Income Tax on Rent Paid to Family Limited Partnership in New York City

A very important part of estate planning, especially for high-income individuals and those with rental income, is setting up a family limited partnership.  Not only does setting up a family limited partnership can help shield your assets and income, but it also provides for various tax benefits including lowering or eliminating estate tax consequences for those estates that owe taxes and lowering income taxes for partners to the partnership.  Family limited partnerships are a complex tool in any estate plan and having one properly set up with the assistance of a New York estate attorney is the best way to make sure you have the asset and tax protections that it provides and don’t run into trouble with the IRS.

A family limited partnership is made up of general partners, those who make decisions on the partnership, and limited partners, those who cannot make decisions but still have a financial gain from the partnership.  The general partners to a partnership can have an ownership interest in as little as 1%, even if their share of what is going into the partnership is higher.  Through using this type of partnership, the general partner can create shelters for their assets from creditors while also lowering their income for tax purposes.

A family limited partnership is often used by high net worth individuals to pass along their assets to their heirs with as little of a tax consequence as possible.  Part of this tax savings is often found in the form of taxes on rental income.  While a family limited partnership would not totally eliminate income taxes coming from rental property, it can be valuable in lowering the tax rate on such income.  The reason for this is that the taxes on such rental property can be determined by the amount of shares owned in the family limited partnership.

An example of what this means is shown when a general partner with very high income holds a 1% share in the family limited partnership while a limited partner owns 35%. It would most likely be the case in such a situation that the general partner would be subject to the highest income tax bracket while the limited partner, which is commonly a child of the general partner, is subject to a much lower tax bracket because they are younger and don’t have as high an income.  Because of this, 35% of the income taxes owed for rental income would be subject to the lower tax bracket, creating a significant tax savings for all who own shares of the family limited partnership.

While family limited partnerships can create a huge tax savings for those with means, they are also closely looked at by the IRS when it comes to if they were properly formed and maintained.  The ultimate purpose for a family limited partnership is to pass along a family business across generations, meaning that there must be some business purpose, rather than just a way to shelter assets and income.  Hiring a New York estate attorney to assist you with your entire estate plan, including one or more family limited partnerships is the best way to make sure that this tool is used correctly along with the rest of your estate and retirement planning. Call the Law Offices of Albert Goodwin at (212) 233-1233 or email [email protected].

The Rental Income Question in Detail

When real estate is held by a family limited partnership and the partnership generates rental income, that income flows through to the partners according to their ownership percentages. The rental income is reported on Form 1065, the partnership return, and each partner receives a Schedule K-1 showing their share of the income, deductions, and credits. The partner then reports their K-1 share on their own personal tax return. Because each partner is taxed at their own marginal rate, the family can in effect shift some of the rental income from a higher-bracket parent to lower-bracket children, reducing the total family tax bill.

The "Kiddie Tax" Limitation

Income shifting to children is not unlimited. The "kiddie tax" rules in Internal Revenue Code Section 1(g) treat unearned income above a defined threshold received by a child under age 19 (or under 24 if a full-time student) as taxable at the child's parent's marginal rate, undoing some of the income-shifting benefit. The thresholds are modest. For a meaningful income-shifting strategy, the children should be old enough to avoid the kiddie tax or the family should structure the partnership to limit the children's share of taxable income to amounts within the safe harbor.

Section 704(b) Substantial Economic Effect

The IRS scrutinizes special allocations of partnership income and deductions to ensure they have "substantial economic effect" under Section 704(b) of the Internal Revenue Code. If allocations do not satisfy the test, the IRS will reallocate income according to the partners' interests in the partnership, ignoring the partnership agreement's allocations. The economic effect test requires that allocations be reflected in capital accounts, that liquidations be based on capital accounts, and that partners with negative capital accounts have a deficit restoration obligation. Properly drafted partnership agreements include the technical language to satisfy these requirements.

Self-Employment Tax Considerations

One under-appreciated benefit of using a limited partnership structure is that limited partners are generally not subject to self-employment tax on their share of partnership income. General partners are subject to self-employment tax on their share. This creates a planning opportunity: a parent who owns a small general partner interest pays self-employment tax on their share, but limited partner children do not pay self-employment tax on their share. For partnerships generating active income, this can produce substantial annual tax savings.

The Estate and Gift Tax Benefit

Beyond the income tax benefits, family limited partnerships provide an estate planning benefit. Interests in a family limited partnership are typically valued at a discount for estate and gift tax purposes — both a discount for lack of marketability (because there is no ready market for the interest) and a discount for lack of control (because limited partners cannot make management decisions). The combined discount is often 25 to 40 percent, meaning that interests transferred during life or at death are taxed at a value substantially below the proportionate share of the partnership's assets.

IRS Scrutiny and Cases That Have Gone Wrong

The IRS scrutinizes family limited partnerships closely. A long line of court cases has invalidated family limited partnerships where the structure was deemed not to have a legitimate non-tax purpose. Common red flags that produce bad outcomes include:

• No business purpose. Partnerships set up solely to obtain valuation discounts are vulnerable.
• Failure to respect entity formalities. Partnerships that do not keep separate books or commingle assets with personal accounts are treated as if they did not exist.
• Last-minute formation. Partnerships formed in the final months of a parent's life are often pulled back into the estate under Section 2036 or Section 2038.
• Personal expenses paid from the partnership. The IRS treats the partnership as a sham when the parent treats partnership assets as personal property.
• No real change in lifestyle. Where the parent continues to enjoy and control the assets in the same way after the transfer as before, the IRS argues that the transfer was not real.

Best Practices for a Family Limited Partnership

• Form the partnership for a real business or investment purpose, separate from estate planning.
• Capitalize the partnership with property the family genuinely intends to hold long-term.
• Operate the partnership as a real business with separate books, separate accounts, and written records of major decisions.
• Avoid using partnership funds for personal expenses.
• File partnership tax returns timely and consistently.
• Distribute income to partners according to their ownership interests.
• Use qualified appraisals when transferring interests, with detailed support for any claimed discounts.
• Make adequate disclosure on the gift tax return so that the three-year statute of limitations begins to run.
• Avoid forming the partnership when the parent is in poor health or near death.

The Family LLC Alternative

Many families today use a family LLC rather than a family limited partnership. The LLC offers similar tax and estate planning benefits with greater flexibility and less administrative formality. The LLC can be taxed as a partnership for federal income tax purposes, qualifying for the same flow-through treatment. The LLC structure is now the default choice for most new entities; existing FLPs are typically maintained because of the cost of conversion.

New York Tax Considerations

New York has its own tax framework that overlays the federal rules. New York does not impose a state-level gift tax but does impose an estate tax with a lower exemption than the federal estate tax. The "cliff" effect of New York's estate tax — where exceeding the exemption by even a small amount eliminates the exemption entirely — creates planning opportunities and pitfalls. New York City imposes the Unincorporated Business Tax (UBT) on certain partnership income earned within the city, which can affect the tax calculus for FLPs that conduct business in New York City.