The most obvious benefit of an FLP is reduced taxes. You accomplish this by transferring assets or income-producing property to children or other family members who are in a lower tax bracket than you, the donor. What’s more, under our tax rules, the transfer of a present interest into a partnership can provide a legitimate deferral of taxable gain.
The primary income tax benefits produced by an FLP result from shifting income between different taxpayers by means of gifts of limited partnership units. If all tax law requirements are met, each partner is liable for tax on his or her distributive share of partnership income. Over several years, the allocation of taxable income to family members in lower tax brackets can substantially reduce overall family income tax.
A second reason to adopt an FLP is that, for estate purposes, the partnership may qualify for a small business valuation discount. Although current tax law has suspended the estate tax, the law expires in ten years, so this benefit of the FLP may return.
A third reason for an FLP is to spread income both to you and your spouse, so that each has qualifying Social Security income. This has the potential to double a couple’s Social Security benefits, assuming that one spouse currently shows no income.
Family Limited Partnerships
An FLP is simply a limited partnership consisting of the members of a family. A limited partnership has both general partners (the ones who actually run the partnership) and limited partners (who are considered passive investors).
Typically, the partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for both general partnership units and limited partnership units. The parents can then embark on a plan of giving any number of limited partnership units to their children and grandchildren, while still retaining the general partnership units that actually control the partnership.
Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, rental real estate property and marketable securities as well as ski resorts, facilities and related businesses. The parents can retain control of the business, draw a salary or wages, all the while sharing the profits with other family members who may be taxed on those profits at a lower tax rate than the parents/owners.
The partnership agreement usually governs how income will be divided among the partners. Usually, both the general and the limited partners will share in income and cash flow based on their respective share or percentage of interest in the partnership. However, although income tax liability passes through to each partner automatically, cash is not actually distributed to the partners until the general partners decide to make a distribution.
In this manner, the general partners retain control over the assets in the FLP while the limited partners are granted very limited rights (primarily, the right to pay taxes). Limited partners also have restrictions on their ability to transfer their partnership units to others, so the general partners can prevent units from being transferred outside the family.
A Word of Caution
There are some legal issues involved in FLPs. After a series of defeats in its attacks on the viability of family limited partnerships and the valuation discounts they often generate, the Internal Revenue Service recently achieved a victory of sorts. The U.S. Tax Court, effectively applying a so-called “substance-over-form” analysis, ruled that a transferor had failed to completely transfer his assets to a partnership.
However, this one court decision should not discourage any ski resort owner or operator thinking about creating or using a family limited partnership. The fact is, a properly established FLP provides transferees with their own substantial capital interests thus entitling them to pro rata distributions for their share of partnership income. And in many cases they will pay less income tax than their parents.
This tax case does show the need for respecting the tax law. For example, if a transferor is receiving more than his or her pro rata share of income from partnership assets, he or she must also be providing adequate consideration, generally in the form of management services. The transferor can not, for example, retain the rent-free use of any partnership assets. And guaranteed payments to the transferor must be reasonably related to services rendered.
Playing by the Rules
While members of a family can be partners, family members (or any other person) will be recognized as partners for income tax purposes only if one of the two following requirements is met:
1) If capital is a material income-producing factor (as it is in most ski businesses), then the transferee must have acquired his or her capital interest in a bona fide transaction (even if by gift or purchase from another family member), must actually own the partnership interest, and must actually control the interest. Capital is ordinarily an income-producing factor if the operation of the business requires substantial inventories or investments in plant, machinery or equipment. For most ski resorts capital is a material income-producing factor, since a substantial part of the gross income of the business comes from the use of capital.
2) If capital is not a material income-producing factor, then the parties must have joined in good faith to conduct a business. They agree that the contributions of each entitles them to a share in the profits, and some capital or service has been (or is) provided by each partner.
A Simple Example
A father sold 50 percent of his ski resort to his son. The resulting partnership had a profit of $60,000. Capital is a material income-producing factor, as it is with most skiing-related businesses and operations. The father performed services worth $24,000, which is reasonable compensation, while the son performed no services. The $24,000 is allocated to the father as compensation. Of the remaining $36,000 of profit due to capital, at least 50 percent, or $18,000, must be allocated to the father since he owns a 50 percent capital interest. The son’s share of partnership profit can be up to, but no more than, $18,000.
When spouses carry on a skiing business together and share in the profits and losses, they may be partners whether or not they have a formal partnership agreement. If so, they should report income or loss from the skiing or resort business on Form 1065. They should not report the income on a Schedule C (Form 1040) in the name of one spouse as a sole proprietor—that forfeits future Social Security income for the other spouse.
To maximize Social Security wages and, therefore, your eventual Social Security income after retirement, each spouse should carry his or her share of the partnership income or loss from Schedule K-1 (Partnership Form 1065) to their joint or separate Form(s) 1040. Each spouse should include his or her respective share of self-employment income on a separate Schedule SE (Form 1040), Self-Employment Tax. This gives each spouse credit for social security earnings on which retirement benefits are based.
Making the Most of FLPs
As already mentioned, there are many benefits—both tax and non-tax—to FLPs. Regardless of what happens to the estate tax in the future, the benefit of reduced asset value through significant valuation discounts still applies for gift tax purposes.
To recap, the benefits of establishing an FLP include:
- The ability of general partners to make substantial gifts and yet maintain control of the partnership assets.
- Continuing control of income from transferred assets, since distributions from a FLP must be authorized by the general partners.
- Identification of assets as partnership assets, not marital assets. This would be important in the event of a divorce.
- Retention of a critical mass of family assets to enhance future investment opportunity—more money in a general “pot” for additional investments.
- Reduced probate costs for real estate located in other states. No secondary or ancillary administration is generally required, thereby reducing costs.
- Institutionalization and enhancement of family communication on family business and investment matters. The family that invests together talks about those investments.
Closing Argument
Using an FLP requires both careful analysis and strict compliance with IRS regulations—not to mention professional assistance. If the transferred property includes real property, art work or a ski resort or business, the transferor must obtain an appraisal in order to establish the value of the property. It is also essential to have a qualified appraisal to estimate the discounted value of the partnership interests.
FLPs, however, are well worth the cost of investigating, establishing and maintaining from several standpoints, not the least of which is taxes.
