Everyone wants to reduce income taxes. Limited liability companies (LLCs) and family limited partnerships (FLPs) are tools that can allow for tax savings on passive income by "borrowing" the lower tax rates of family members.

FLPs and LLCs are quite similar. You can think of them as closely related, like brothers and sisters, as they share many of their best characteristics.

Similarities between the FLP and the LLC include the following:

1. They are both legal entities certified under state law. Both FLPs and LLCs are legal entities governed by the state law in the state where the entity is formed. Many of these laws are identical, as they are modeled after the Uniform Limited Partnership and Limited Liability Company acts, which have been adopted at least partially by every state. As state-certified legal entities, state fees must be paid each year to keep an FLP or LLC valid.

2. They both have two levels of ownership. We'll call one ownership level "active ownership." Active owners have 100 percent control of the entity and its assets. In the FLP, the active owners are called general partners, while in the LLC the active owners are called managing members.

As you may have already guessed, the second ownership level is "passive ownership." Passive owners have little control of the entity and only limited rights. The passive owners are called limited partners in the FLP, and members in the LLC.

This bilevel structure of ownership allows a host of planning possibilities because clients can then use FLPs and LLCs to share ownership with family members without having to give away any practical control of the assets inside the structures as described below.

3. They both have beneficial tax treatment. In terms of income taxes, both tools can elect pass-through taxation, meaning neither the FLP nor the LLC is liable for income taxes. Rather, the tax liability for any and all income or capital gains on FLP and LLC assets passes through to the owners (partners or members).

Two big differences between the FLP and LLC are:

1. Only the LLC can be used for a single owner. Most states now allow single-member (owner) LLCs, while a limited partnership in every state must have at least two owners. Thus, for single clients, the LLC is often the only option.

2. The FLP's general partner has liability for the FLP. While a general partner has personal liability for the acts and debts of the FLP, a managing member has no such liability for his LLC. For this reason alone, asset protection experts always recommend using an LLC rather than an FLP when the entity will own dangerous assets — those that have a relatively high likelihood of creating liability.

Common dangerous assets included real estate (especially rental real estate), cars, recreational vehicles, trucks, boats, airplanes, interests in closely held businesses and others.

How FLPs and LLCs help reduce taxes

You've learned that FLPs and LLCs are effective asset-protection tools to shield assets, when exempt assets will not suffice. If used properly in the right situations, FLPs and LLCs can also save thousands of dollars in income taxes each year.

By gifting interests of the FLP or LLC to family members who are in lower marginal income tax brackets, the donors are effectively income sharing. A percentage of the income generated within the LLC/FLP will be taxed at the lower rates of the partners in lower marginal tax brackets. Typically, these are children or grandchildren.

While the exact rules are more complex, generally, as long as the child is over 18 years old (or over 24, if a full-time student and a dependent), the child's share of the income will be taxed at a rate that is presumably lower than that of the working parents.

Case study: Danny and Rina's LLC reduces income taxes

Danny and Rina had annual taxable income of $100,000 from their rental real estate, which was worth $1 million. In a 50 percent combined state and federal tax bracket, their total income tax on this income came to $50,000. To reduce their taxes, they set up an LLC (per above, an LLC is preferred for a "dangerous asset" like rental real estate).

The LLC was funded with the real estate. Danny and Rina appointed themselves as managing members, so they have 100 percent control. They gifted a 3 percent membership interest to each of their four children (Zach, Elgin, Earvin and Jerry) for a total of 12 percent removed from their estate.

Because each child's interest would be valued at about $20,000 (3 percent of $1 million, less the minority valuation discount), no gift tax applied to the transfers to the children. Danny and Rina made these 12 percent transfers to their children annually for five years.

Under the LLC agreement, the children were taxed on their share of the LLC's income, which after five years became 60 percent. Thus, in year five, 60 percent of the FLP's taxable income would be taxed at the children's lower tax rates. So, when the LLC assets earn $100,000 in income, 60 percent of that income was taxed at the children's rate — 15 percent.

Thus, their tax bill for operation of the LLC was $29,000 (50 percent on $40,000, the parents' share) plus $9,000 (15 percent on $60,000, the children's share). Danny's family tax savings would therefore be as follows:

• Total tax with the LLC, year five: $29,000
• Total tax without the LLC, year five: $50,000
• Year five family income tax savings with the FLP: $21,000

It must be remembered that there were also savings in years one through four. What's more, under the LLC agreement, the managing members did not have to distribute any LLC income to the members. This was totally within the discretion of Danny and Rina as managing members. Thus, Danny and Rina could pay all LLC taxes with the income and reinvest the remaining proceeds.

Conclusion

If you are in the position to make gifts of income-producing assets and have family members subject to lower tax brackets, using an LLC or FLP to "borrow" their tax brackets as above may make sense for you.