How do GRATs and family limited partnerships get taxed?

Here’s what HIVE AI had to say about “How do GRATs and family limited partnerships get taxed?”:

Taxation of GRATs and Family Limited Partnerships (FLPs)

Grantor Retained Annuity Trusts (GRATs)

Income tax during the GRAT term

• Most GRATs are structured as grantor trusts, so all trust income, deductions, and gains are taxed to the grantor while the grantor retains powers or interests that trigger grantor trust status. Under Rev. Rul. 85-13 principles, transactions between the grantor and a grantor trust are disregarded for income tax purposes, and the grantor is treated as the owner of the trust assets while grantor trust status applies 1.
• The annuity amount can be paid from income and, if needed, principal; excess income is typically added to principal. This is a feature commonly seen in GRAT governing instruments and is consistent with trust administration described in IRS technical advice 2.

Gift and GST at funding

• For gift tax, the taxable gift occurs at inception and equals the fair market value contributed minus the present value of the retained annuity; that present value is determined using section 7520 assumptions referenced in IRS rulings on GRAT structures 2.
• For GST, automatic allocation rules apply unless you affirmatively opt out. The IRS has granted relief to taxpayers who needed additional time to opt out of automatic GST allocation to GRATs, underscoring the need to make intentional GST elections with GRATs that pour over to multigenerational trusts 3.

Estate tax if the grantor dies during the term

• If the grantor dies before the annuity term ends, the trust assets are generally included in the grantor’s gross estate under section 2036 because the retained annuity did not terminate before death. Treasury regulations provide examples applying section 2036 to retained interests, including GRATs 4.

What happens after the term

• If the grantor survives the term, the remaining trust corpus typically passes to remainder beneficiaries (often a family trust) without further gift tax at that time; post‑transfer appreciation in excess of the 7520 assumptions generally avoids estate inclusion (assuming no retained strings and proper administration). Income tax ownership ends if grantor trust status ceases; future trust taxation may shift to the trust or beneficiaries depending on structure 1.

Family Limited Partnerships (FLPs)

Basic income tax framework

• Partnerships are pass‑throughs: the partnership itself does not pay income tax; each partner takes into account their distributive share of income, deductions, credits, and other separately stated items on their own return 5. The IRS’s partnership publication reiterates the pass‑through treatment and partner‑level reporting 6.
• Under the centralized partnership audit regime, adjustments to partnership‑related items are generally determined at the partnership level, and assessed and collected accordingly unless an exception applies 7.

Family transfers of partnership interests

• A donee of a capital interest in a partnership in which capital is a material income‑producing factor is recognized as a partner; however, the donee’s distributive share must reflect reasonable compensation to the donor for services and cannot disproportionately attribute income to donated capital compared to the donor’s own capital. These guardrails implement section 704(e)’s family partnership rules 8.
• The IRS partnership publication mirrors these rules, cautioning that family member gifts of capital interests are subject to the reasonable compensation and proportionality limits and noting that purchased family interests may be treated as donated capital for determining distributive shares 6.

Allocations and built‑in gain mechanics

• Section 704(b) and 704(c) principles govern capital accounts and allocation of built‑in gain or loss on contributed property. The “traditional method” allocates post‑formation gains/losses to noncontributing partners and allocates built‑in gain/loss to the contributing partner, but the ceiling rule can distort outcomes by limiting tax allocations to the partnership’s actual tax items for the year, potentially shifting some built‑in gain impact to other partners 9.

Payments to partners for services or property

• Payments to partners may be treated as occurring “outside” the partnership under section 707(a) (e.g., guaranteed payments or service/property payments), rather than as distributive shares. The One Big Beautiful Bill amended section 707(a)(2) text; while primarily a statutory wording change to “Except as provided,” it underscores the specific treatment of partner‑service/property payments in applying section 707(a) after enactment 10.

Gifts and capital interests in practice

• When capital is a material income‑producing factor (typical in investment FLPs), income attribution follows capital ownership, subject to the 704(e) rules above. For service‑heavy partnerships (e.g., management companies), ensure reasonable compensation for services is respected to avoid improper income shifting among family members 8.

Partner‑level limitations and reporting notes

• Partners must track basis, at‑risk, and passive loss limits; instructions for AMT also require recomputing loss limitations for estates and trusts owning PTP or partnership interests—an illustration of the separate limitation regimes that can apply to partners and fiduciaries 11.
• The IRS partnership publications and Schedule K‑1 instructions emphasize that certain items must be reported separately to preserve character at the partner level and to apply partner‑specific limits (for example, investment interest, passive activity groupings, and specialized codes for items like inversion gain) 12.

Putting it together: typical planning tax outcomes

GRATs

• During the term, the grantor pays the income tax on the GRAT’s income (grantor trust), receives fixed annuity payments, and if the grantor survives the term, the remainder typically moves to the next‑generation trust or beneficiaries without further gift tax at that time; failure to survive the term generally pulls assets back into the estate under section 2036 1 4.
• Coordinate GST: either opt in or out intentionally for GRAT transfers and any downstream “pour‑over” to GST‑potential trusts to avoid unintended automatic allocations or exposures 3.

FLPs

• The FLP does not pay federal income tax; partners do. Family gifts of partnership capital interests are respected if they meet 704(e) requirements, including reasonable compensation for services and proportionality to capital. Built‑in gain and depreciation allocations must follow 704(b)/(c) rules, mindful of ceiling‑rule distortions. Payments to service‑providing family members may be section 707(a) payments rather than distributive shares, with different timing and character consequences 5 8 9 10.

Practical tips

GRATs

• Draft annuity terms and powers to ensure grantor trust status and qualify the annuity as a section 2702 qualified interest; keep contemporaneous valuation and 7520 rate documentation used to compute the retained annuity. Monitor mortality risk through term selection to mitigate section 2036 inclusion risk 2 4.
• Make explicit GST elections (opt‑in or opt‑out) for each GRAT funding and track automatic allocation status to downstream trusts 3.

FLPs

• Align partnership agreement allocations with section 704(b) substantial economic effect and 704(c) methods; document revaluations, capital account maintenance, and the method chosen to address built‑in gain (and ceiling‑rule impacts) 9.
• For family gifts of interests, ensure compensation arrangements are reasonable, and that distributive shares attributable to donated capital are not disproportionately larger than the donor’s capital share to satisfy 704(e) 8.
• Classify service/property payments correctly under section 707(a) rather than as distributive shares when appropriate, particularly after the statutory update in the One Big Beautiful Bill 10.

Sources

1 – IRS Determination 200846001 📄 Summarize
2 – TAM 200011005 📄 Summarize
3 – PLR-110656-16 📄 Summarize
4 – Treasury Regulation 20.2036-1 📄 Summarize
5 – Treasury Regulation 1.701-1 📄 Summarize
6 – IRS – Publication 541 Partnerships 📄 Summarize
7 – IRC § 6221(a) 📄 Summarize
8 – Treasury Regulation 1.704-1 📄 Summarize
9 – IRS – Publication 5800 Small Business/Self Employed Partnership Job Aid 📄 Summarize
10 – One Big Beautiful Bill Act Sec. 70602. Treatment of payments from partnerships to partners for property or services 📄 Summarize
11 – IRS.gov – Instructions for Schedule I (Form 1041) (2024) 📄 Summarize
12 – IRS – Instruction 1065 (Schedule K-1) Partner’s Instructions for Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc. 📄 Summarize

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