The Dangers of Underreporting Family Limited Partnership Income

By Daniel A. Perry, Esq.

A Family Limited Partnership (FLP) is a family-controlled business entity which provides liability protection and a manner to transfer business assets, and other assets, to the next generation without giving up control during the owner’s lifetime. When it comes to family businesses, this can be a very powerful estate planning tool.

However, from a tax perspective, members of FLPs must be careful when it comes to the accurate reporting of income. An FLP is not taxed directly, instead it is a pass-through tax entity where the income passes through to the individual members of the FLP based upon their ownership percentage and reported on the individual member’s tax return.

Following an IRS audit, if the IRS determines that the FLP has underreported its income, then the FLP will pay the tax directly and not the individual members of the FLP. This can occur at the highest individual income tax rate or the highest corporate tax rate.

There is a way to avoid this higher tax bracket in the event of a tax audit. The FLP can opt out of this higher taxation by electing a Partnership Representative and filing a Form 1065 in a timely manner — commonly referred to as the “Push-Out” election. This allows the FLP to push out the new tax liability to the individual members of the FLP. However, an opt out of this taxation regime can only be obtained by an FLP with 100 or fewer partners.

As you might imagine, this power in the Partnership Representative can cause a partner dispute. This is especially true if one of the partners has significant tax liability in a given year and this new tax liability is passed on them.

For more information

This is just one of the many tax rules affecting Family Limited Partnerships. If you have questions about the taxation of Family Limited Partnerships or believe that establishing one could be a smart decision for your family, please contact our office at (513) 241-0400 or use our contact form to schedule a time to discuss how we can help you and your family.

The attorneys at Aronoff, Rosen & Hunt, LPA are here to help you!