Many people use family limited partnerships (FLPs) to transfer wealth from one generation to the next. Why? FLPs enable the older generation to maintain control and the family to obtain discounts. While we generally focus on the estate planning benefits of FLPs, we often overlook the income tax consequences of funding them, which can be significant.

The “Investment Company” Issue

A family usually forms an FLP by contributing cash, securities and other assets to the partnership in exchange for interests in the partnership. The FLP then owns the family assets. In general, the partners recognize no gain or loss on the contribution of property to the FLP. However, if the FLP is considered an investment company under the tax law, the partners may be required to recognize gain on the exchange of appreciated assets for partnership interests.

The Internal Revenue Code defines an investment company to include a partnership holding more than 80% of the value of the assets (excluding cash and nonconvertible debt obligation) for investments that consist of readily marketable stocks or securities. If a transfer to an investment company results in the diversification of the transferor’s interest, then the transferor may recognize a current capital gain.

When Does Diversification Occur?

Diversification generally takes place when two or more people transfer nonidentical assets to the FLP. For example, if Paul and Linda create an FLP, and Paul contributes 100 shares of A Corporation and Linda contributes 100 shares of B Corporation, both publicly traded companies, Paul and Linda will recognize gain. What is the diversification? Paul and Linda each individually now hold 50 shares of A Corporation and 50 shares of B Corporation. In this case, the FLP is an investment company because it holds 100% of the partnership assets for investment and the assets consist of marketable stocks.

In reality, however, a family often creates a partnership with the transfer of already diversified portfolios. Realizing that the tax rules regarding recognition of gain generally were not aimed at those situations where partners did not realize any advantage by further diversification, Congress changed the law to broaden the nonrecognition rules. Portfolio transfers made after May 1, 1996, that are already diversified will generally not be subject to recognition of gain.

What Makes A Portfolio Diversified?

A portfolio is considered diversified if not more than 25% of the value of total assets is invested in the stock and securities of any one issuer, and not more than 50% of the value of total assets is invested in stock and securities of five or fewer issuers. While for the 25% and 50% tests government securities (such as Treasury bills) are included in total assets for purposes of the denominator, they are not treated as securities of an issuer for purposes of the numerator.

For example, assume Dad contributes his portfolio of publicly traded stocks to an FLP, and no single stock accounts for more than 20% of the value of his portfolio. His children contribute Treasury bills. Before the change in the law, Dad would have recognized gain on the contribution. With the new provision, however, Dad will be considered diversified prior to the exchange. The transfer avoids investment company rules because no more than 25% of the noncash assets are invested in any one issuer, and no more than 50% of the assets are invested in five or fewer issuers.

Avoiding Recognition Rules

While the rules regarding the income tax consequence of FLP creation can be confusing, they cannot be overlooked. You can avoid the recognition rules before forming an FLP, however.

For example, if Paul and Linda were married, they could have avoided recognition in the original example by each giving the other 50 shares of their respective stocks. Because of the marital deduction, this transfer would have had no gift tax consequence. Paul and Linda then could have each transferred their 50 shares of A Corporation and 50 shares of B Corporation to the FLP and avoided the recognition. In nonspousal situations, however, you must carefully review the assets before contributing them to the FLP.