Under certain circumstances, Congress permits income splitting among numerous family members to avoid higher tax brackets by the use of the “family partnership.” If capital is a material income-producing factor in the business, a family member will be recognized as a partner for federal income tax purposes only if he or she acquires a genuine capital interest in a partnership through a bona fide transaction. He must actually own the partnership interest, and he must actually control it. The transfer may be accomplished by gift or by a purchase. Capital is an income-producing factor if the operation of the business requires substantial inventories or investments in buildings, machinery, or equipment.
If capital is not a material income-producing factor in the partnership, the family member must provide substantial or vital services to the business, or he must purchase the partnership interest with his own funds in order to be a bona fide partner who is taxed on his share of the partnership earnings. Generally, capital is not a material income-producing factor if the income of the business consists mainly of fees, commissions, or other compensation for personal services performed by the partners or their employees.
A capital interest in a partnership is an interest in the business assets that is distributable to the owner upon his withdrawal from the partnership or upon the liquidation of the partnership. The mere right to participate in the earnings and profits of a partnership is not sufficient to constitute a capital interest.
If the transferor of a partnership interest retains incidents of ownership that deprive the family member of complete control of the interest, the family member will fail to qualify as a partner. The IRS and courts will look at the transaction as a whole to determine whether or not control is held by the family member by weighing the following relevant factors: the execution of legal, irrevocable deeds transferring the interest to the family member; the retention of direct or indirect controls by the transferor; the ability of the family member to participate in the management of the business; the actual distributions of partnership income to the family member; the treatment of the family member as a partner; and the presence of a tax avoidance motive.
Generally, a minor child cannot be a member of a family partnership unless he or she is competent to manage his own property and to participate in the business activities. Competency is assessed based on the child’s maturity and experience to enter into business dealings with third parties as an adult, even if the applicable state law imposes restrictions on his conduct. However, transferring an ownership interest to a minor child who cannot yet manage his own property may be accomplished by creating a fiduciary relationship in which an independent third party takes the interest on behalf of the minor.
If a family member fails to qualify as a partner holding a valid partnership interest, the Internal Revenue Service may treat any distribution of partnership income to him as an assignment of income taxed to the assignor of that income.