Income Taxation of Family Partnership Interests Many people create and fund family business entities for estate tax purposes; i.e., to gift shares of the entity to remove it from one s taxable estate. These may hold an actual business or it can simply hold securities and other investments and even plain cash. When done within a family for estate planning reasons, they usually take the form of: Limited Partnership Limited Liability Company (LLC) S corporation Federal Income Taxation Lecture 13 Slide 1
Family Businesses as an Income Shifting Method These forms of business are pass through entities which combine centralized management, limited liability and single taxation. Any income earned by any of these is attributable directly to the owners of the entity in proportion with their ownership interests. This income allocation occurs whether the partners actually get the income or not. Therefore, transferring partnership interests from family members in high income tax brackets to family members in low income tax brackets can save tax money for the family as a whole. Federal Income Taxation Lecture 13 Slide 2
Income Shifting Example Derrick has $2,000,000 in stocks and bonds. They earn roughly $120,000 in income each year. Since Derrick earns a nice salary aside from his assets, all of that is taxed at 33% just on the federal level. Assume that Derrick creates a partnership called Derrick, LP, and puts all $2,000,000 into the partnership. He then gives his adult child, Samantha (watch out for the kiddie tax for minor children) 20% of Derrick, LP, over the course of a few years. Assume that Samantha is in the 25% income tax bracket based on her own salary. 20% of the annual income ($24,000) is now taxed at 25% instead of 33%, thereby saving the family about $2,000 per year! Federal Income Taxation Lecture 13 Slide 3
Conditions Required for Family Partnerships to Work as an Income Shifting Tool There has been a history of Congress trying to prevent income shifting in this manner. Although, today, this method of income shifting is generally effective. However: 1) If any partnership income is attributed to services provided on behalf of partnership, that amount is taxable to the person who provided the services (as salary). 2) The basic asset of the partnership must be capital (something of value) and not just a service providing mechanism 3) If the asset is liquidated, the partners must have the right to receive their pro rate shares of the partnership assets. Federal Income Taxation Lecture 13 Slide 4
Below Market Loans These rules apply to any loan that is below the applicable federal rate, which is set by the federal government and is based on interest rates of government bonds. There are also different rates that apply to short and long term loans. The rule, in effect, makes the lender pay income tax as though the borrower had paid full market interest on the loan. The amount that is in excess of what the borrower actually paid is considered a gift back to the borrower. Federal Income Taxation Lecture 13 Slide 5
Below Market Loan Example John lends $100,000 to his daughter, Mary, interest free for one year. Assume the applicable rate is 10%. Thus, John would have received $10,000 had it been a market loan. Therefore, John must report $10,000 as his income, even though Mary didn t actually pay him any interest on the loan. Also, the $10,000 in foregone interest is considered a gift to Mary for gift tax purposes. Federal Income Taxation Lecture 13 Slide 6
Capital Gains Tax In General A capital gain is any profit earned on a sale; i.e., any time a sale is made for a higher sum than the property s basis. The formula for a capital gain is simple: Sale price (minus expenses incurred in sale) minus cost basis Short term capital gains are taxed as ordinary income Long term capital gains (where the asset has been held more than one year) are taxed at a lower rate than ordinary income: See capital gains rates However, capital losses get worse treatment than many deductions: Capital losses can be used in any amount to offset capital gains Losses in excess of gains are limited to a deduction of $3,000 per year though the excess can be carried over indefinitely. Federal Income Taxation Lecture 13 Slide 7
Capital gains of Taxpayers other than Individuals Trusts and estates get the same capital gains tax treatment as do individuals. Corporations have much tougher rules regarding capital gains. They include: Capital gains by corporations are taxed at the normal corporate tax rate probably because there s no real policy reason to encourage corporations to save money, as there is with individuals Corporations, like individuals, may deduct capital losses to offset capital gains Corporations may not deduct capital losses at all in excess of capital gains; though they may carry a loss forward up to 5 years or back up to 3 years to offset a capital gain in one of those years. Federal Income Taxation Lecture 13 Slide 8
Capital Gains Tax Rate These apply to long term capital gains for individuals: For capital gain on collectibles, some types of small business stock The tax is the lesser of 28% and the taxpayer s marginal rate For capital gains to the extent that you previously depreciated real property The tax is the lesser of 25% and the taxpayer s marginal rate For other capital gains: If your marginal tax rate is 25% or higher, the rate is 15%; Otherwise, it s 5% (0% for 2008) Cannot be more than your marginal tax rate Federal Income Taxation Lecture 13 Slide 9
Policy reasons for the Reduced Capital Gains Tax Avoid putting the taxpayer in a higher bracket unfairly just because s/he held the asset for a number of years Capital gain really includes normal inflation as part of its gain Avoid discouraging people from selling appreciated assets thereby locking up capital Encourage savings and growth of assets Encourage starting new businesses that could be sold and only taxed at capital gains rates Federal Income Taxation Lecture 13 Slide 10