- Written by Martin M. Shenkman
Practitioners dealing with partnership tax returns face a myriad of complex tax issues. Additionally, consideration should be given to the broader planning context as changes in the law (e.g., resulting from the Budget Control Act mandates) and the economy (low interest rates and depressed asset values) will undoubtedly affect the status of many partnerships and client objectives. The following checklist highlights a list of some of the points practitioners should consider when reviewing Forms 1065:
√ Should you be filing a partnership return for a partnership or limited liability company of which spouses are the only two partners or members? If the couple meets the requirements to qualify as a qualified joint venture under IRC Sec. 761(f).2 they can avoid filing a Form 1065. The requirements are as follows:
- The joint venture must involve the conduct of a trade or business.
- The only members of such joint venture are a husband and wife.
- Both spouses materially participate (within the meaning of IRC Section 469(h) without regard to paragraph (5) thereof) in such trade or business.
- Both spouses elect the application of this subsection. #####
√ Proposals are pending to restrict many of the estate and gift tax advantages of using family limited partnerships (“FLPs”). If these proposals have not become effective when you are reviewing a FLP return encourage clients that may benefit from shifting wealth out of their estate, not only for tax reasons, but for asset protection or divorce protection, to act while the benefits may remain. Some of the changes include the expansion of Code Section 2704(b). Under current law restrictions on transfer which are more restrictive than state law are ignored for valuation purposes. In response to this, some states have made their statutes extremely restrictive, thereby negating the need for taxpayers to adopt restrictive partnership agreements, undermining the intent of this provision. Transfers before a change in the law becomes effective of entities organized in states with advantageous laws may provide considerable advantage.
√ Proposals have been made to tax higher income taxpayers at higher rates. In addition, starting in 2013 a 3.8% Medicare tax will apply to net investment income if your adjusted gross income ("AGI") is over $200,000 single ($250,000 joint) threshold amounts. IRC Sec. 1411. The greater of net investment income or the excess of modified adjusted gross income (MAGI) over the threshold will be subject to this new tax. The historic use of FLPs before discounts became the rage was to shift income to lower bracket family members. Before dismantling existing FLPs, practitioners should review the potential for income shifting, and the new requirements this entails. For example, to shift income by gifting FLP interests to a child, capital must be a material income-producing factor in the partnership. IRC §704(e)(1); Treas. Reg. §1.704-(e)(1)(ii).
√ Hedge fund interests have been the subject of considerable talk about restricting tax benefits managers can realize. Carried interests are a right that entitles the general partner of a private or public fund to a share of profits as compensation for managing the fund’s assets. These can be vested or unvested. Management fees are taxed at ordinary income tax rates while carried interests are taxed under present law as capital gains and are exempt from employment tax. Thus, the general partner receives income for services rendered at capital gain rates. 2007 HR 2834 introduced to tax carried interests as ordinary regardless of the charter of the item at the partnership level. This concept was reintroduced in 2009 when the House passed HR 4213 to tax carried interests less favorably. President Obama’s Greenbook, JCX-59-09 p.5, estimated the increment to the federal government from taxing carried interests at ordinary income tax rates at $24 billion. Evaluate the impact of such changes with any client holding these interests.
√ Proposals have been made to limit the maximum income tax rate at which higher-income individuals can realize a tax benefit of itemized deductions, personal exemptions, and certain preferences to 28 percent. It has been estimated that this change in the tax law will generate $410 billion in revenue. Practitioners should be alert to investment activities that may be suitable to shift into a partnership solution where the related deductions may potentially avoid these restrictions.
√ The transfer for value rules can result in the proceeds of a life insurance policy being subject to income tax. However, transfer of an insurance policy to a partner of the insured (or a partnership in which the insured is a partner) will not trigger the transfer for value rules. IRC Sec. 101(a)(2)(B). Practitioners should be alert for opportunities to help clients restructure the partners in a partnership to include those taxpayers who may be involved in insurance transfers. The partnership involved, however, must be a bona fide entity, and not merely an entity established to effectuate the insurance transfer. If the partnership owns significant other assets, and was not formed for the purpose of facilitating the transfer of the insurance policies, it may be respected as qualifying for an exception to the transfer for value rule. PLR 200120007.
√ Series LLCs are becoming more common. Delaware enacted the first law permitting series LLCs, but Texas, Oklahoma, Illinois and Tennessee have as well. In a series LLC the client can form one LLC and under its umbrella create a series of other LLCs each providing liability protection but without the cost and complexity of creating multiple entities. Practitioners should be alert for clients that may benefit from this technique, e.g. a client with many retail stores presently organized as a single partnership or LLC. Series LLCs may have their own business or investment purpose, classes of ownership interest, and liability limitations. The classification of a series that is recognized as a separate entity for federal tax purposes is determined under Reg. 301.7701-1(b). If an LLC with three members (A, B, and C) establishes two series LLCs (LLC-1 and LLC-2), with A and B the owners of LLC-1 Series, and C the owner of LLC-2 Series, the default classification of LLC-1 Series is a partnership and of LLC-2 Series is a disregarded entity. Under Reg. 301.7701-1(b).
√ Annual gifts of interests in partnerships will be obvious from the small changes in K-1 ownership percentages. If these gifts are apparent from the return practitioners should be certain that clients have had the partnership agreements (operating agreements in the case of an LLC) reviewed by counsel to be certain that the requirements for a present interest gift (a prerequisite to qualifying for a gift tax an annual exclusion) are met. IRC Sec. Sec. 2503(b). The Regulations provide that a future interest may be created by the limitations contained in an instrument of transfer used in effecting the gift. Regs. Sec. 25.2503-3(a). Thus, the partnership agreement, the assignment forms used to transfer the partnership interests or other documents may all undermine the clients sought after tax benefit. Price v. Commissioner, T.C. Memo. 2010-2.