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What Will Happen to My Partnership Interest in a Divorce?

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What Will Happen to My Partnership Interest in a Divorce?

Most partnership agreements have anti-assignment provisions that prevent a partner from assigning their partnership interests to a non-partner third party. While at the same time most partnership agreements allow for the assignment of a partner’s right to distributions even where the party receiving the distribution is not technically a partner. Consequently, many marital settlement agreements require a transfer of a right to distributions between the spouses that is treated as a gift under Section 1041. However, the holder of a mere right to distributions, as opposed to the holder of a complete assignment of a partner’s partnership interest, has a disadvantaged legal status under general partnership law that can only be somewhat mitigated by agreements between the former spouses. A holder of a mere right to distributions is not accorded the rights held by a partner under general partnership law. As such they are not legally empowered to compel distributions, not owed the typical fiduciary duties a partner can expect from the other partners, and are not legally entitled to financial reports or granted the right to inspect the partnerships books and records.

How Does this Affect divorce Tax Planning?

An opportunity exists to use IRC § 1041 to achieve overall tax savings in situations where the ex- spouses are in substantially different income tax brackets, though assignment of income principles, or whom enjoy substantially different capital gain rates, through selective distribution of marital assets. In negotiating the martial settlement agreement and ultimately the division of the martial estate, H and W should be counseled to consider allocating to the spouse with the lower comparative capital gain rates the marital assets that have appreciated and thus are carrying built in gains.  The spouse with the higher marginal capital gain rate should be allocated assets that have not appreciated or that have declined in value.

For additional insight as to how this mechanism can work, consider a scenario where W expects to sell depreciated stock that will generate a substantial capital loss following the divorce. To mitigate the $3,000 annual limitation on the deductibility of capital losses, H and W should contemplate transferring to W sufficient appreciated capital assets to absorb the anticipated capital loss.