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March 1994

Planning for distributions of passive activities by estates. (Estates & Trusts)

by Svagna, Marco

    Abstract- The suspended losses ascribable to a passive activity are non-deductible at the time of the disposition of the activity to a beneficiary by an estate or trust. Instead, the losses should be included as basis of the activity. In other words, they should be capitalized. This means that the beneficiary cannot deduct the losses as such. Instead, the benefit of the losses will be carried over in the computation of gain or loss upon the beneficiary's ultimation distribution of the activity. For disposition of noncash property, a fiduciary may have the estate or trust recognize gain or loss in the same fashion as though the distributed property had been disposed to the beneficiary at its fair market value. This allows the beneficiary to use the fair market value as the basis in the property instead of the basis of the estate or trust. The election's effects on the trust are discussed.

The Rules

Generally, when an estate or trust distributes property (other than in satisfaction of a pecuniary amount), no gain or loss is recognized on the distribution. In such an instance, there is a carryover of the property's basis from the fiduciary to the beneficiary.

If an estate or trust distributes a passive activity to a beneficiary, the suspended losses attributable to the activity are not deductible at such time. Rather, they must be added to the basis of the activity |IRC Sec. 469(j)(12) or, practically speaking, they are capitalized. Therefore, the beneficiary will never be able to deduct those losses as such. The benefit of those losses will instead be reflected in the computation of gain or loss recognized upon the ultimate disposition of the activity by the beneficiary.

Example. The estate of John B. Jones owns an interest in S corporation XYZ. On July 2, 1993, the estate has a basis of $50,000 and suspended losses of $20,000 If the estate distributes the interest in XYZ to a beneficiary of the estate on that day, the beneficiary's basis will be $70,000, with no suspended losses.

The IRC Sec. 643(e)(3) Election

For noncash property distributions, a fiduciary may elect to have the estate or trust recognize gain or loss in the same manner as if the distributed property had been sold to the beneficiary at its fair market value. The election applies to all distributions made during the tax year |IRC Sec. 643(e)(3). As a result of the election, the beneficiary's basis in the property is its fair market value rather than the estate or trust's basis (as adjusted by any suspended losses). Since a trust and a beneficiary of a trust are considered related parties |IRC Sec. 267(b)(6) the following restrictions apply (only to trusts):

1. The trust will not be permitted to recognize any loss resulting from an IRC Sec. 643(e)(3) election. A beneficiary receiving a distribution from a trust that incurred a nondeductible loss due to the limitations imposed by the relate party rules may be allowed to deduct the loss upon disposition of the property. If the beneficiary disposes of the property at a gain, he or she can deduct the loss to the extent of but not in excess of the gain. |IRC Sec. 267(d)

2. If a trust distributes depreciable property, IRC Sec. 1239 denies any capita gain treatment on the distribution if the IRC Sec. 643(e)(3) election is made.

Since assets generally do not appreciate significantly during the administratio of an estate, the potential for recognizing a substantial gain by making the election will generally not be that significant. But why would the estate want to recognize any gain at all?

The Benefits of the Election

Under IRC Sec. 469(g)(1), if a taxpayer disposes of his entire interest in a fully taxable transaction, any suspended losses attributable to such interest become deductible in the year of the disposition. Under IRC Sec. 643(e)(3), the distribution is considered to be a sale for income tax purposes. Therefore, if passive activity is distributed to a beneficiary of an estate and a IRC Sec. 643(e)(3) election is made, any suspended losses attributable to that activity will be deductible by the estate making the distribution. Once again, the related party rules come into play and limit the benefits of utilizing an IRC Sec. 643(e)(3) election in triggering suspended losses for trusts. This is due to IRC Sec. 469(g)(1)(B), which states that if a passive activity is sold to a related party any suspended losses attributable to that activity are not deductible at that time. Rather, the suspended losses remain with the seller until the related party (assuming another related party does not acquire the activity), the suspended losses become deductible by the original seller.

Example. The estate of John Doe owns an interest in S Corporation ABC. On Augus 30, 1993, the estate's basis in the corporation is $100,000 with $30,000 in suspended losses. The fair market value is $105,000. On that day, the executor will distribute the estate's entire interest in the corporation to the sole hei of the estate. By making an IRC Sec. 643(e)(3) election, the estate will recognize a capital gain of $5,000 ($105,000 minus $100,000), and it will be able to deduct $30,000 in suspended losses. The basis of the corporation to the heir will be $105,000 ($100,000 plus the recognized gain of $5,000). If no election is made, the estate will not recognize any gain or loss. Furthermore, the basis of the corporation to the heir will be $130,000 ($100,000 plus $30,00 in suspended losses). A summary is presented in the box at right.









Bad News for Revocable Living Trusts

It should be noted from the above discussion that the IRC Sec. 643(e)(3) election cannot be utilized to trigger suspended losses when a trust is involved. What happens to a revocable living trust once the taxpayer dies? The answer is that it continues to be a trust. Therefore, this planning opportunity cannot be utilized in instances where a passive activity is held in a revocable living trust prior to a taxpayer's demise.

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