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income of a minor would have been taxed at the income tax rate that applies to trusts and estates, those rules were repealed beginning in 2020.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

(2)  Where the partner receives the partnership interest as a gift, and capital is a material income-producing factor, the donee’s distributable partnership share will be included in taxable income except to the extent of:

a. the donor’s reasonable compensation for services rendered to the partnership; and

b. a proportionately greater distributive share attributable to donated capital compared to the donor’s capital.³Thus, although a proportionate share of income attributable to a gifted capital interest may be shifted to a family member, compensation for personal services may not be shifted in such a manner, nor may distributive shares based on capital interests be arbitrarily realigned without proportional reference to the underlying capital interest. This means that where the donor-partner performed all or nearly all of the personal services rendered in connection with partnership activities, income allocated to the donee would be reduced (and taxed to the partner who performed the services) by the reasonable value of the services.

(3)  Where an interest in a family partnership is acquired by purchase from another family member, the interest is treated as if it was acquired by gift from the seller unless it can be shown that the sale was a bona fide arm’s-length transaction.⁴ If the transfer is a gift, the purchaser’s (donee’s) basis in the interest is limited to the fair market value of the interest and not the purchase price.

For purposes of applying these rules to “family” partnerships, IRC Section 704(e)(3) defines the “family” as including only a spouse, ancestors (including an individual’s parents and grandparents), lineal descendants (including children and grandchildren); and trusts, if the primary beneficiaries are any of the above.

As a general rule, a family partnership may consist of two or more of the following: spouses, children, grandchildren, grandparents, or a trust for the benefit of any of those individuals. A partnership formed only by siblings, in-laws, or uncles and aunts is subject only to the rules applicable to partnerships in general, and are not limited by the more restrictive rules imposed on family partnerships.

Although as a general rule, minor children will not be afforded treatment as partners for purposes of Section 704(e), two narrow and limited exceptions do exist for children age 18 and older:

(1)  If the minor child can be shown to be competent to manage and own property and to participate in the partnership activities in a manner consistent with the management of such property interests, partnership status may be afforded with the result that the child’s distributive share of partnership income will be taxed to the child rather than, for example, to a parent-partner.⁵

(2)  Where the exception above cannot be shown to exist, a minor child may still qualify as a partner to the extent partnership income is “earned income.”