8939 / What is a family partnership? What special considerations apply in the context of a family partnership?
In the income tax context, a business owner may wish to reduce tax liability by allocating a portion of the business income to minor children, essentially engaging in “income shifting.” To this effect, the owner may form a family partnership between the parent and the children in which the children own an interest in the partnership that entitles them to specified portions of the partnership’s income.
In theory, if this income was taxable to the children separately, it would be taxed at a lower rate bracket. Today, however, this tax reduction technique has very limited applicability because of the so-called “kiddie tax” (see Q 8601). The kiddie tax requires that “unearned” income of a child under age 18, or 24 for certain students, be taxed at the parent’s tax rate. Although the 2017 tax reform legislation modified the kiddie tax rules so that the unearned income of a minor would have been taxed at the income tax rate that applies to trusts and estates, those rules were repealed beginning in 2020. “Unearned income” is essentially any income other than that received for personal services rendered by the child.
Generally, family partnerships will be recognized for tax purposes only if the following special requirements are met:
(1) A family member, in general, will be deemed to be a partner only if the family member owns a capital interest in partnership property (such as machinery and equipment, real property or inventory) where the business of the partnership is such that capital is a material income-producing factor, whether or not such interest was derived by purchase or gift.1 If the partnership business is such that personal services are a material income-producing factor, a family member who regularly renders valuable personal service to the business will generally be eligible for partner status for tax purposes.2