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:: Partnership - Audit Technique Guide - Chapter 11 - Family Partnerships (12-2002)
Chapter 11 - Table of
Contents
INTRODUCTION
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.
ISSUE A: INCOME SHIFTING
USING FAMILY PARTNERSHIPS
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.
Capital Is Not a Material
Income-Producing Factor
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).
Capital Is a Material Income
Producing Factor
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.
ISSUE B: FAMILY
PARTNERSHIPS AND TRANSFER TAXES
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.
Example 11-1
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.
Example 11-2
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.
Examination Techniques
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.
Issue Identification
-
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
Interview Questions
-
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?
Supporting Law
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.
Resources
Treas. Reg. section
1.704-1(e)(1) and (2)
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