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Sunday, November 08, 2015

Congress Tinkers with Family Partnership Rules

The recently enacted Bipartisan Budget Act of 2015 moves around the family partnership rules so as to clarify their application.

THE OLD RULE

Section 704(e)(1) provided that a person is recognized as a partner of a partnership if capital is a material income-producing factor, whether the partnership was obtained by purchase or gift. This was commonly referred to as the “family partnership rule.”

THE PURPOSE OF THE OLD RULE

A transfer of a partnership interest by gift (or even by sale) opens the door to an impermissible assignment of income. That is, income from property or a business can be transferred in a manner that would be a disrespected assignment of income if such a transfer was conducted outside of the partnership form. The family partnership rule is a safe harbor from IRS attack based on assignment of income principles when capital is a material income-producing factor in the partnership. Per the focus on capital, the safe harbor will not provide protection for service businesses or other businesses where capital is not a major requirement.

CONGRESSIONAL CONCERN

To be considered partners for federal income tax purposes, the legal partners must have joined together with an intent to conduct an active trade or business. Some taxpayers have argued that this rule does not apply if the family partnership rule applies. That is, they claim that the family partnership rule is an alternative way of being considered a partner, without the requirement of an active trade or business.

SO WHAT DID CONGRESS DO?

It moved the family partnership rule out of Section 704(e)(1) and into Section 761(b). As it now reads, Section 761(b) makes clear that one still has to meet the general requirements of being a member of a partnership. The family partnership rule is now only a qualification to the above general rule such that in testing whether one is a partner a gift transfer cannot be used as a challenge if capital is a material income-producing factor. Section 761(b) now reads:

(b) Partner. For purposes of this subtitle, the term “partner” means a member of a partnership. In the case of a capital interest in a partnership in which capital is a material income-producing factor, whether a person is a partner with respect to such interest shall be determined without regard to whether such interest was derived by gift from any other person.

MISC.

Code Sections 704(e)(2) (relating to special rules on allocation of income on gifted interests) and 704(e)(3) (relating to purchases of interests by family members being treated as a gift transaction) are left behind in Section 704(e), and are renumbered as (e)(1) and (e)(2) respectively.

EFFECTIVE DATE OF CHANGE

For partnership tax years beginning after 12/31/2015.

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