of the $100,000 inside basis).Thus, a sec. 754 election increases the total basis of the marketable securities (in P's hands) from $100,000 to $640,000. The marketable securities are later sold for $1.1 million. As a result, P incurs only $460,000 in gain ($1,100,000 - $640,000), rather than $1 million.

The QTIP trust provisions were enacted in 1981 for decedents dying after 198I.They included sec. 2044, under which the assets transferred to a QTIP trust on the first spouse's death are included in the surviving spouse's estate, as long as the latter had a qualifying income interest for life, even if he or she had no power or control over the trust property. If the marital trust is a GPA trust, the surviving spouse has the power to appoint the entire trust interest in favor of himself or herself, his or her estate, his or her creditors, or the creditors of his or her estate. A GPA trust is includible in the surviving spouse's estate under sec. 2041.

The Marital Trust Dilemma

The triggering event in the example above is the partner's death. If the partnership interest had instead been owned by a marital trust, there would have been no trigger, because the partner (i.e., the trust) cannot die.This is true even though the surviving spouse (as the marital trust's beneficiary) will have to include the property in his or her taxable estate under sec. 2044 or 2041.Thus, the partnership may not be eligible to make a sec. 754 adjustment to basis, because there has not been either a transfer of a partnership interest by a sale or exchange, or a partner's death.

Potential Alternative

Nevertheless, the partnership will be able to step up the inside basis of the partnership interest held by the marital trust, but not as of the spouse's date of death. Instead, an "exchange" that qualifies for a step-up under sec. 754 will occur when the marital trust distributes the partnership interest to the trust's beneficiaries. This is based on sec. 761(e), Distributions of partnership interests treated as exchanges, which states:

Except as otherwise provided in regulations, for purposes of

(1) section 708 (relating to continuation of partnership),

(2) section 743 (relating to optional adjustment to basis of partnership property), and

(3) any other provision of this subchapter specified in regulations prescribed by the secretary, any distribution of an interest in a partnership (not otherwise treated as an exchange) shall be treated as an exchange.

Thus, based on sec. 761(e)(2), the marital trust's distribution of the partnership interest to the trust's beneficiaries will qualify as an exchange under sec. 743. As a result, mere will be a sec. 754 adjustment, but it will apply only when the marital trust distributes the partnership interest to the beneficiaries, not when the surviving spouse dies.

Caveats

The main problem is the often typical, significant time delay from when the surviving spouse dies until the trustee distributes the assets to the beneficiaries. For example, the trust provisions may not allow the trustee to distribute the assets until the beneficiaries reach a specified age (e.g., 25,35 or 45). Even if the marital trust assets are distributed soon after the administration of the surviving spouse's estate, there could be a delay of at least 12-18 months or, perhaps, as long as three or more years, depending on the circumstances. A delay can create a disparity between the "outside basis" of the partnership interest (which will be stepped up to FMV as of the surviving spouse's date of death under sec. 1014(b)(10)), and the "inside" basis, which will not be stepped up via sees. 754 and 761 until the marital trust distributes the partnership interest to the beneficiaries.

Another practical problem is that the partnership interest's FMV will have to be redetermined when it is distributed from the marital trust. If the FMV of the assets fluctuates significantly, or a significant period has elapsed since the surviving spouse s death, a new valuation appraisal may be needed.

A distribution of the marital trust as soon as possible after the surviving spouse's death is always advantageous, because it limits the difference between the partnership interest's outside and inside bases.