Strategic Integration of Family Limited Partnerships and Family Offices: Maximizing Tax Efficiency and Wealth Preservation
The Rundown
High net worth families face increasing IRS scrutiny of family wealth structures, threatening both estate tax planning benefits and income tax deductibility of professional fees.
Strategic integration of Family Limited Partnerships with family office structures using the findings from recent court cases creates defensible structures that maximize both estate and income tax efficiencies.
Placing independent professionals in leadership positions while maintaining separation between family office ownership and managed assets not only strengthens tax positions but also creates opportunities to deduct previously non-deductible investment expenses.
Optimizing Generational Wealth Transfer: Strategic Applications
Family Limited Partnerships (FLPs) represent a cornerstone of advanced estate planning, enabling high net worth individuals to maximize wealth preservation across generations through strategic mitigation of gift and estate tax liabilities. Effective wealth structuring requires balancing estate tax efficiency with operational functionality while maintaining compliance amid increasing IRS scrutiny.
The tax planning opportunities available through properly structured FLPs are extensive. Some notable examples include:
applying valuation discounts to partnership interests,
utilizing lifetime gifting to reduce the overall transfer tax burden compared to transfers made at death (see detailed analysis here),
implementing estate freeze techniques such as GRATs, preferred partnerships, and installment sales to intentionally defective grantor trusts (see detailed analysis here),
and making gifts of FLP ownership interests to dynasty trusts and trusts domiciled in states without income taxation.
While estate tax planning remains the primary motivation behind FLP formation, combining these structures with a family office creates significant income tax advantages that preserve current wealth, enhance family governance, educate future generations, and strengthen the foundation of estate planning techniques. These income tax benefits preserve additional cash flow through tax reduction, creating more transferable wealth for future generations while simultaneously reinforcing the tax position against potential IRS challenges.
Two principal income tax advantages emerge:
SALT Deduction Maximization: FLPs can maximize deductions related to state and local taxes—otherwise limited to $10,000 under the Tax Cuts and Jobs Act—by electing into state-level SALT workaround programs for pass-through entities.
Business Expense Deductibility: When structured alongside a family office, FLPs potentially allow for the deduction of professional fees that would otherwise be nondeductible under the TCJA provisions effective since 2018.
High net worth individuals typically incur substantial professional expenses, including investment management, accounting, and legal fees. The TCJA eliminated deductions for investment-related expenses while business-related expenses remain deductible. Establishing a family office in conjunction with an FLP can, under appropriate circumstances, recharacterize these fees as deductible business expenses rather than nondeductible investment expenses.
While FLPs and family offices serve distinct primary functions, their strategic integration creates powerful synergies for tax efficiency and operational legitimacy. Given heightened IRS scrutiny under IRC §2036 and §162, proper structuring of these entities is essential. This integrated approach creates a more robust estate and income tax strategy while effectively mitigating risks of regulatory challenges.
Intersection of FLPs and Family Offices: A Strategic Alignment
Recent court cases, notably Estate of Powell v. Commissioner and Cahill v. Commissioner, underscore the IRS's intensified scrutiny of Family Limited Partnerships. This scrutiny particularly targets arrangements where retained control over partnership assets triggers estate inclusion under §2036—effectively negating the intended tax benefits by subjecting previously transferred partnership interests to estate taxation upon the donor's death. Concurrently, landmark rulings such as Lender Management, LLC v. Commissioner have established valuable precedent for family office structures utilizing profits interests, creating new opportunities for business expense deductions under §162 of the Internal Revenue Code.
The deliberate integration of FLPs with professionally managed family offices presents a strategically compelling approach. A properly structured FLP demonstrates substantive business purpose and operations, while a well-established family office reinforces the essential "trade-or-business" classification required for §162 deductions—benefits otherwise unavailable for purely investment-related expenses. This synergistic arrangement creates a more defensible tax position that both minimizes estate tax exposure and enables FLP partners to secure valuable income tax deductions that would otherwise be disallowed under the Tax Cuts and Jobs Act's elimination of miscellaneous itemized deductions for investment expenses.
Critical to this strategic framework is the meaningful involvement of independent third parties and extended family members. Robust fiduciary oversight, implemented through independent management structures or participation of non-family partners, substantially strengthens the position that these entities serve legitimate business purposes beyond mere tax avoidance—a distinction increasingly vital under current IRS enforcement priorities.
IRS Scrutiny Under Sections 2036 and 162: Key Considerations
Section 2036 – Estate Tax Inclusion
Under §2036, assets transferred to an FLP may be included in a taxable estate if the IRS determines the individual retained control over those assets. Courts have consistently ruled against FLPs where control
was determined to have been effectively retained, as seen in Estate of Strangi v. Commissioner and Powell.
In Estate of Powell v. Commissioner, the Tax Court addressed a case where a decedent's son, acting under power of attorney, transferred $10 million of her assets to an FLP just one week before her death. The decedent received a 99% limited partnership interest, which the son immediately transferred to a charitable lead annuity trust.
Significantly, the court ruled that the contributed assets must be included in the decedent's gross estate under §2036(a)(2), which requires estate tax assessment on assets transferred during life but for which the donor retained the right to determine who can possess or enjoy the assets and associated income. This marked the first time the Tax Court applied this section to a scenario where the decedent held only limited partnership interests without any general partner interest. The court determined that the decedent, acting with other partners, retained the power to dissolve the partnership and reclaim her contributed assets.
The court notably declined to extend the protective precedent of Byrum, which typically shields gifted shares from estate inclusion when a donor maintains control but is bound by fiduciary duties. Instead, the court characterized these fiduciary duties as "illusory" since the son served simultaneously as the decedent's attorney-in-fact, creating an inherent conflict. Further weakening the taxpayer's position, the court emphasized that the FLP conducted no meaningful business operations, functioning merely as an investment vehicle for the family.
Section 162 – Deduction of Business Expenses
On the income tax front, §162 permits business deductions, but the IRS has challenged whether family offices qualify as trade or business entities. The Lender case confirmed that a family office can be a business if it actively manages assets for multiple family members and follows a formalized structure. However, the Hellmann case illustrated the IRS's skepticism when family members own both the management entity and the assets under management.
For high-net-worth families, properly classifying expenses under §162 is critical. The Tax Cuts and Jobs Act of 2017 significantly limited §212 deductions, which previously allowed taxpayers to deduct investment expenses. Currently, §212 investment-related deductions are suspended through 2025, and likely to be extended further in a 2025 reconciliation bill, making the distinction between a trade or business under §162 and an investment activity under §212 more important than ever. If expenses are classified as §212 investment expenses, they are largely disallowed under current law. By contrast, qualifying under §162 allows family office expenses to be fully deductible as ordinary and necessary business expenses. The difference in classification can dramatically impact a family's overall tax liability.
The IRS has focused its scrutiny on this distinction, as demonstrated by the contrasting outcomes in Lender and Hellmann. Both cases featured family offices organized as LLCs with partnership tax treatment that provided investment management services. Each family office received profits interests as compensation. Both faced scrutiny regarding whether their activities constituted a legitimate "trade or business" under §162 rather than mere personal investment management under §212.
The Ownership Overlap Test
The fundamental difference—and the IRS's focal point in Hellmann—was the degree of ownership overlap between the management entity and the managed investments.
In Lender, the family office was predominantly owned (99%) by one son through a trust, with another son holding 1%. Crucially, this ownership structure remained largely distinct from the three investment LLCs (i.e., the FLPs) the family office managed, which were owned by extended family members. The 99% owner of the family office held less than 4% in one FLP and less than 10% in another. The Tax Court specifically noted that "Most of the assets under management were owned by members of the Lender family that had no ownership interest in Lender Management (the family office)."
By contrast, in Hellmann, four family members equally co-owned the family office (GFM) while simultaneously constituting—through their trusts—the primary owners (99%) of the six investment partnerships (i.e., the FLPs) GFM managed. The IRS maintained that this substantial overlap essentially meant GFM was managing its owners' personal investments.
The Lender case concluded favorably for the taxpayer, with the Tax Court affirming the family office's trade or business status under §162. The court's reasoning highlighted that Lender Management provided services primarily benefiting clients other than itself, with active investment management and compensation reflecting more than mere investment returns.
Though Hellmann settled before judicial resolution, the IRS's summary judgment motion revealed its position that the structure more closely resembled self-directed investment management due to the ownership overlap. The Tax Court itself questioned the comparison to Lender and requested further factual development.
Lender succeeded in demonstrating authentic business relationships between the family office and the FLPs. Family investors expected professional-caliber services comparable to hedge fund management, and their ability to withdraw investments indicated independent client status rather than unified economic interests.
In Hellmann, the IRS challenged the economic substance, noting that aligned ownership and profit allocation suggested the family was essentially reimbursing itself for services—undermining the premise that the family office functioned as a genuine profit-seeking enterprise.
These cases illustrate the emergence of what might be termed an "ownership overlap test" in the IRS's analysis of family office structures. Lender demonstrated sufficient separation between management ownership and managed assets, while Hellmann raised red flags through significant ownership alignment. This distinction has become instrumental in determining whether family office expenses qualify for business deductions under §162 rather than facing the limitations imposed on personal investment expenses.
A Trap For The Unwary – Inadvertent Application of the Investment Company Rules
When investors contribute appreciated assets to a partnership or LLC taxed as a partnership, they typically avoid recognizing taxable gain or loss on the transfer. However, pursuant to IRC Section 721(b) a significant exception arises when the receiving entity qualifies as an investment company and the contribution results in portfolio diversification. In such cases, partners must recognize the built-in gain on their contributions, potentially creating an unexpected tax liability at formation.
Under IRC Section 351(e)(1) and the corresponding regulations, a transfer creates an investment company if it results in diversification of any partner's interests and the receiving entity qualifies as an investment company. An entity qualifies as an investment company when more than 80% of its assets consist of cash, stocks, securities, or certain other specified investments, including interests in regulated investment companies (RICs) or real estate investment trusts (REITs).
However, even if a partnership meets investment company criteria, partners can avoid recognizing taxable income on contributed appreciated property if they don't diversify their investments. Treas. Reg. Section 1.351-1(c)(5) states that no diversification occurs if partners contribute identical portfolios. Moreover, when non-identical assets comprise an insignificant portion of total contributions, they will be disregarded for purposes of the diversification analysis. In this case, no diversification occurs for purposes of triggering the rules requiring the recognition of gain. For instance, if partners Avery and Taylor each contribute $10,000 in identical securities while partner Jen contributes $200 in different securities, that third contribution would be disregarded, resulting in no recognition of gain.
The IRS also scrutinizes multi-step transactions designed to avoid gain recognition. If a transfer is part of a broader plan to achieve tax-free diversification—including through delayed subsequent transfers—the original transfer will be treated as a diversification event, regardless of whether each step individually qualifies for nonrecognition treatment.
Another exception to the investment company rules requiring the recognition of gain provides that partners contributing already-diversified portfolios will not trigger gain recognition. Under Treas. Reg. Section 1.351-1(c)(6)(i), a portfolio qualifies as diversified when it meets both:
- The 25% test: No single issuer's securities exceed 25% of portfolio value; and
- The 50% test: No five issuers' securities exceed 50% of portfolio value.
For example, a portfolio with equal amounts in 10 different companies passes both tests, as each holding represents 10% (below 25%), and any five holdings total only 50%. Government securities receive special treatment - they count toward total assets but don't count as a single issuer, allowing unlimited government holdings without triggering gain recognition, provided they weren't acquired solely to avoid these rules.
Best Practices for Structuring FLPs and Family Offices
Governance Best Practices
Establish Independent Oversight: Implement robust fiduciary oversight through independent management structures or participation of non-family partners.
Avoid Conflicting Roles: Prevent senior family members from simultaneously serving as general partners in the FLP and holding power of attorney over family assets.
Formalize Decision-Making: Create an independent board or advisory committee to ensure true operational integrity and document decision processes.
Limit Distribution Discretion: Include specific limitations on the FLP general partner's discretionary power to make distributions.
Strategically Position Senior Family Members: Consider having senior family members avoid FLP general partner interests entirely, either by relinquishing them during their lifetimes or never holding such interests.
Operational Best Practices
Implement Active Investment Management: Document and execute investment selection, portfolio management, and asset acquisition strategies with continuity.
Maintain Strict Financial Separation: Establish dedicated accounts with meticulous record-keeping to avoid commingling personal and entity finances.
Distribute Economic Benefits Proportionally: Ensure all economic benefits flow according to ownership interests to avoid the appearance of implied agreements.
Create Service Agreements: Ensure the family office provides meaningful investment related services to the family members invested in the FLPs that are established in formal services agreements with fair market compensation structures and professional oversight.
Conduct Regular "Stress Tests": Proactively identify vulnerabilities in the structure before they become IRS challenges.
Documentation Best Practices
Maintain Comprehensive Records: Document entity formalities, including meeting minutes, resolutions, and compliance with governing documents.
Keep Accurate Financial Records: Maintain books that reflect the underlying operations and that are consistent with provisions in the entity's operating agreement.
Issue Regular Financial Statements: Routinely provide financial reports to all entity members.
Track Capital Accounts Meticulously: Maintain capital accounts in accordance with the operating agreement and governing documents with ongoing accuracy.
Document Professional Services: Maintain records of all professional services rendered and their business purpose.
Additional Strategic Benefits
Succession Planning
Family offices facilitate succession planning by helping families develop strategies for transferring wealth and control to future generations. This can involve creating family charters, investment education programs, and conflict resolution mechanisms.
Philanthropic Planning
Family offices can assist with philanthropic planning, managing charitable entities, and ensuring compliance with regulations.
SEC Registration
Family offices may need to be structured to avoid burdensome SEC registration requirements. They can qualify for a family office exemption by limiting their clients and owners to family members.
The Need for Expert Guidance
Structuring FLPs and family offices requires a careful balance of tax efficiency, operational legitimacy, and compliance with IRS guidelines. The interplay between §2036 and §162, as illustrated by recent case law, underscores the importance of maintaining both estate and income tax integrity.
For high-net-worth individuals and families, working with experienced tax and estate planning advisors is essential. A well-executed structure not only enhances tax efficiency but also ensures the long-term sustainability of family wealth. Given the complexities involved, consulting with a qualified professional to assess the best approach tailored to specific needs is highly recommended. By integrating thoughtful planning with proactive governance, families can leverage FLPs and family offices to preserve wealth, optimize tax outcomes, and navigate regulatory challenges with confidence.
As tax laws continue to evolve and IRS scrutiny intensifies, these integrated structures will likely become even more valuable. Families that establish robust, defensible arrangements now will be well-positioned to adapt to future regulatory changes while preserving their wealth transfer objectives for generations to come.
This Toplitzky&Co publication provides information and comments on tax issues and developments of interest to our clients and friends. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide tax advice. Readers should seek specific tax advice before taking any action with respect to the matters discussed herein.
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