A great way to lower taxes: part 2
Editor's note: This is the second of two parts. Read part 1.
Compensate limited partners by transferring a future ‘profits interest'
In a partnership, the majority partner, or grantor, can transfer a "profits interest" in any income that may be earned in the future by the partnership's assets. At the time of transfer, the profits interest has zero or low value because there is no guarantee that the asset in a partnership will be profitable, and the profits interest transferee will not receive any interest in the asset's value generated in the past. The transfer, which can be used with liquid or non-liquid assets, will not result in immediate income or a gift and won't be taxed.
If a partnership profits interest is used, the recipient of the interest receives a share of profits on a going-forward basis. So, if at the receipt of the profits interest, the value of the partnership is $100, the recipient does not share in the $100, he just shares in the profits on a going-forward basis. So, if the entity profits have generated a value of $500 going 5 yrs from now the partner has his percentage of the increase of $400. There was no shift of the past value and the partner only shared in the future value increase from that point on.
Why do it? It's an alternative to outright gifting that allows the limited partner to share in the appreciation of the asset but not the current value of the asset. You shift the income out of the parent's tax bracket and into the kid's or limited partner's bracket. It's great for funding college education or a new business.
Consider capping the profits interest
You can cap, or fix, future profits interest to any of the partners. This would allow you to provide new, limited partners buy-in, and then they will receive their own future profits interest. The typical way you would structure this would be to give existing partners future profits capped at, for example, 6 percent. It almost acts like a preferred return.
Another technique available is to set your partnership up with segregated asset classes, each of which would provide different future profits percentages. This would allow the partnership to appropriately allocate different risks and returns - and different assets - to specific limited partners based on their individual risk/return profiles. For example, those children actively involved in running a business might warrant a different future profits percentage than passive family members. Another way to accomplish the same goal would be to divide assets into separate partnerships.
One note about the taxation of profits interest: currently, appreciation is treated as a capital gain, which is lower than regular income tax. Congress is likely to push to tax appreciation of the partnership as regular income tax where partners contributed labor to the partnership. Some prominent private equity firms will not be enthusiastic about the change.
Sale of a partnership interest to a defective trust
Another option is to sell a partnership interest to a defective trust. A defective trust is similar to a regular grantor trust. If I form a trust and have control, I'm a Grantor. All income is mine. The same can be said with a defective trust, except there is a specific clause that makes it defective and allows it to be treated as a grantor trust for income tax purposes only. For all intents and purposes, it's still an irrevocable trust, so the assets are not taxed in an estate situation.
When the defective trust is formed with assets from the grantor, owner or parents, the assets are sold to the defective trust in the form of some cash and a note or loan. The trust then makes payments to the parents/grantor on the note. The value of the assets is frozen and any appreciation goes to the beneficiaries.
It should be noted that this technique might not be allowed in the future. Congress is considering legislation that would restrict private equity and hedge funds from using it. Nonetheless, entities using these techniques set up before the new law is enacted would likely be grandfathered.