If one or both parents have a business, then there can be significant tax savings if it is organized as a family business, which includes other members of the family as shareholders or as limited partners. The family business must be organized as a partnership, limited liability company, or as an S or C corporation. However, a family can form a number of different business entities to maximize tax savings, although this must be weighed against their cost of operation and the administration of the entities. Family members can also help to start a business by pooling their resources. Furthermore, a family business can be an effective estate planning tool. However, a family business must be a real business — it cannot simply be a means to transfer wealth to descendants. This generally means that it must be an active business, so a family business that holds only investments would not qualify.
There are several major tax advantages to a family business. Families can hire their minor children and pay deductible wages. Neither the business nor the minor children have to pay either Social Security and Medicare (FICA) taxes or federal (FUTA) and state unemployment taxes if the child is under 18. [IRC §3121(B)(3)] The child would not have to pay any taxes for wages up to the standard deduction for the child. However, the rate of pay must be in the neighborhood of what a business would pay a stranger, although the compensation could be somewhat higher since compensation does vary considerably for the same job. A traditional IRA can also be set up for the child, allowing an additional $5,500 of income that can be tax-deferred, although a Roth IRA would be more advantageous for a minor, since the tax savings of a traditional IRA would be insignificant for a low income worker. Additionally, the earnings in a Roth IRA could grow tax-free and all qualified withdrawals from the Roth IRA when the child reaches retirement age would also be tax-free.
So if a parent in the 25% tax bracket pays his child $10,000 in wages to work for his business, then the $10,000 can be deducted from the business income, saving $2,500 in ordinary income taxes plus about $1,400 in self-employment taxes that the parent must pay if it were part of his income.
Children can also be given stock in the family business. They do not have to work in the business nor do they have to pay for the stock themselves. However, if the children do not work in the business, then their income will be subject to the kiddie tax: the income would be taxed at the rate of the parent with the highest adjusted gross income.
Families can also put their parents on the payroll if they are retired, but it only makes sense if the parents are in a lower tax bracket, need the income, and if it does not increase taxes on their social security benefits.
Since 2007, the IRS has allowed a form of business entity where spouses can work as co-proprietors — each must participate in the business and file a Schedule C reporting their share of their income, and there can be no employees, including their children. Both spouses will also have to pay self-employment tax. But a co-proprietorship is easier to manage and to administer than a partnership.
Sometimes, it is advantageous to have a spouse volunteer to work in a business, working without pay, which can save a considerable amount of taxes if the owner spouse has an income greater than the Social Security contribution and benefit base, which for 2019 is $132,900. For instance, suppose the working spouse earns $200,000 a year from her business and she decides to pay her spouse $50,000 per year to work in the business. In such a case, the family unit must pay 15.3% in employment taxes on the income to the other spouse, but if the spouse simply volunteered to work in the business, then the $50,000 would only to be subject to the 2.9% Medicare tax of the high-income spouse. (Actually, the percentage would be a little less than this, since a self-employed person only pays self-employment tax on 92.35% of her income, yielding an effective tax rate of 0.029 × .9235 = 0.0268 = 2.68%. Tax law also permits a deduction of the amount of the self-employment tax owed, lowering the percentage even further, but the actual percentage will vary depending on the taxpayer's tax bracket. See Self-Employment Tax for more details.)
Family Partnerships and Limited Partnerships
A family business can be organized as a partnership, limited liability company (LLC), an S corporation, or as a C corporation. Although a C corporation has the largest tax benefits, any dividend income will be subject to double taxation. Moreover, S and C corporations are more complicated business entities and additional taxes, such as the state corporate franchise tax, would also have to be paid. A limited liability company with 2 or more members is taxed as a partnership, and while general partnerships are easy to organize, they can have complex tax consequences.
For income tax purposes, a family member can only be a general partner if she owns a capital interest in the partnership in which capital is a material income producing factor, or she provides significant services to the business; otherwise, the IRS may disregard the partnership as an assignment of income to the family member. Capital is not deemed an income-producing factor, if most of that income is earned from fees and commissions, or other income earned from providing services. As evidence of a true capital interest, if the owner withdraws from the partnership or the partnership liquidates, then that owner must receive a distribution commensurate with his capital interest: the mere right to share in profits is not considered a capital interest. If the parents do all the work, then they will be taxed on the entire income. The distributive share of income must be proportional to the capital interest of the partner and the partner must have proportional voting rights in the partnership. IRC §704(e)
If a family member receives a gift of capital interest in a partnership, where the capital interest is a material income-producing factor, then the donee's distributive share of income as restricted as follows: the partnership income must be reduced by reasonable compensation for the donor's services, and the donee's share of income must not exceed the donor's distributive share attributable to the donor's capital.
Your business had a profit of $100,000, and you give 40% of your business to your daughter. Reasonable compensation for your services to the business is $30,000. The partnership interest to be divided must 1st be reduced by the $30,000 for compensation for your services, yielding a $70,000 capital interest. Of this, your daughter's capital interest equals $28,000 (= $70,000 × 40%) and your remaining capital interest equals $42,000.
One of the most common ways of organizing a family business is as a family limited partnership (FLP), which is taxed like a limited partnership but in which the children do not have to contribute capital or even work in the business. Ownership in the FLP is represented by FLP units, which are equivalent to shares in a corporation in that each unit represents a certain ownership percentage of the business. The FLP units are given as gifts to the children, thus making them limited partners. One or both parents serve as the general partners who control and operate the business. As limited partners, the children have no say in the business. The benefit of the limited partnership is that the parents can transfer units of the partnership to the children tax-free if the value of the shares is less than the annual gift tax exclusion limit, which is $15,000 for 2019 and 2020. A married couple can double that amount for each child. Additional value can be transferred tax-free because the units can be discounted because of restrictions on their disposition and because the limited partners have little control over the business.
Additional advantages include:
- general partners maintain control
- value of units can be discounted
- FLP units are easily transferred and easily divisible
- easy to start: prepare a partnership agreement, transfer the deed or title of any property to the partnership name, then issue partnership certificates
- avoids probate
- unlike a will, transfers of wealth through an FLP are private
- the partnership agreement can list a successor manager who could take over in case of sudden death, or incompetence resulting from illness or accident.
Another advantage of FLPs is that units can be transferred to minors under the Uniform Transfers to Minors Act or Uniform Gifts to Minors Act. When the child reaches the age of majority, 18 to 21 in most states, then she receives all the property or money in the account. A drawback to allowing a child to receive so much at such a young age is that they may squander it, but if the value of the account is in FLP units, then the general partners maintain control, and the partnership agreement can prevent the disposition of the FLP units without the consent of the general partners.
FLPs do have some disadvantages:
- If the donor maintains too much control, then the IRS may disallow the discounting of the FLP units in the transferred units and they may be included in the donor's estate.
- Additionally, determining discounts may be problematic, since valuations are subjective. Consequently, the valuation should be done by an expert appraiser who specializes in evaluating business interests. The FLP value is determined on the date of the gift.
To pass IRS muster, the FLP must serve a true business purpose – it cannot be used simply to avoid tax. That means that the partnership must actually be engaged in the business or investment activity where capital is a major factor for producing income. Anyone who works for the partnership must be paid a market compensation for the services provided. The partnership should have periodic meetings, file periodic reports to the limited partners, file partnership tax returns, and perform any other functions that would be required to achieve its business objectives.
The new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorship's and independent contractors to deduct 20% of the revenue. However, this deduction starts to phase out for couples earning at least $321,400.
Discounting FLP Units
Because shares in a family corporation or a family limited partnership generally have impaired marketability, tax law allows the shares to be discounted by at least 15% to 35%, and sometimes by as much as 50%, especially for shares without voting rights or with other trading restrictions, which further limits their market. For instance, a common partnership restriction on the disposition of any FLP units is that the remaining partners have the 1st right of refusal. Larger discounts can be justified if the spouses maintain most of the control of the business, which is usually the case. A higher discount would also be plausible if the shares pay no dividends or are never redeemed, since redemption would set the price of the shares. Other factors that may affect the discount of the shares is whether the stock is publicly traded or not, the competitiveness of the business, and the competence of the company management. However, the IRS may require a professional assessment of the value of the shares to ensure that their value is less than the gift tax annual exclusion amount.
Because family limited partnerships are often abused, the IRS scrutinizes any estate tax returns that includes an interest in an FLP. If there is no valid business reason for the FLP, if the original owner still treats it as his own property, or if the discounting of the FLP units is much greater than 35%, then the IRS may treat the FLP as a sham, and disregard it. Common valid business reasons include having a family member who is experienced in the business to manage the assets for the family or to reduce administrative costs.
Family Limited Liability Companies
A limited liability company can also be used instead of an FLP. The primary advantage is that everyone in the partnership, including the general partners, has limited liability for claims against the partnership. By contrast, in a regular partnership, the general partners would have unlimited liability for the debts and other liabilities of the partnership. However, LLC members generally have the right to dispose of their units, so discounting will be less than with an FLP. Also, in some states, withdrawal by an LLC member or the death of a member may dissolve the entire partnership. These problems can be prevented through proper wording of the partnership agreement. Because state laws for partnerships and limited liability companies varies greatly from state to state, get professional help to set up an FLP or LLC.
Employee Stock Ownership Plans (ESOPs)
Employee stock ownership plans (ESOPs, IRC §404) are another effective way to transfer income to children but they can only be offered by a C corporation, and the children must be employees of the corporation. However, the ESOP must be offered to all full-time employees, not just family members, so this would only yield significant tax savings for a closely held corporation. The corporation can contribute its stock annually to an ESOP trust — the corporation can deduct the contribution and it is not treated as income to the employees. The corporation can contribute up to 25% of the total of employee salaries, and each individual employee is given a number of shares proportional to the percentage of their salary over the total compensation paid by the corporation.
Example: If the total value of a corporation's stock is $1 million and it pays out $500,000 in salaries to employees, then it can contribute $500,000 × .25 = $125,000 to purchase corporate stock for the ESOP, which represents 25% of the total payroll of the company and 12.5% of the company stock. So an employee who makes $80,000 can be allocated 2% of the stock annually ($80,000 / $500,000 × 12.5% = 2%).
Unlike other profit-sharing plans, there is no diversification requirement for an ESOP, so it can hold 100% of the company stock. However, employees aged 55+ with at least 10 years of service with the company must be offered 3 alternate investments, at least annually, for up to 6 years, so that they can diversify their holdings. These employees should be allowed to transfer up to 25% of the company stock to the alternative investments for the 1st 5 years; and in the 6th year, up to 50%.
ESOPs can also have vesting requirements, so that if an employee leaves the company before the end of the vesting period, the nonvested shares can be reallocated to the remaining employees.
Major advantages of an ESOP include:
- employer receives the tax deduction for either a cash contribution or a non-cash contribution in the form of stock shares;
- corporate borrowing can be reduced since it can borrow from the plan;
- employee ownership provides a performance incentive;
- improved liquidity of company stock;
- no realization of income until shares are distributed;
- taxation is deferred until sold by the employee;
- a shareholder may receive tax benefits by selling stock to the plan.
Furthermore, there is no tax on capital gains from the sale of the company stock for a C corporation, but not for an S corporation, if the proceeds are reinvested in marketable securities, such as stocks and bonds, within 1 year. An additional advantage is that an ESOP can hold shares of an S corporation and pay no tax on the income.
However, there are certain disadvantages. A major expense is setting up the ESOP. Because of its complexity, a CPA or tax attorney must be hired to set up the ESOP, but at least the cost would be deductible. Ownership may be diluted for some shareholders. A primary disadvantage of an ESOP is that the employees are subject to substantial investment risk, since a major portion of their compensation will be tied to the fate of the company.
Few people will be subject to the estate tax, since the exemption amount is so high. For instance, in 2020, the exemption amount, which is now adjusted annually for inflation, is more than $11.5 million per individual, so a married couple can leave more than $23 million tax-free to their descendants. There are many tax loopholes to save even more on estate taxes — a family business is one of those ways. However, if most of the business interest in the family business becomes part of the parents' estates, then the heirs still have several options. One possibility is to pay the estate taxes with the proceeds of a life insurance policy. Note, however, that joint ownership does not save on estate taxes unless the joint owner is a surviving spouse.
Another option is to pay estate taxes in installments. When the business owner dies, the family business need not be liquidated to pay estate taxes, since the IRS has an installment payment option to allow a cash-poor estate to pay estate taxes over a longer time period. A closely held business that composes 35% of the adjusted gross estate can pay the estate tax in 10 annual installments after a deferral period of as much as 5 years. However, only the tax attributable to the business interest is deferrable. Interest must be paid on the deferred tax, but the interest rate is only 2% on a portion of it [IRC §6601(j)(1)]. Some business stock can be redeemed to pay estate or generation-skipping transfer taxes without disqualifying the estate or the beneficiaries from taking advantage of the installment payment option.