Transferring Wealth from
Small Businesses & Real Estate
The gift tax limits are currently $15,000 per person. A parent along with spouse can gift $15,000 to each child (or anyone else – my address is on the contact page) without triggering gift tax implications. There are times when larger gifts would be considered and is a reasonable planning tool, but for now we will focus on transferring wealth within the limits.
When considering major gifts, cash is probably the wrong asset to choose. There is also the problem that children will abuse the cash and ruin the intention of the gift. To give cash to children - even young adults is often a mistake. The primary reason for the donor making the gift is often lost.
If you are considering a method of transferring wealth relatively painlessly, own your own business, and don't want to loose control, maybe we have an idea.
A small business often owns property from which it operates such as a store, an office building or condo, maybe residential or commercial rental property. This is a good idea since the deductions from the property are also deductions from the business, reducing tax. Rental receipts don't amount to much when you want to buy your next investment, so owning is usually better than renting.
A family physician owns a building from which he practices medicine. He files his taxes and deducts the costs of operating the office. Easy. The mortgage interest, taxes, insurance, depreciation, maintenance and any other reasonable expenses are deducted and he has a nice business deduction, maybe $40,000 or so. Great. Sure, he could have rented just as nice an office for $40,000 or so and deduct the expense, but instead he owns property that will likely appreciate most years and he also gets to deduct $40,000 from his business income. That works better than rent as it serves two purposes. The objective of increasing one's assets while deducting the expenses has been met. Can we do better? Can we address three?
What if there are kids? The children? Do we want to increase their assets? Maybe the business doesn't generate enough money, or maybe the parents just don't want to want to gift $13,000 or so in cash per year to the kids. Can anything be done to increase family assets at the same rate while transferring more of the wealth to the next generation?
Enter the Family Partnership.
In a partnership, each member partner is responsible for paying the tax on income generated from the partnership relative to his share. So if the net income is $10,000, and the share is 10%. of income, he must show $1,000 income on his personal tax return.
For real estate rentals, especially in the beginning, there is usually no income. Expenses of mortgage, taxes and insurance, depreciation, maintenance, etc gobble up the majority - or even more than the rental income can provide.
Partnership rules state that when capital is a material factor in a partnership (the rental property is considered acquired with capital) a partner may not be legitimate unless they acquired the interest in a bonafide financial transaction and actually control the interest. A gift does qualify as a bonafide financial transaction, it is the second requirement that is tougher to meet with young children, as they can't be expected to "control" anything. This can be overcome by appointing unrelated trustees.
Don't worry. The control aspect is not dangerous to your control. As General Partner you retain 100% control and can never be outvoted even as you give away more and more of the asset to the kids. You can give the children non-voting Limited Partnership shares, to be controlled by someone else who, in reality doesn't do anything at all. You control every aspect either way, even to the extent of retaining money in the account for future use. So by allowing a friend or attorney control of your child's share, they can't really do anything with it anyway.
So, as managing General Partner, you control it all even if the children eventually own most of the interests as time passes. As mentioned before, each partner is entitled to his or her proportional share of cash distributions, but as GP, you decide whether to distribute it or to keep it in reserve for future use in the partnership.
If there is a time when you want to take some money out and do not want to give it to the kids, you can pay yourself a management fee as general partner. This fee would be taxable income to you and must be "reasonable" in nature. I wouldn't count on abusing this aspect. After all, the purpose is transfer of wealth, not transfer of income from one fully taxable source to another for yourself to be taxed at the same rate. It doesn't make any sense to plan that. It is nice to know it could be there in a pinch if some unforeseen circumstance arises.
Gradually Gift Partnership Interests
As time goes buy you can gift interests in the partnership to the kids. For example, let's say the property is worth $500,000. 1% then would be worth $5,000. So - by gifting 2% each year, you in effect gift $10,000 worth of property without taking a cent from your pocket. As the property and partnership interests increase in value, the percentages may change some, but the gifting limits may also increase. We deal with the tax laws as they are at the time, and adapt.
Real Estate Works Great
One of the reasons real estate is one of the easiest methods of accomplishing this is because there is usually so little cash flow - at first. In the example above, our doctor is spending $40,000 on his building and deducting it from his income tax return. Whatever his income would have been from his practice, it is $40,000 less for operating the building. What if he instead paid $40,000 rent to his own family partnership? His net income from business would be the same, and the partnership would likely show little or no income as it is eaten away by the deductions of the building.
The rent paid to the partnership has to be reasonable. By reasonable the IRS means that your rent must be about the same as any other unrelated person might be willing to pay in a fair transaction. You can't overload the partnership with passive rental income that would have otherwise been taxed as business income. So for example, if you make $200,000 as a physician, from a partnership and decided to pay $150,000 rent, reducing your business income to $50,000 - not happening. Good idea, and I commend your loathing of taxation, but IRS will clobber you and they have big guns. Why? Rent is passive income and taxed less (no social security) than business income.
As the building ages, the mortgage interest deductions decline, depreciation disappears and rent increases with inflation, more taxable income will be generated. If you don't want to be taxed on it, refinance it and buy another building.
If you have a small business, operate out of your own separate building and want to begin to transfer assets to children (or anyone else) consider the partnership route as an option. You don't give up much, and the transfers through gifting takes place over a period of time.