Increasingly, clients' investments are being structured in family limited partnerships (FLPs) or family limited liability companies. These structures can confer substantial benefits to your clients and, in turn, to your practice. But such benefits often come with risks, and FLPs are no exception. They pose a risk that should be of particular concern to wealth managers: a costly tax trap.

Forming an FLP consisting primarily of securities typically carries no adverse income tax consequences. If the FLP meets the definition of an investment company and your clients diversify their previously undiversified securities portfolios in funding the FLP, however, then all of the gains on all assets they contributed will be subject to income tax. Making this taxation sword even more threatening is the fact that it only cuts one way. Although gains trigger income tax, losses don't trigger deductions.

As with most tax rules, this one started with good intent—to encourage taxpayers to start businesses. The general tax rule is that if you form a business organized as a partnership, it should be tax-free. This includes limited liability companies (LLCs) that are taxed as partnerships. (LLCs are the most common form of new business structure.)

Closing the Loophole

Congress did not intend for your clients to take advantage of its good graces by forming FLPs or LLCs (taxed as partnerships) to circumvent the tax rules on the recognition of gains from diversifying securities. So the investment company rule was created as an exception to rules allowing FLPs to be formed tax-free.

Consider the hypothetical example of 10 investors who each contribute $250,000 of a different appreciated security to a partnership. In doing so, each investor would be diversifying his or her single-stock holding for a tenth share of a diversified portfolio. The general rules permitting tax-free formation of a partnership don't apply, so each partner would have to recognize the gain inherent in the specific securities he or she contributes to the FLP.

Some of the investment company rule's provisions are inscrutable. They're easier to understand if you don't bring to them any real-world perspective or any nettlesome concerns such as conventional wisdom on securities laws or state prudent investor legislation.

For an FLP to be classified as an investment company, more than 80% of the value of its assets must comprise readily marketable stocks or securities, including regulated investment companies or real estate investment trusts (REITs). Stocks and securities are considered readily marketable if they're traded on a securities exchange or traded or quoted regularly in the over-the-counter market. These include convertible debentures, convertible preferred stock, warrants and other stock rights if the stock into which they may be converted or for which they may be exchanged is readily marketable. (Cash is considered marketable.)

Although this analysis is performed when the assets are transferred into the partnership, if assets are transferred at other times, the IRS may aggregate the various transfers if it believes they were transferred at different times pursuant to a plan. You can make a plan by using the right language in the investment policy statement (IPS) or in documents you create for the client.

Even if the FLP is classified as an investment company, taxable income isn't triggered unless the transfer results in the "diversification of the transferors' interests." Diversification is defined in tax terms, not in investment terms. Tax laws provide a mechanical test to determine whether diversification has occurred. A portfolio is considered diversified if less than 25% of its assets are invested in any single issuer and less than 50% are invested in any five or fewer issuers.

The Investment Company Act poses a challenge for advisors who are encouraging their clients to set up FLPs: How do you avoid the income tax trigger of diversification? Answer: By being vigilant about the diversification status of portfolios, of the FLP itself before and after these portfolios are contributed and of any post-formation diversification. If portfolios deemed undiversified (under the tax law definition above) combine in an FLP to produce an entity that is undiversified under the definition, there are no income tax triggers. Similarly, if diversified portfolios combine in an FLP to produce a diversified portfolio, again, there's no problem. However, if the contribution of undiversified portfolios results in an FLP with a diversified portfolio, this triggers taxable income on gains.

Taking Action

One way to protect your clients is to diversify the individual portfolios before they are contributed to the FLP. You can sell holdings to diversify the partnership's portfolio, consistent with the post-formation IPS, after the transfer of assets to the FLP is completed without pulling any tax triggers. There are some actions that advisors should consider taking to protect their clients from the investment company tax trap. These include: