Partnership Distributions to a Trust
How Does It Cash Flow?
We recently received a call on the Bukers Hotline from an analyst who was spreading a business return of a partnership entity that was owned by a married couple. The analyst was reviewing the Schedule K-1s issued from the partnership to the two individuals and noticed that the recipient was listed as “Jane Doe Trust” rather than simply “Jane Doe” (same for her husband, John Doe). The analyst asked us if they could treat the distributions from the partnership to the partner’s trust as cash flow to the individual. In this month’s cash flow article, let’s determine the best way to help the analyst.
Background - How can a Trust be a Partner of a Partnership?
Did you know that non-individuals can be partners in a partnership? Typically, partners of a partnership are individuals, but other types of entities can qualify as a partner in a partnership. These other entities include, but are not limited to corporations, other partnerships, estates, and trusts. This wide array of qualifying partners is one of the main differences between a partnership and an S corporation. Shareholders of an S corporation are limited to individuals, estates, and a handful of trusts. Because of this key difference, it is more common to see non-individuals acting as partners of a partnership than it would be to see non-individuals acting as shareholders of an S corporation.
Relevant Factors to Consider for Trusts
Back to the question at hand, can the analyst consider cash distributed to the Jane Doe Trust to be cash flow to Jane Doe? As many times is the case with complex tax issues, the answer is – it depends on the facts and circumstances.
The first relevant factor for the analyst to consider is the control of the assets. Typically, when the partnership distributes cash to the Jane Doe Trust, the cash is held in the trust and is not immediately in the hands or control of Jane Doe. The trust, regardless of its name, is usually its own separate, legal entity from the individual. If the individual wanted to receive that cash, the trust would likely have to make another distribution to the individual. In theory, this can be facilitated with ease, but there are other relevant factors to now consider.
What kind of restrictions are held against the trust from distributing the cash to the individual? Are there other parties who are also beneficiaries of the trust who have the right to the cash held in the trust? Who is the fiduciary of the trust? Are there any conditions that must be met for cash to be distributed? If the analyst is thinking any of these questions to themselves, they are already on the right track. The answers to their questions can likely be found in the second relevant factor our analyst should consider – the trust agreement.
Every trust has an agreement that stipulates things like distribution of assets, restriction of assets, processes in place to distribute assets fairly among beneficiaries, and so on. If the analyst could receive a copy of the trust agreement, it would likely shed quite a bit of light on the situation at hand and would answer a great number of our questions. If the analyst is unable to receive the trust agreement, they can contact the borrower, the borrower’s accountant, or the fiduciary of the trust and ask probing questions (like the ones posed above) to determine the relevant factors of the situation.
Important Caveat - Living Revocable Trusts
An important caveat to this topic needs to be made regarding living revocable trusts, which are often set up in a way to ease the facilitation of assets directly to a particular individual. Living revocable trusts can be created so that the same person who creates the trust (the grantor) is the same person who has control over deciding how assets are distributed (the fiduciary), and they are also the same person who receives those distributions (the beneficiary).
These specific trusts are often created to avoid the trust assets going through probate after the death of an individual. While the individual is still living, however, the trust assets can be considered directly under that individual’s control, since the living revocable trust is a disregarded entity for tax purposes. It is still important in these situations to analyze all facts and circumstances to ensure that there are no other fiduciaries or beneficiaries who may disrupt the flow of assets to the individual who set up the trust.
Varying Trust Structures - Example
The analyst’s main goal should be determining the individual’s access to trust assets and their overall ease of receiving cash held by the trust. Remember, cash held by the trust is not necessarily cash held by the individual, but the varying answers to the relevant factors considered above can affect the way we view the individual’s access to cash.
For example, consider two varying trust structures. The first is a trust solely held by the individual and their spouse, and there are no restrictions in the trust agreement that affect the individual’s access to cash. The second structure is a trust held by the individual and their five siblings, each with equal share of assets held in the trust, and each with specific voting rights that decide when distributions are made. Comparing the two situations, the first situation suggests the individual has greater access and ability to withdraw cash from the trust, while the second scenario provides barriers to distribution and a lower distributive share of the same cash held in the trust.
Conclusion
This question is a great example of how the facts and circumstances of a given case can completely change the answer we may provide. For this reason, it is important for analysts to have a good foundational understanding of pass-through entities like trusts.
For more information on complex topics like this, check out Bukers Academy. Our self-paced, online training platform teaches the ins and outs of cash flow analysis and explores tons of complex topics similar to the content discussed above. For more information, visit our website or email learning@taxanalysis.com.