7.4 Family Partnership Rules

• Library: Limited Liability Companies in Virginia (Virginia CLE) (2017 Ed.)

7.4 FAMILY PARTNERSHIP RULES

7.401 Overview. The family partnership rules under I.R.C. § 704(e) ¹⁸ are designed to ensure that the income of a partnership (or an LLC taxed as a partnership) is taxed to the person who earns it through his or her own labor and skill or the use of his or her capital. ¹⁹ In a partnership in which capital is a material income-producing factor, a person will be recognized as a partner for income tax purposes if he or she owns a capital interest in the partnership, even though the interest was acquired by gift. ²⁰ For this purpose, a purchase of a partnership interest from a family member is treated as acquired by gift. ²¹

If partnership interests have been acquired by gift (or through a purchase from a family member that causes the partnership interest to be treated as if it were acquired by gift), the partnership income must be allocated in a special manner. First, the donor must receive reasonable compensation for his or her services rendered to the partnership. Second, the balance must be allocated in such a way that the amount allocated to the capital interests of the partners acquiring their interests by gift is not proportionately greater than the amount that is allocated to the donor's capital interest. ²²

7.402 Bona Fide Transaction. A donee or a family member who purchases his or her capital interest from another family member is not recognized as a partner unless the interest is acquired in a bona fide transaction. To be recognized, a transfer must vest control of the partnership interest in the transferee. The existence of control is determined by all the facts and circumstances, both at the time of the transfer and afterward. A transfer will not be recognized if the transferor retains such incidents of ownership that the transferee has not acquired complete ownership of the

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partnership interest. In addition, to be treated as a partner, the donee or purchaser must be the real owner of the interest. This requirement is fleshed out in considerable detail by the regulations. ²³

7.403 Capital as a Material Income-Producing Factor and Capital Interest. Capital is a material income-producing factor if a substantial portion of the gross income of the business is attributable to the employment of capital in the business conducted by the partnership. In general, capital is not a material income-producing factor where the income of the business consists principally of fees, commissions, or other compensation for personal services performed by members or employees of the partnership. On the other hand, capital is ordinarily a material income-producing factor if the operation of the business requires substantial inventories or a substantial investment in plant, machinery, or other equipment. ²⁴

A capital interest in a partnership is an interest in the assets of the partnership that is distributable to the owner of the capital interest upon his or her withdrawal from the partnership or upon liquidation of the partnership. The mere right to participate in the earnings and profits of the partnership is not a capital interest in the partnership. ²⁵

7.404 Basic Tests as to Ownership.

A. In General. Whether an alleged partner who is a donee of a capital interest in a partnership is the real owner of the capital interest and whether the donee has control over the interest must be ascertained from all the facts and circumstances of the particular case. The execution of legally sufficient and irrevocable deeds or other instruments of gift under state law is a factor to be taken into account but is not determinative of ownership by the donee. The reality of the transfer of ownership of the property to the donee is to be ascertained from the conduct of the parties with respect to the alleged gift and not by any mechanical or formal test. ²⁶...