Income tax problems associated with family limited partnerships (FLPs) are rarely serious enough to militate against their use in estate planning. Nevertheless, income tax issues arising in connection with the formation and operation of FLPs deserve consideration, since problems can minimized by careful tax planning.

Partnerships possess the desirable income tax attribute of being subject to no tax at the entity level. Instead, partnership income is “passed through” to partners who pay tax on their share of partnership income. Partners report their “distributive share” of items of income, loss, deduction and credit. Under §704(b), partners are free to specially allocate these items provided the allocations have “substantial economic effect.” For example, a partner with expiring NOLs might be allocated more than his pro-rata share of partnership income. An agreement which requires, as many do, that allocations be made in accordance with the partner’s interest in the partnership, will not permit special allocations and will not, therefore, be subject to § 704(b) restrictions.

Under § 721(a), the contribution of property to a partnership is generally a nontaxable event. An exception provided by § 721(b) requires that gain (but not loss) be recognized if the partnership resembles an “investment company”. The problem is avoided if marketable securities and portfolio assets comprise no more than 80 percent of the value of assets contributed. Since real estate and collectibles are not considered portfolio assets, their contribution will help avoid the application of § 721(b).

Distributions of property other than cash are generally not taxable under §731; the recipient takes a substituted basis. However, §731(a)(1) taxes cash distributions to the extent they exceed the partner’s outside basis in the partnership. Distributions of marketable securities are deemed cash distributions.

Gain may be recognized on the contribution of encumbered property, since §752(b) provides that debt relief is considered a cash distribution to the contributing partner to the extent of any decrease in the partner’s share of partnership liabilities. Thus, the contributing partner may wish to satisfy an existing liability prior to transferring the asset to a partnership, or to consider transferring an unencumbered asset.

The FLP can shift income to lower-bracket family members. Even with current compressed rates, a 10 percent differential may result in significant tax savings. The “family partnership” rules curtail income-shifting by requiring the donor of a partnership interest to be adequately compensated for services provided. This reduces the taxable income available for allocation to donees of gifted interests.

To obtain the maximum valuation discounts for estate tax purposes, FLP agreements often contain significant restrictions on transferability and on a partner’s ability to force a distribution. Regulations under § 704(b) provide that excessive restrictions will cause the donor-partner to be taxed on the donee-partner’s share of partnership income.

When liquidating a partnership, partners may either (i) sell partnership assets and distribute the proceeds or (ii) distribute assets in-kind to partners. Built-in gain from the sale of appreciated property by the partnership is allocated to the contributing partner.

The contributing partner must also recognize gain if, within 7 years of contribution, the partnership distributes property in-kind to a partner other than the contributing partner. However, recognition of gain is avoided if either (i) the property is distributed in-kind back to the contributing partner or (ii) all partners have § 704(c) built-in gain in proportion to their partnership interests and the partners effect a proportionate distribution of partnership assets.