Minimization of Income Tax
Family Limited Partnerships (FLPs) accomplish income tax minimization via the principle of “income spreading.” The principle of income spreading essentially allows for income to be spread among various partners of the FLP, including children, who, if they are 14 or older, are usually in lower tax brackets [income earned by children under 14 years of age is taxed at their parents’ income tax bracket]. Total taxes are thus less than they would be if all of the income is taxed at the highest tax bracket of the wealthy parents. [“Income spreading” is available to partnerships actually engaged in business, e.g., owning or managing rental property or owning a controlling interest in a business.]
Consider Dr. Jones and his family. Assume that Dr. Jones is taxed at the highest income tax bracket possible. On the other hand, Dr. Jones’ teen-aged children are all students and each is in the lowest tax bracket.
If Dr. and Mrs. Jones transfer their assets into FLPs, the FLPs become the owners of the assets. Any income earned on these assets is no longer directly taxable as Dr. Jones’ income, but instead is treated as income of the FLP. Partnerships, including FLPs, are treated as “flow through” entities for tax purposes. Income earned by an FLP “flows through” to the general and limited partners of that FLP, and each partner’s share of that income is taxed according to the partner’s tax bracket.
Thus, when Dr. Jones’ FLP’s income “flows through” to each partner, each child will pay income tax at his or her lower bracket on his or her share of the income earned by that FLP. [The FLP may distribute or lend enough money to each partner to pay the income taxes.] As a result, there is an overall lower tax on the family’s income.
FLPs also allow for another level of income tax minimization, similar to the income tax deduction granted to an individual for contributing to a qualified retirement plan. If an FLP is engaged in business, the FLP may employ Dr. Jones, Mrs. Jones and each of their children to provide services to the FLP (e.g., management, bookkeeping, rent collection, etc.).
The FLP can therefore contribute pre-tax dollars to qualified pension plans on behalf of the FLP’s employees. Contributions made by the FLP to such pension plans would be tax-deductible expenses of the FLP, reducing the gross income of the FLP prior to the “flow through” of net income to the individual partners.