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With Tax Breaks Set to Expire, the Wealthy Turn to Partnerships

Paul Sullivan, The New York Times
Monday, 9 Jul 2012 | 2:22 PM ET
Robert Kent | Lifesize | Getty Images

A family limited partnership was once a rather esoteric way for wealthy families to centralize the management of real estate and various pots of money. But this is not a normal tax year.

The arcane device has suddenly become popular because of the scheduled expiration of the $5.12 million gift tax exemption at the end of this year.

For years, the exemption for gifts to heirs had been $1 million, and it’s not clear what will happen to the tax break, just one of many tax and spending measures expiring at the end of 2012.

But wealth advisers cautioned that the rush to set up a partnership in order to use the tax break could lead families to do something that is not right for them.

For some families, a partnership is attractive. It is a way to combine money to reach the higher investment requirements that hedge fund and private equity managers require. But its most alluring feature may be the ability to discount the value of the assets put into the partnerships because the shares distributed from it are less liquid since only another family member can buy them.

A discount of 25 percent generally does not attract scrutiny from the Internal Revenue Service, and that could allow someone to increase a $5.12 million gift exemption to $7 million. Since the partnerships are not overly expensive to administer, several advisers said they have seen people starting them with as little as $2 million.

But affluent families on the lower end of that range also risk running afoul of the I.R.S. by being too aggressive in what they put into a partnership and how much they discount it. As families look for ways to get the most out of this year’s gift tax break, many of the advisers I spoke with said they were worried that less sophisticated families would be misled into thinking that they could put everything they had into a family limited partnership and never worry about taxes.

Jason Cain, a director in the family wealth group at Credit Suisse Private Bank, said less affluent families — usually those with $10 million or less — had misused these partnerships. “The I.R.S. has been very selective in litigating only the most egregious scenarios,” he said. “They have gone after $6 million families that put all of their assets into a family partnership and then treated it as their checking account.”

G. David Hamar Jr., co-chairman of the family office services group at Silvercrest Asset Management, said he, too, had seen people misusing these partnerships by doing things like putting their primary residence into one and continuing to live there rent-free.

But he said the hurdle for any family was having a legitimate business purpose for setting up one of these partnerships. Many of the cases that the I.R.S. has questioned have partnerships set up to avoid estate taxes, Mr. Hamar said. “Highly liquid assets have been transferred in, and then the gifting is done on the deathbed, and they send out the discounted assets.”

(Mr. Cain added that using these partnerships to keep a family together could be a bad idea. “Families should be together because they want to be together, not because Grandpa decided there was going to be a family investment that could never be liquidated and everyone had to stay together,” he said.)

Still, in a year when the gift tax break will be on many people’s minds, many affluent families are going to find themselves talking about family limited partnerships. The partnerships can work if approached correctly.

Browne Rice, a Texas businessman, said his extended family had reaped tremendous financial benefits from a family limited partnership that his father created in 1992. The family formed it by pulling together assets that had been placed in various trusts created when the family sold 1,750 acres of land outside Houston in 1984.

Mr. Rice, who is the general partner of the partnership, said his family considered the investment vehicle immensely successful. From May 1992 to May 2011, he said, it paid out distributions worth 166 percent of what was originally put into it and still had 82 percent of the principal left.

“There have been a lot of advantages for us,” Mr. Rice said. “The main advantage was we could all contribute assets to the partnership, and those assets were valued at about a 40 percent discount because everyone became a minority partner in the partnership.”

He added that after the partnership was formed, his parents continued to move their assets into it so there was little left in their estate when they died in 2005.

Yet the Rice partnership did not exist solely for tax purposes. It had a series of business interests that included mineral rights, real estate and royalties from oil and gas. It also made direct investments in small companies, including a hotel in Belize that Mr. Rice started.

Drew Kanaly, chief executive of Kanaly Trust, a Houston wealth advisory company, said that while the financial aspect was important in partnerships, handling issues unrelated to business was crucial to their success, since the shareholders were family members. “Be careful of these tax-driven decisions,” he said. “They can drive you into irrevocable decisions that you later on regret.”

Drew Kanaly’s father, Deane, who worked with Mr. Rice’s father, left the family trust company to him and his two brothers. One, Jeff, is the vice chairman of the firm and another brother, Steve, worked there from the 1970s until his death two years ago. Now, the family is working to ensure that the next generation is prepared to keep running it.

“Getting to the third generation is really tough,” Drew Kanaly said. “You can put the structure in place, but you have to make sure that everyone’s orientations and expectations are set for it. There is no guarantee that you’ll have leadership from the third generation.”

Mr. Rice said he and his siblings rarely struggled over the investment decisions they made as a family, but he knows they were fortunate. At 67, though, he said there were challenges ahead. One sister has no children, and he and his other sister and brother have seven among them. His wife is also not the mother of his two girls.

“It’s easy to keep it equal among the four siblings,” he said. “Beyond that, it gets much more complicated.”

Jeff Kanaly said that his own family had relied on advisers to help them realize that business decisions often had to trump family interests.

“We had issues that kept coming up,” he said. “We had a consultant who told us, ‘We’re going to take those issues and put them in a special place, and we’re going to call it the swamp.’ Going there only creates frustration, and it doesn’t solve what we’re trying to solve.”

Staying out of the swamp is not easy for any family. But when these partnerships work, they keep relatives focused on the investments and not on who was given a nicer car at age 16.

A general partner of a New York-based family partnership — who asked to be anonymous so as not to cause problems in his family — said he was grateful that the current and junior generations consisted of only 12 people. This man, whose family’s money goes back to a previous Gilded Age, said he saw the partnership as a tool to teach the younger generation about wealth as much as to get better money managers.

“You have to learn to sit down and make decisions for the greater good,” he said. “We’ve heard stories about families battling over Uncle Harry’s silver. We’ve gotten that stuff out of our system. Our shared economic interest has kept us together.”

That is when family partnerships can succeed. Mr. Hamar said he equated them to family foundations. “If it works, it can keep kids talking and have some connection to their family heritage,” he said. “It can keep them together.”

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  • A reporter and editor, Robert Frank is a leading authority on the American wealthy for CNBC.