Family Investment Partnerships

Most substantial families are probably familiar with family partnerships that are designed to reduce estate taxes.¹⁶ But family partnerships can also serve investment purposes.

In a typical case, the senior living generation of a family will control most of the wealth. This generation is able to access the best managers (most of whom impose high minimum account sizes), can take advantage of fee break points, and they will also have available to themselves sophisticated investment strategies that require investors to be “accredited,” that is, to have a certain minimum income and/or net worth. Younger generations may be stuck with inferior managers or mutual fund products. But by creating family investment partnerships (or limited liability companies—LLCs) to “pool” the family's investment assets, the senior generation can significantly expand the investment opportunities available to the younger generations while simultaneously reducing investment costs.

From the point of view of money managers, the client is not the individual family units but the partnership itself. Hence, the partnership is able to meet the high minimum account sizes demanded by many of the best managers. The middle and younger generations of the family might not otherwise have access to these managers. In addition, of course, the family partnership is able to take advantage of fee break points, giving all members of the family the advantage of lower investment costs. Finally, by investing through separate account managers, rather than mutual funds, younger family members can tax-manage their portfolios, significantly enhancing their net returns. The family can leverage these advantages by involving the middle and younger generations in meetings with money managers and other advisors, helping educate them about investment issues.

Family investment partnerships are sometimes established in a vertical fashion and sometimes in a horizontal fashion. In a horizontal partnership, the family creates an entire, diversified investment portfolio in which all members of the family participate (via the partnership). Horizontal partnerships provide maximum leverage, because all the family's assets are pooled into one partnership, but they can be clumsy investment vehicles. If there are three or four living generations, for example, what possible investment strategy would be appropriate for all the family members? When families organize horizontal partnerships, many of the more astute members of the family will put the core of their wealth in the partnership, but will keep other assets out in order to customize their own strategy.

Vertical partnerships are typically established for each asset class in which the family plans to invest. Thus, there might be separate partnerships for U.S. large-cap, U.S. small-cap, international, emerging markets, fixed income, hedge, private equity, and so on. Individual family members can put whatever percentage of their own assets they wish into each category, allowing for significant customization.

The main problem with vertical partnerships is complexity. Partnership accounting is always complex, and having to deal with ten partnerships, rather than one, can ratchet up the paperwork burden substantially. Fortunately, excellent software exists for managing these issues, and many of the better accounting firms and custodian banks can be engaged to handle the accounting, preparing Form 1065s, K-1s, and so on.

Finally, families can take the route of forming a single master partnership that has unitized funds corresponding to each asset class. The advantage is that only one Form 1065 and K-1 needs to be prepared. The disadvantage is that the 1065 cannot be completed until each asset class is finalized. Thus, a family member invested only in fixed income must wait until the 1065 is complete—which can't occur until the private equity K-1s have come in—in order to file his tax returns.

Note that there is no reason why a traditional family limited partnership designed for estate tax-discounting purposes cannot also serve as a family investment partnership. Indeed, there can be special advantages to doing so. When the IRS challenges family limited partnerships it will typically argue that there was no reason for the formation of the partnership other than avoiding taxes. If one reason for forming the partnership was to pool family investment assets, that can be a compelling business reason for a partnership that also claims discounted values for gift and estate tax purposes. On the other hand, the cohort of family units that is appropriate to participate in a family limited partnership formed for discounting purposes may be quite different from the cohort of family units that would be appropriate for a family investment partnership. Each family will have to work these issues out for themselves.