Family Investment Partnerships: All the Perks

Editor: Jon Almeras, J.D., LL.M.

Partners & Partnerships

Family investment partnerships (IPs) are frequently used to manage and control multigenerational family wealth. Aggregating family assets in an IP may also result in significant economic and tax benefits. Accomplishing a family’s investment goals, however, requires understanding its investment objectives, the nature of its underlying investments, and the degree of investment flexibility sought by participating family members or entities. Although these entities appear complex, they are now much easier to administer because technology helps to reduce the burden of tracking sophisticated global investment products and complying with U.S. tax reporting requirements.

A well-conceived IP structure and investment strategy could provide the following benefits:

1. Access to leading money managers who are available to institutional or wealthier investors;
2. Larger asset blocks achieved by pooling family assets, thus providing a more efficient size for trading purposes and lower proportionate investment advisory and banking fees;
3. Fewer managed accounts and account fees;
4. Opportunities to reduce the tax cost of wealth transfer among generations;
5. Ability to accommodate various asset classes ranging from liquid cash equivalents and marketable securities to illiquid private equity and real estate;
6. Ability to rebalance investment portfolios in a cost- and tax-efficient manner for family members with differing investment needs and objectives;
7. Co-investment by family members who individually may have access only to costlier retail investment products; and
8. Ability to compensate family office executives in a manner that is directly aligned with their performance.

An IP structure is typically composed of one or more partnerships through which a family may invest in marketable securities or illiquid alternative investments. The characteristics of these partnerships, such as allocations of income and distribution of cashflow, vary greatly depending on the asset classes in which the partnerships invest.

Accounting for the movements of capital in these entities also can be complex, but rules permitting the aggregation approach of tracking “reverse” Sec. 704(c) gain or loss help manage the allocation of taxable income or loss among the partners. If the IP invests in marketable securities and meets the definition of an investment partnership under Regs. Sec. 1.704-3(e)(3)(iii)(B)(2) (90% of its assets must be actively traded property), then partnership income or loss is permitted to be allocated using the aggregation method, which is favored because it makes tax accounting for the IP’s investments in liquid assets easier.

An IP that invests in illiquid asset classes, such as private equity, real estate, or oil and gas, typically will require partners to commit to contribute capital for a fixed percentage of ownership in the entity. The IP receives capital contributions from the partners as the underlying investments issue draw requests against the IP’s commitments. Distributions to partners are made only when underlying investments generate distributable cashflow from operations or when a liquidity event occurs. There is little or no flexibility to admit a partner to the IP or participate in an underlying investment once initial commitments are made, because allocations of taxable income and loss, as well as cash distributions, are typically required to comply with the percentages fixed in the partnership agreement at the date of formation.

To enable partners in IPs to invest in different asset classes, IPs are often organized with multiple divisions or “side pockets.” A side pocket is a separate accounting division within a partnership that is not intended to be a separate legal entity for federal or state income tax purposes. As a division of the IP, the side pocket must maintain a separate balance sheet, including partner side-pocket capital accounts and a separate profit-and-loss statement. Allocations of side-pocket economic and taxable income or loss are made only to those partners that have designated a portion of their investments to the side pocket. Because a side pocket is not a separate legal or tax entity, only one federal partnership income tax return is filed, combining the activity of each side pocket. A partner’s Schedule K-1 reflects the allocable share of taxable income or loss from the IP by consolidating the partner’s side-pocket investments. The benefits of side pockets include reduced tax compliance costs and increased flexibility to rebalance investments within a single investment vehicle.

Rebalancing is rarely an option for illiquid asset classes such as private equity, but using “vintage accounts” to hold illiquid assets yields tax compliance savings that are similar to those for side pockets. Vintage accounts are generally organized with fixed commitments to illiquid asset classes over a designated period of time—from one to three years—or by asset class. A partner’s level of investment and percentage of ownership may vary between vintage accounts, but they will remain constant within any given account until it is liquidated. IPs that invest in illiquid assets may allow the entry and exit of partners; however, allowing this movement will typically require liquidity to execute redemptions, make reliable valuations of underlying assets without a ready market, and track differences between book and tax capital under Regs. Sec. 1.704-3 without the benefit of the aggregation method.

Although side pockets and vintage accounts may increase flexibility, such benefits may be outweighed by the increase in administrative complexity as the number of investment choices or side pockets increase. Therefore, a balance between the two is advisable. Combining liquid, hedge, and illiquid assets in the same IP may also have an adverse effect on the ability of the IP to use the aggregation method of allocating “reverse” Sec. 704(c) gain or loss. It may also decrease its ability to qualify under the favorable investment partnership rules afforded by many states.

An alternative to using side pockets or vintage accounts for IPs is investing in separate asset classes through series LLCs, which currently are recognized by a limited number of states. Recent Prop. Regs. Sec. 301.7701-1(a)(5) indicates that the IRS believes that each series generally represents a separate entity for federal income tax purposes, for which a separate partnership tax return must be filed. Determining whether a separate series has been established varies under state law. A series LLC structure may be appropriate if there are concerns that liabilities of one asset class or investment may adversely affect the operations, investment, or tax results of another asset class, or if the family simply favors separate legal entities.

Family investment vehicles are frequently used to facilitate tax-efficient transfers of wealth among generations. Generally, interests in an entity that are transferred by sale or gift are valued net of discounts for lack of control and marketability. The size of the discounts may vary greatly depending on a partner’s level of flexibility to withdraw, partially redeem, or alienate its interest. Because IPs typically allow partners to enter or exit the partnership relatively frequently, discounts are not increased upon intergenerational transfers of IP interests. Family limited partnerships (FLPs), on the other hand, may be more suitable vehicles for wealth transfer, as FLP agreements typically place significant restrictions on limited partners’ rights of withdrawal, distributions, alienation, and control. As a result, whereas it is not common to see intergenerational transfers of IP interests, it is common to see such transfers of FLP interests. In many instances, one of the assets of the FLP may be an interest in an IP.

While IPs may simplify and reduce the cost of tax compliance, they remain subject to the complex rules of partnership taxation. The managing members and general partners of IPs therefore must be counseled about the need to consult their advisers when changes to the structure are proposed or material transactions are contemplated.

EditorNotes

Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, DC.

For additional information about these items, contact Mr. Almeras at (202) 758-1437 or jalmeras@deloitte.com.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.