Partnership - Audit Technique Guide - Chapter 11 - Family Partnerships (12-2002)
NOTE: This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.
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The original focus of Family Partnerships was to split income among family members. With the reduction in marginal tax rates, the emphasis has shifted to exploiting Family Partnership to reduce estate and gift tax.
One of the earliest, and most often cited, Supreme Court cases is Lucas v. Earl, 281 U.S. 111 (1930). The question presented was whether Guy Earl could effectively assign half of his compensation from the practice of law in 1921 and 1922 by contract to his wife. The validity of the contract was not questioned, but the Court held that the “fruits cannot be attributed to a different tree from that on which they grew.” This has come to be known as the “Fruit of the Tree Doctrine” and has found application in many areas.
Subsequent taxpayers attempted to use the partnership provisions in lieu of a bare contract to attempt to divert income to family members and others. If successful, this stratagem would not only reduce income and employment taxes, it would completely circumvent transfer taxes. With the decline in income tax rates the principal focus in this area has become transfer tax avoidance.
IRC section 704(e) is titled “Family Partnerships” but only one subsection applies to family members. Subsection (e)(1) provides that if any “person” acquires an interest in a partnership from any other “person” by purchase or gift, and if capital is a material income producing factor, then the person will be considered a partner whether they acquired the interest by purchase or gift. It provides a “safe harbor” with respect to partnerships in which capital is a material income-producing factor.
Subsection (e)(2) applies in the case of partnership interests acquired by gift. It provides that a donee’s share of partnership income must be reduced to the extent of the donor’s reasonable compensation for services rendered to the partnership.
Subsection (e)(3) is the one applicable to family members only and for this purpose, family means spouse, ancestors and descendents or trusts set up for their benefit. It provides that partnership interests purchased from family members shall be treated as if created by gift.
Partnership income arises from services, capital or both. If capital is not a material income producing factor, and a partner performs no services, partnership income is allocated to the partner who performs the services. Lucas v. Earl, and IRC section 704(e)(1) and (2).
A determination of whether the interest was acquired by purchase or gift must first be made. If the partner is a family member, the purchase from another family member is treated as though it was acquired by gift. To be considered a partner for the purpose of receiving income allocations, the partner must be an owner in substance, and not just form. Treas. Reg. section 1.704-1(e)(2) describes the basic tests for ownership based on all the facts and circumstances. The following factors indicate that the donee is not a bona fide partner:
- Donor retains direct control: This can be achieved through restrictions on distributions, rights to sell or liquidate, or retention of control over the assets of the business and retention of management powers inconsistent with normal (arms length) relations among partners.
- Donor retains indirect control: The donor may control a separate entity that manages the partnership. The management entity may place restrictions that limit the ownership interest of the donee.
- Donee does not participate in the control and management of the business, including major policy decisions. The degree of participation may indicate whether the donor has actually transferred an interest to the donee.
- Partnership distributions actually are not actually made to the donee. If they are, the donee does not have full use or enjoyment of the proceeds.
- The partnership conducts its business in the manner expected of a partnership. For example, it has a separate bank account, follows local law for business operations and treats the donee in the same way any other partner would be treated.
- Other facts and circumstances may indicate the donor has retained substantial ownership of the interest transferred.
Treas. Reg. section 1.704-1(e) also addresses the issue of trustees as partners, ownership by minor children, and the use of limited partnerships. In the case of a limited partnership interest, does the limited partner have the right to sell, transfer, and liquidate without substantial restrictions? Does the donee-limited partner have the same rights as unrelated limited partners?
If the donee is not a bona fide partner the income must be allocated to the real owner of the partnership interest.
If the donee is a bona fide partner the donor still must be reasonably compensated for services rendered to the partnership and the donee’s share of partnership income must be in proportion to donated capital. If these conditions are not met, there is reason to change the allocation.
Reducing income taxes by shifting income is not as important as it once was due to the reduction in tax rates and changes in rules for taxing unearned income of children. Income tax savings may contribute to the overall success of a family partnership set up to reduce transfer taxes as illustrated below.
Estate and gift taxes are imposed on the transfer of property at death or the gifting during lifetime by a decedent or donor, respectively. The rates are graduated starting at 18 percent and rising to 55 percent on amounts over $3 million. The tax is imposed on the fair market value of the property involved, that is, the price a willing buyer and willing seller would agree upon.
A “unified credit” is provided to each taxpayer that reduces the actual amount of tax payable. The same amount of credit applies for both gift and estate taxes. The credit shelters a certain amount of otherwise taxable transfers. The equivalent amount of total property that is sheltered from tax by the unified credit is currently $675,000; that amount will rise to $1,000,000 by 2006. For this purpose “total property” applies to taxable gifts during lifetime and the remaining taxable estate at death.
For estate tax purposes prior taxable gifts are added to the value of the estate and the credit (plus any prior gift tax paid) is subtracted again. Gifts, and estate devises to spouses are fully deductible.
For gift tax purposes a married donor may elect to treat any gift as made one-half by each spouse. Because each donor is allowed an annual exclusion of $10,000 per donee, gift splitting can result in a substantial amount of gifts being sheltered from taxation even before the use of the available unified credit.
Fred Donor gives $50,000 in cash to his married daughter and her husband. He elects to “split” the gift with his own spouse, Mary. Fred is considered to have given $12,500 to child and $12,500 to child’s spouse; Mary is considered to have done the same. Fred and Mary are each entitled to a $10,000 annual exclusion for each of their two gifts. (They need to file separate gift tax returns. Gift tax returns are required to be filed by the donors, not the donees, and there are no joint returns.) As a result, Fred has a $5,000 taxable gift and Mary has a $5,000 taxable gift. The resulting tax on each donor’s $5,000 taxable gift is now sheltered by any remaining lifetime, unified credit.
In the past, an Estate and Gift Tax Attorney was permitted to examine and adjust all gifts made during a decedent’s lifetime unless a gift tax had actually been paid. In that case the statute of limitations would run 3 years after the filing or due date as in the case of income tax returns. The Code was amended in 1997 to provide that (generally) the filing of a gift tax return would start 3-year statute of limitations regardless of whether the taxable gifts were fully sheltered by the unified credit. If the Service did not propose changes within that period, the numbers could not be adjusted later, for example, during the examination of an estate tax return. This provision has created an added burden on E&G Attorneys to take a harder look at gift tax returns.
The following example illustrates the use of valuation discounts and the unified transfer tax system. For purposes of this illustration, the taxpayer is considered to split each transfer with his own spouse and to make each annual gift to the donee and the donee’s spouse.
Fred Donor operates a successful retail sporting goods store worth $1,000,000. He has made all the money he needs and wants to pass the business to his two children and minimize the transfer taxes. He transfers the business to an LLC and begins making gifts of 10 percent each year to the donees. Upon his death in 6 years, his remaining 40 percent interest is included in his gross estate.
The gifts are discounted for lack of marketability and control. Lack of marketability applies to securities which are not publicly traded. A minority interest has a lower fair market value since it has no control over management or distributions.
It is important to note that after consideration of gift splitting, the annual exclusion, and the lifetime unified credit, transfers of partnership capital and any claimed discounts must be very substantial in order to justify a referral to Estate and Gift.
Where the partnership is engaged in an active business, determine that family members are compensated for services they perform for the partnership.
Carefully examine any allocations that are not proportionate to capital accounts when family members are partners. They must be based in that case on actual services provided.
Where younger family members’ allocations are purportedly based on services, the same audit techniques used in corporate excess compensation cases can be used. However, since the tax effects are much smaller in the partnership context, you may not want to pursue the issue unless the amounts involved are substantial before pursuing this issue.
Where substantial gifts with significant claimed discounts are present the case should be referred to the Estate and Gift Tax group.
- Does the partnership contain the word “Family” in the name? Do the Schedules K-1 indicate a family relationship, such as same last names, trusts or same addresses?
- How long has the partnership been in existence? Was it formed by the transfer of an existing business?
- Is the partnership engaged in a trade or business, or is it an investment partnership? Is capital a material income-producing factor?
- Does the return or partnership agreement show the recent addition of a related partner or an increase in capital of a younger family member? Do the Schedules K-1 indicate a transfer of capital from one family member to another?
- Are there disproportionate allocations of income to family members? Are those providing services to the partnership adequately compensated?
Documents to Request
- Partnership Agreements including any amendments.
- Copies of any gift tax returns filed with respect to the transfer of any partnership interest or capital.
- Calculations regarding any disproportionate income allocations
- Are any of the partners related by blood or marriage?
- Were any interests in the partnership acquired by gift?
- Were any interests acquired by purchase from a family member?
- How are income allocations calculated?
Lucas v. Earl, 281 U.S. 111 (S CT 1930). This case established the principle that the “fruit of the tree” must be taxed to the tree on which it grew.
IRC section 704(e) which provides rules consistent with Lucas for testing the allocation of partnership income, particularly where family members are partners.
Treas. Reg. section 1.704-1(e)(1) and (2)